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Module 7: Incremental Method

SI-4251 Ekonomi Teknik


Muhamad Abduh, Ph.D.
Outline Module 7
 MARR
 Incremental Analysis

7-2 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


The Minimum Attractive Rate of Return
 The Minimum Attractive Rate of Return (MARR) is the
rate at which an entity can always invest. MARR is set as
the result of a policy decision by the entity, which
represents the entity’s profit objective.
 MARR is set a based on entity’s view of future
opportunities along its financial situation:
 MARR too low  may allow proposal that is marginally
productive or result in a loss.
 MARR too high  may result in rejecting investment that
would have good returns.

7-3 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Establishing MARR
 An entity (corporation) accumulates funds (capital) by means
of two sources: debt financing, equity financing, or the mix of
the two
 Debt financing refers to capital borrowed from other party
that will be paid back at stated interest by a specific date.
 No direct risk involving the lender on repayment of funds and
interest, or profits resulting from the funds
 (short, medium, long) terms loans, bonds, mortgage
 Capital financing represents capital owner by the corporation
used to generate revenue.
 Sales of common or preferred stocks for public corporations
 Own money for private companies
 Retained earning

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Establishing MARR
 For capital budgeting and alternative evaluation MARR (the cost of capital)
is set calculated independently for each type of financing
 The interest rate paid for (cost capital) for mixed financing is calculated
from weighted proportion of source of financing
 Weighted Average Cost of Capital:

WACC = (equity fraction) x (cost of equity capital) +


(debt fraction) x (cost of debt capital)
Example:
A company is deciding to increase its capital in order to finance an alternative
investment. With a 40-60 D-E mix with debt costing 8.5% and equity costing
10%, calculate WACC.

WACC = (40%)(8.5%) + (60%)(10%) = 9.4%

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Establishing MARR
 MARR is then set based on that cost, which reflects the
view and/or preference of the entity (corporation)
toward alternatives of investment
 The MARR varies from one alternative to another,
because of:
 Project risk  which should return higher that MARR
 Sensitivity of project area  lowering MARR in one area may
provide incentive to encourage investment in other area
 Tax structure  tax adds to the reduction of net income
 Capital-financing method  demand – supply for capital
 Rates used by other firms (competitors) 

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Incremental Analysis
 With respects to MARR, where unlimited investment
opportunities yielding return at the MARR is extended into
the future, it can be assumed that the proceeds produced by
the current investments can be invested at the minimum
attractive rate of return.
 The decision for selection of alternatives is based on the
analysis of the difference between mutually exclusive
alternatives.
 The incremental investment analysis considers all feasible
alternatives (that is yielding return > MARR), starting from the
least cost investment.

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Incremental Analysis
Fund of $ 1,500,000 is available for investment. MARR is set at 15%
 Alternative P: investment $ 1,000,000 @ 21% return
 Alternative Q: investment $ 1,400,000 @ 18% return
 Alternative R: investment $ 1,250,000 @ 20% return

Yield Remaining Yield Total Return


Investment
Alternative Rate Return Fund Rate Return Yield RoR
($ K)
(%) ($ K) ($ K) (%) ($ K) ($ K) (%)
P 1,000 21 210.0 500 15 75.0 285.0 19.0
Q 1,400 18 252.0 100 15 15.0 267.0 17.8
R 1,250 20 250.0 250 15 37.5 287.5 19.2

7-8 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Incremental ROR – Net Cash Flow Tabulation
 Rate of return can be calculated from cash flow tabulation of
individual alternative.
 Selection of alternatives is done by sequential comparison of
two alternatives, starting from the lowest to the next higher
initial investment. For positive cash flow, start with “do
nothing” alternative
 Net cash flow (difference between two cash flow) is to be
used to calculate incremental ROR

Net cash flow = cash flow B - cash flow A = 0  iAB

7-9 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Incremental Investment:
Net Cash Flow Tabulation

Cash Flow A Cash Flow B Cash Flow (B-A)


Initial cost - 125,000,000 - 157,750,000 -32,750,000
End of year 1 -9,800,000 +2,800,000 12,600,000
End of year 2 +21,750,000 +11,000,000 -10.750,000
End of year 3 +45,900,000 +65,500,000 19,600,000
End of year 3 +88,750,000 +82,750,000 -6,000,000
Salvage value +75,000,000 +95,000,000 20,000,000
PW C/F @ 10%

Higher initial cost

7-10 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Example
 Three alternatives investment are being considered at MARR
12%
X Y Z
Initial cost - 650,000,000 -540,000,000 -720,000,000
Yearly expenses - 135,000,000 -123,500,000 -130,000,000
Yearly revenues 330,000,000 321,000,000 357,500,000
Salvage value 45,000,000 52,000,000 202,000,000
period 5 5 5

(yearly cash flow) 195,000,000 197,500,000 227,500,000

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Solution
Y X Z
comparison “do nothing” to Y
Incremental cost, P -540,000,000
Incremental C/F, A 195,000,000
Incremental SV, SV 45,000,000
Present Worth C/F @ MARR
Incremental i*
Decision
PWNet-C/F = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0
For i = 12%  (P/A, 12, 5) = 3.6048 (P/F, 12, 5) = 0.5674
For i = 10%  (P/A, 10, 5) = 3.7908 (P/F, 10, 5) = 0.6209
For i = 15%  (P/A, 15, 5) = 3.3522 (P/F, 15, 5) = 0.4972

7-12 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Solution
Y X Z
comparison “do nothing” to Y Y to X Y to Z
Incremental cost, P -540,000,000 -110,000,000 -180,000,000
Incremental C/F, A 195,000,000 2,500,000 32,500,000
Incremental SV, SV 45,000,000 7,000,000 157,000,000
Present Worth C/F @ MARR ? ? ?
Incremental i* > 12% < 12% > 12%
Decision Select Y RetainY Select Z
PWNet-C/F = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0
For i = 12%  (P/A, 12, 5) = 3.6048 (P/F, 12, 5) = 0.5674
For i = 10%  (P/A, 10, 5) = 3.7908 (P/F, 10, 5) = 0.6209
For i = 15%  (P/A, 15, 5) = 3.3522 (P/F, 15, 5) = 0.4972

7-13 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.


Homework #7
A ready-mix concrete producer is considering to install a new mixer system:
Operating characteristics System A System B System C
Installed cost ($) 2,250,000 2,950,000 2,750,000
Annual Operating cost ($) 320,000 495,000 401,500
Annual production (cm) 10,500 21,200 19,900
Unit price ($/cm) 122.50 122.50 122.50
Overhaul cost ($/ 2 years) 220,000 245,000 295,000
Salvage value ($) 221,500 308,000 367,500
Useful life (year) 4 6 6
a) develop net cash flow tabulation
b) if the company has set MARR at 12%, which system should be installed?
c) if all alternatives are to use MARR, will you recommend otherwise?

7-14 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.