1. Slide Sets to © 2005 by McGraw-Hill,10-1
Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas
Executive Summary Version
Chapter 10
Making Choices: The
Method, MARR, and
Multiple Attributes

2. Slide Sets to © 2005 by McGraw-Hill,10-2
LEARNING OBJECTIVESLEARNING OBJECTIVES
1. Choose a
Method
2. Cost of capital
and MARR
3. WACC –
Weighted
Average Cost of
Capital
4. Cost of debt
capital
5. Cost of equity
capital
6. High D-E mixes
7. Multiple
attributes
8. Weighted
attribute methods

3. Slide Sets to © 2005 by McGraw-Hill,10-3
Sct 10.1 Comparing Mutually ExclusiveSct 10.1 Comparing Mutually Exclusive
Alternatives by Different Evaluation MethodsAlternatives by Different Evaluation Methods
 Different problem types lend themselves to
different engineering economy methods
 Different information is available from
different evaluation methods
 Primary criteria for what method to apply
Speed
Ease of performing the analysis
 See Tables 10-1 & 10-2 for a concise summary

4. Slide Sets to © 2005 by McGraw-Hill,10-4
Evaluation TimesEvaluation Times
 Equal lives of the alternatives
PW, AW, FW
 LCM of lives
PW approach
 Specified study period
Normally exercised in industry
 Infinity (capitalized cost)

5. Slide Sets to © 2005 by McGraw-Hill,10-5
Decision GuidelinesDecision Guidelines
 Select the alternative with:
 Numerically largest
PW, FW, or AW value
For ROR and B/C
 Apply the incremental analysis approach

6. Slide Sets to © 2005 by McGraw-Hill,10-6
Sct 10.2 MARR Relative to the Cost ofSct 10.2 MARR Relative to the Cost of
CapitalCapital
 Establishing the MARR within the enterprise
 Requires:
Cost of equity capital (cost of corporate funds)
 Cost of retained earnings included here
Cost of debt capital (cost of borrowed funds)
 Debt Capital
$$ acquired from borrowing outside of the firm
 Equity Capital
$$ acquired from the owners and retained earnings

7. Slide Sets to © 2005 by McGraw-Hill,10-7
Cost of Capital and the MARRCost of Capital and the MARR
Established MARR
is the sum of:
(expressed as a % cost)
 Cost of capital +
 Expected return +
 Risk factor
 MARR will vary
from firm to firm
and from project to
project
Cost of capital
(%) CC
Min. MARR
Expected return
(%) ER
CC + x% = ER
Established MARR
Risk factor added (R%)
ER + R%

8. Slide Sets to © 2005 by McGraw-Hill,10-8
Factors Impacting the MARRFactors Impacting the MARR
 Perceived project risk
 Higher the risk – higher the MARR for that project
 Investment opportunity
 Expansion opportunity – may set a lower MARR
 Maintain flexibility
 Tax structure
 Higher tax rate – higher MARR
 Federal reserve monetary policy – interest rates
 Limited capital
 Tighter constraints on capital – higher MARR
 Market rates of other firms
 Competitors alter their MARR - the firm could follow suit

9. Slide Sets to © 2005 by McGraw-Hill,10-9
Sct 10.3 Debt-Equity Mix and WACCSct 10.3 Debt-Equity Mix and WACC
 D/E ratio (Debt to Equity mix)
 Ex.: 40-60 DE = {40% from debt, 60% from equity}
 Weighted Average Cost of Capital (WACC)
 WACC = (equity fraction)(cost of equity capital)
+ (debt fraction)(cost of debt capital)
 Both ‘costs’ are expressed as a percentage cost
 Example: WACC = 0.6(4%) + 0.6(9%) = 7.8%
 A variety of “models” exist that will approximate the
WACC for a given firm

10. Slide Sets to © 2005 by McGraw-Hill,10-10
WACC: Example 10.3WACC: Example 10.3
Source of Capital Amount ($) Cost (%)
Common Stock $5 million 13.7%
Retained
Earnings
$2 million 8.9%
Debt from bonds $3 million 7.5%
CS = 50%; RE = 20%; Bonds = 30%
WACC = (0.50)(13.7) + (0.20)(8.9) + (0.30)(7.5) = 10.88%
This firm’s MARR must be > 10.88%
Sum: $10 million

