Engineering Economic Analysis Canadian Edition

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Engineering Economic AnalysisCanadian Edition

• Chapter 15 Selection of a Minimum Attractive
  Rate of Return

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Chapter 15. . .

• defines sources of capital and costs of funds.
• selects MARR based on opportunity cost.
• adjusts MARR for risk and uncertainty.
• discusses the impact of inflation on the cost of
  borrowed funds.
• uses spreadsheets for cumulative investments and
  the opportunity cost of capital.

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Four Sources of Capital

• Internal
• Operation of the firm (retained profits and
  depreciation)
• External
• Short term banks (generally unsecured)
• Long term banks, insurance companies, pension
  funds, mortgage bonds (secured)
• Permanent sale of company stock

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Cost of Funds

• Cost of borrowed money influenced by
• Size of loan and interest rate
• Financial strength of borrower (credit history)
• Duration of loan
• Cost of capital (after taxes)
• Overall capitalization of the firm (weighted
  average)
• Interest on debt (loans and mortgage bonds) is
  tax-deductible but Dividends are not tax
  deductible

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• Cost of capital is the after-tax weighted ROR of
  borrowed funds from all sources.

Example 15-1
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Investment Opportunities

• Firms have more investment opportunities than
  individuals
• they have more money to invest
• opportunities internally than externally
• Opportunities vary by rates of return, duration,
  and uncertainty

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• Two independent aspects to investing
• Source and quantity of money
• Investment opportunities
• Generally, if the total cost of opportunities
  exceeds money available ? opportunities must be
  rejected
• Selected projects must be better than rejected
  projects.

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• The best rejected project is the best opportunity
  foregone ? opportunity cost
• Opportunity cost is the ROR of the best
  opportunity foregone.

Example 15-2
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Selecting a MARR

• MARR is generally the maximum of the
• cost of borrowed money
• cost of capital
• opportunity cost

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What is the opportunity cost of a
capitalexpenditure budget of 650,000?
Opportunity cost 14
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Adjusting MARR to Account for Risk and
Uncertainty

• What happens in the future can differ
  considerably from todays estimate?
• Risk
• Probabilities can be assigned to a set of future
  outcomes.
• Enables the use of various techniques.
• expected value and simulation
• Uncertainty
• Unable (unwilling) to assign probabilities to
  future outcomes.

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• Increase MARR to avoid marginal projects.
• Assess the projects using techniques other than
  economic analysis.

Additionally, MARR might be adjusted to reflect
imminent inflation.
Example 15-3
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Effect of Inflation on the Cost of Borrowed Money

• Nominal interest rate (long-term borrowing)
• 3 inflation rate
• Real interest rate nominal interest rate
  inflation rate
• If inflation 2
• Real cost of money (borrowers) 5
• Real return for lenders 3

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• Higher inflation ? increase in borrowing rates
• Complex relationship between interest rates and
  inflation

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Representative Values of MARR Used in Industry
In addition to these two factors,many other
factors also affect interest rates public vs.
private organization, debt/equity position, risk
posture, etc.
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Excel Spreadsheet Function

• RATE function to determine the rate of return for
  a project
• RATE (Life, Net Annual benefit First cost,
  Salvage value)