1. Capital Budgeting Decisions
Lecture No. 63
Chapter 15
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th edition, © 2007

2. Example 15.11 Four Energy Saving Projects under Budget Constraints (Budget Limit = $250,000)
Investment
Annual
O&M Cost
Annual Savings (Energy)
Annual Savings (Dollars)
IRR 1
$46,800
$1,200
151,000 kWh
$11,778
15.43% 2
104,850
1,050
513,077 kWh
40,020
33.48% 3
135,480
1,350
6,700,000 CF
32,493
15.95% 4
94,230
942
385,962 kWh
30,105
34.40%
Contemporary Engineering Economics, 4th edition, © 2007

3. Contemporary Engineering Economics, 4th edition, © 2007
Marginal Cost of Capital Schedule (MCC) and Investment Opportunity Schedule (OSC)
Contemporary Engineering Economics, 4th edition, © 2007

4. Mutually Exclusive Decision Alternatives (Example 15.11)j
Alternative
Required Budget
Combined Annual Savings 1 2 A1
$(46,800
$10,578 3 A2
(104,850)
38,970 4 A3
(135,480)
31,143 5 A4
(94,230)
35,691 6
A4, A1
(141,030)
46,269 7
A2, A1
(151,650)
49,548 8
A3, A1
(182,280)
41,721 9
A4, A2
(199,080)
74,661 10
A4, A3
(229,710)
66,834 11
A2, A3
(240,330)
70,113 12
A4, A2, A1
(245,880)
85,239 13
A4, A3, A1
(276,510)
77,412 14
A2, A3, A1
(287,130)
80,691 15
A4, A2, A3
(334,560)
105,804 16
A4, A2, A3, A1
(381,360)
116,382
Best
Alt.12
Infeasible
alternatives
Contemporary Engineering Economics, 4th edition, © 2007

5. Optimal Capital Budget
Contemporary Engineering Economics, 4th edition, © 2007

6. Contemporary Engineering Economics, 4th edition, © 2007
Summary
Under conditions of capital rationing, the selection of MARR is more difficult, but generally the following possibilities exist:
Conditions
MARR
A firm borrows some capital from lending institutions at the borrowing rate, k, and some from its investment pool at the lending rate, l.
l <MARR< k
A firm borrows all capital from lending institutions at the borrowing rate, k.
MARR = k
A firm borrows all capital from its investment pool at the lending rate, l.
MARR = l
Contemporary Engineering Economics, 4th edition, © 2007

7. Contemporary Engineering Economics, 4th edition, © 2007
The cost of capital used in the capital budgeting process is determined at the intersection of the IOS and MCC schedules.
If the cost of capital at the intersection is used, then the firm will make correct accept/reject decisions, and its level of financing and investment will be optimal. This view assumes that the firm can invest and borrow at the rate where the two curves intersect.
Contemporary Engineering Economics, 4th edition, © 2007

8. Contemporary Engineering Economics, 4th edition, © 2007
If a strict budget is placed in a capital budgeting problem and no projects can be taken in part, all feasible investment decision scenarios need to be enumerated. Depending upon each investment scenario, the cost of capital will also likely change. Our task is to find the best investment scenario in light of a changing cost of capital environment. As the number of projects to consider increases, we may eventually resort to a more advanced technique, such as a mathematical programming procedure.
Contemporary Engineering Economics, 4th edition, © 2007