11. Slide Sets to © 2005 by McGraw-Hill,10-11
Tax ImplicationsTax Implications
(detailed in Chapter 17)(detailed in Chapter 17)
 WACC values are computed:
Before-tax basis
After-tax basis
 After-tax WACC = (Before Tax WACC)(1- Te)
 Where Te represents the effective tax rate
composed of:
o Federal rate
o State rate
o Local rate(s)

12. Slide Sets to © 2005 by McGraw-Hill,10-12
Sct 10.4 Determining Cost of Debt CapitalSct 10.4 Determining Cost of Debt Capital
 Debt financing
 Loans (borrowing)
 $ borrowed from banks
 $ borrowed from Insurance companies, etc
 Issuance of bonds (borrowing)
Interest on loans and bonds are tax deductible in the US
Bonds are sold (floated) within a bond market by investment
bankers on behalf of the firm
Subject to extensive state and federal regulations
 Interest payments from the firm to the lenders is tax
deductible – important cost consideration

13. Slide Sets to © 2005 by McGraw-Hill,10-13
Tax Savings from Debt FinancingTax Savings from Debt Financing
 The cost of financing by debt is lower than the actual
interest rate charged because of the tax deductibility
of the interest payments
 Assume Te = the effective tax rate (%)
 Tax Savings = ($ expenses)(Te)
 Net Cash Flow = {$ expenses - $ tax savings}
 NCF = expenses (1 – Te)
 See Example 10.4

14. Slide Sets to © 2005 by McGraw-Hill,10-14
Example of Tax Deductibility ImpactExample of Tax Deductibility Impact
on Cost of Debt Capitalon Cost of Debt Capital
 Assume a loan has a 10% interest rate charged to the
borrower
 The effective tax rate is 30%
 The after-tax cost of borrowing at 10% is
(0.10)(1 – 0.30) = (0.10)(0.70) = 0.07 or 7%
Observations
 Due to tax deductibility the effective cost is 7% after tax
 Higher tax rates result in lower after-tax borrowing rates

15. Slide Sets to © 2005 by McGraw-Hill,10-15
Sct 10.5 Determination of the Cost ofSct 10.5 Determination of the Cost of
Equity Capital and the MARREquity Capital and the MARR
 Sources of equity capital
1. Sale of preferred stock (PS)
2. Sale of common stock (CS)
3. Use of retained earnings (RE)
 RE = past profits retained within the firm
 This money belongs to the owners of the firm
 Sale of new stock is handled by investment
bankers and brokerage firms – highly
regulated – charge the firm for these sales

16. Slide Sets to © 2005 by McGraw-Hill,10-16
Types of StockTypes of Stock
 Preferred Stock
A form of ownership
Pays a stated dividend per share periodically
Generally a conservative type of stock
 Common Stock
A form of ownership
Carries more risk than preferred
No guarantee of dividends to be paid

17. Slide Sets to © 2005 by McGraw-Hill,10-17
Cost of Equity CapitalCost of Equity Capital
 Cost of equity capital generally applies some
form of a dividend growth model or valuation
model
Basic model
 “g” is the estimated annual increase in
returns to the shareholders
e
1
e
first-year dividend
R expected growth rate
price of the stock
DV
R =
P
g
= +
+

18. Slide Sets to © 2005 by McGraw-Hill,10-18
Capital Asset Pricing Model -- CAPMCapital Asset Pricing Model -- CAPM
 Re for equity capital is specified by
Re = risk-free return + premium above risk-free return
Re = Rf + β(Rm – Rf)
β = volatility of firm’s common stock relative to other stocks
ο β = 1 is the norm
Rm = return on stocks is a defined market portfolio as measured
by a prescribed index
Rf = quoted US Treasury Bill rate (considered a safe investment)
(Rm – Rf) = premium paid above the safe or “risk-free” rate
 See Example 10.6

