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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

MAKING CHOICES: THE


METHOD, MARR, AND
MULTIPLE ATTRIBUTES

Blank & Tarquin: 5th edition. Ch.10 Authored by Dr. Don Smith, Texas A&M University 1
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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

Learning Objectives

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10. Learning Objectives


1. How to choose an appropriate method
for the analysis.
2. How to describe the cost of capital and
relate to a proper MARR.
3. To understand the debt-to-equity mix
and the weighted average cost of
capital.

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10. Learning Objectives


4. How to estimate the cost of borrowed
(debt) capital.
5. How to estimate the cost of equity
capital.
6. Understand corporate risk with high-
debt-to-equity mixes.
7. Understand Multiattribute analysis.
8. How to apply Multiattribute analysis.

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.1
Comparing Mutually Exclusive
Alternatives By Different Evaluation
Methods

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10.1 Review of the Basic Methods

In chapters 5, 6, 7, 8, and 9:
 The basic cash flow evaluation methods
have been shown.
 Present Worth,
 Annual Worth,
 Future Worth,
 Rate of Return, and
 Benefit/Cost.
Any of the above methods, correctly
used, will result in the same outcome.

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10.1 Review of the Basic Methods

For certain problem types, one of the


previously mentioned methods is
preferred because:
 Ease of use;
 Customary based upon the industry/sector;
 Personal managerial preferences.

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10.1 Evaluation Time Period

Private Sector with costs and revenues:


 Equal or unequal lives;
 PW, AW, ROR methods are popular.
Public Sector:
 Benefit/Cost ratio;
 Generally long-life projects.

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10.1 Type of Alternative

Private Sector:
 Some cost-only types (Service-type);
 Assume any revenue cash flows are
identical for all identified alternatives.
 Mixture of costs and revenues.

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10.1 Recommended Method

Manual methods
Computer (spreadsheet models) or
specialized software specific to the
industry or sector.

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10.1 Suggested Mutually Exclusive Methods

Eval. Alt. Rec. Series to


Period Types Method Evaluate
Equal Lives Cost/Rev. AW or PW: Cash Flows
B/C(AW or PW)
Unequal Cost/Rev. & AW: B/C using CF’s or Cash
Lives Public Sect. AW Flows

Study Period Cost/Rev.: AW or PW: Updated CF


Public Sect. B/C (AW,PW) or CF’s
Long to  Cost/Rev.: AW or PW: Cash Flows
Public Sect. B/C (AW) or CF’s

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10.1 Series to Evaluate


Use the Cash Flow series or the
Incremental cash flow.
 One Alternative –
 The estimated future cash flow series.
 Present worth or Annual worth
 ROR if revenues and costs are involved.
 Two Alternatives –
 Suggest incremental analysis – use the
incremental cash flow
 If Rate of Return:
 Two or more alternatives – Must apply
incremental analysis based upon proper
rankings.
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10.1 Equivalence Relation:


Basic Relationships Are:
 Present Worth formulation
 Capitalized Cost model (present worth
type).
 Future Worth – variant of present worth.
 Annual Worth formulation
 AW is another variant of present worth;
 AW = PW(A/P,i%,n).

 AW assumes the repeatability


assumptions for alternatives with
unequal lives.

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10.1 Lives and Time Periods…


Analysis Period – n :
 Equal Lives for all alternatives, or
 Unequal lives.
 Infinity – capitalized cost problems.
Remember:

PW analysis always requires the LCM of all alternatives.


Incremental ROR and B/C methods require the LCM of
the two alternatives being compared.
AW method allows analysis over the respective
alternative lives.

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10.1 Lives: One Exception


Incremental ROR.
 If you have unequal lives and intend to

perform an incremental ROR analysis;


 Must use the LCM of the two
alternatives.
 OR,
 Impose a study period on both options
adjusting the cash flows as needed.

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10.1 Series to Evaluate


For:
 PW, AW, FW, B/C ratio, or ROR:

 Use the estimated future cash flows, or


 The incremental cash flow.

See Table 10-2 on page 336 for a complete


summary of all methods.

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10.1 Rate of Return – Special interest rate


For PW, AW, FW, the discount rate must
be specified “up front” and applied directly
as part of calculating the equivalence
relationship.
For ROR –
 One finds the i* or i* rates for the problem
initially. (Multiple roots cause problems!)
 Then, the i* rate is compared to the MARR rate
for a decision.
 The MARR is applied after the i* rate is
determined!

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10.1 Decision Guidelines


Pure Cost Problem:
 Lowest PW, AW, FW valued alternative.
Cost/Revenue:
 Highest PW, AW, FW valued alternative.
Incremental Methods:
 ROR and B/C:
 Rank appropriately first and compute the
CF.
 i* must equal or exceed the MARR value.