19. Slide Sets to © 2005 by McGraw-Hill,10-19
Sct 10.6 Effect of Debt-Equity Mix onSct 10.6 Effect of Debt-Equity Mix on
Investment RiskInvestment Risk
 D-E mix (Review Section 10.3)
 As the proportion of debt increasesDue to t the
calculated cost of capital tends to decrease
 Tax advantage of deducting interest
 But…..leverage offered by larger percentage of debt
capital increases the risks of funding future projects
within the company
 Too much debt is a “bad thing”
 Objective – strive for a balance between debt and
equity funding

20. Slide Sets to © 2005 by McGraw-Hill,10-20
Too Much Debt…..Too Much Debt…..
 Use of larger percentages of debt capital
increases the risk that is assumed by
Investors (owners) and
Lenders
 Over time, investor confidence in the firm may
diminish and the value of the stock could well
decline
Difficult to attract new investment funds
Lenders will charge higher and higher interest
rates to hedge the risk

21. Slide Sets to © 2005 by McGraw-Hill,10-21
Sct 10.7 Multiple Attribute Analysis:Sct 10.7 Multiple Attribute Analysis:
Identification and Importance of Each AttributeIdentification and Importance of Each Attribute
 Refer back to Chapter 1 and
7-steps in Figure 10-5
 Up to now we have focused on one attribute
of a decision making problem
Economic attribute!
 Complex problems possess more than one
attribute
Multiple attribute analysis is often required
Quantitative attributes
Subjective attributes

22. Slide Sets to © 2005 by McGraw-Hill,10-22
Identification of Key AttributesIdentification of Key Attributes
 Must ID the key attributes
Comparison
Input from experts
Surveys
Group discussion
Delphi methods
 Tabulate and then agree on the critical mix of
subjective and objective attributes

23. Slide Sets to © 2005 by McGraw-Hill,10-23
Importance of Each AttributeImportance of Each Attribute
 Determine the extent of importance of each
attribute
Implies some form of weighting – wi
Given m attributes we want:
1
1.0
m
i
i
W
=
=∑
Value ratings Vi j
Tabular format of attributes
vs. alternatives
Weights for each
attribute

24. Slide Sets to © 2005 by McGraw-Hill,10-24
Weighting MethodologiesWeighting Methodologies
 Equal Weighting
 All defined attributes are assigned equal weights
 Default model
 May or may not be appropriate
 Rank Order
 m attributes are ranked in order of increasing importance (1
= least important; 2, 3, ….)
 Weighted Rank Order
 m attributes ranked in order of importance and apply:
1
i
i m
i
i
s
W
s
=
=
∑

25. Slide Sets to © 2005 by McGraw-Hill,10-25
Value Rating of AttributesValue Rating of Attributes
 Each alternative is assigned a value rating – Vij
for each attribute i
Can apply a scale of 0-100
Can apply a Likert Scale
4-5 graduations (prefer an even number of choices)e.g.
o Very Poor
o Poor
o Good
o Very good
See Table 10.4

26. Slide Sets to © 2005 by McGraw-Hill,10-26
Sct 10.8 Evaluation Measure for MultipleSct 10.8 Evaluation Measure for Multiple
AttributesAttributes
 Weighted Attribute Method
 Selection guideline
Choose the alternative with the largest Rjvalue
 Assumes increasing weights mean more important
attributes
Increasing Vij mean better performance for a given
alternative
 See Example 10.10
1
n
j i ij
j
R WV
=
= ∑

27. Slide Sets to © 2005 by McGraw-Hill,10-27
Chapter SummaryChapter Summary
 Best methods for economic evaluation
PW and AW at the stated MARR
 Public projects
Use the B/C ratio
 The interest rate used is based upon the cost
of capital, mix between equity and debt, and
risk levels
 Multiple attributes incorporate more than
objective measures and permit the
incorporation of criteria that is not totally
economic based

28. Slide Sets to © 2005 by McGraw-Hill,10-28
Chapter 10Chapter 10
End of SetEnd of Set