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.2
MARR Relative to the Cost of Capital

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10.2 Notes Regarding the MARR


For engineering economy studies, the
appropriate discount rate is one of the
most important parameters.
The firm must set the MARR relative to
the firm’s financial condition and external
factors.
Firms have to raise money for investment
purposes.
Money (investment funds) is not a free
commodity – it has a “cost.”

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10.2 Financing the Firm – Cost of Capital


Firms raise capital in the following ways:
 Sell stock – equity capital.
 Issue bonds or assume loans – debt capital
 Use retained earnings – a form of equity
capital.
Equity Capital:
 Belongs to the owners of the firm.
 The firm owns nothing – the owners “own.”
Debt Capital:
 Provided by outside agencies (Banks, etc.)
 Cost: Interest paid on the borrowed funds.
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10.2 Debt and Equity Capital


Every firm has a capital structure:
 Debt component;
 Equity component.
Each component:
 Has a cost associated with it.
 The cost is normally expressed as a percent
 Similar to an interest rate expression.
Take each source of capital:
 Compute its cost as a percent.
 Compute a weighted average cost.

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10.2 Cost of Capital: WACC


Compute the cost of:
 Debt component, and
 Equity component.
Each component then has a cost (%) so
computed.
Compute a weighted average % cost.
 Termed – The Weighted Average Cost of
Capital – WACC.
 The WACC is expressed as a %.

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10.2 Debt and Equity Capital


The WACC (once computed) forms the
basis for the establishment of the
estimated MARR that the firm requires.
The WACC is an estimate of all of the
components of the firm’s capital structure.
For sound investing, the returns to the
firm must cover at least the costs of
capital involved with investing…
 PLUS an additional % amount for:
 Required return over cost, and
 Perceived risk elements.
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10.2 Formal Definitions


Debt capital represents borrowing from
outside the company, with the principal
repaid at a stated interest rate following a
specified time schedule.
Debt financing includes borrowing via
bonds, loans, and mortgages.
Cost:
 The interest rate charged or required per dollar
utilized by borrowing.

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10.2 Debt Capital

The lender does not share in the profits


made using the debt funds;
There is risk in that the borrower could
default on part of or all the borrowed
funds.
The amount of outstanding debt financing
is indicated in the liabilities section of the
corporate balance sheet.

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10.2 Equity Capital


Equity capital is corporate money
comprised of the owners’ funds and retained
earnings.
Owners' funds are further classified as:
 Common and preferred stock proceeds, or

 Owners' capital for a private (non-stock-

issuing) company.

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10.2 Retained Earnings


Retained earnings are funds previously
retained in the corporation for capital
investment.
The amount of equity is indicated in the
net worth section of the corporate balance
sheet.
Retained earnings come from after-tax
profits retained in the firm and not
distributed as dividends to the
shareholders – belongs to the owners.

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10.2 Debt Example


A firm needs a $5,000,000 computer
system.
The firm sells bonds paying 8% to raise
the entire amount.
The cost of the $5,000,000 is then “8%.”
If this is the only activity for the time
period and a MARR is to be established,
then:
 The basis for the MARR is 8%!
 MARR will be greater than 8%, but not lower!

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10.2 Fundamental Relationship - MARR

The 8% floor is
then modified
upward by adding
additional %
increments until a
11% MARR rate is
reached.
Note the
additional
increments added
in!

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10.2 Setting the MARR


First – it is not an exact process!
MARRs will vary over time.
Within a firm, different MARRs may exist.
 New equipment investment might be set at
10%;
 Expansion projects or new products might be
set at, say, 20%.
MARRs may vary from project to project!
 Why?

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10.2 MARR’s May Vary…


Five reasons “Why.”
1. Project Risk;
2. Investment Opportunity;
3. Current Tax Structure;
4. Limited Capital;
5. Market rates at other corporations.

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10.2 Project Risk


Project risk: Where there is greater risk
(perceived or actual) associated with
proposed projects, the tendency is to set a
higher MARR.
This is encouraged by the higher cost of
debt capital for projects considered risky.
This usually means that there is some
concern that the project will not or may
not realize its projected revenue
requirements.

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10.2 Investment Opportunity


Investment opportunity: If management
is determined to expand in certain areas,
the MARR may be lowered to encourage
investment with the hope of recovering
lost revenue in other areas.
This common reaction to investment
opportunity can create havoc when the
guidelines for setting on MARR are too
strictly applied.
Flexibility becomes very important.

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10.2 Tax Structure


Tax structure. If corporate taxes are
rising (due to increased profits, capital
gains, local taxes, etc.), pressure to
increase the MARR is present.
Use of after-tax analysis may assist in
eliminating this reason for a fluctuating
MARR,
 since accompanying business expenses

will tend to decrease taxes and after-tax


costs.

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10.2 Limited Capital


Limited capital. As debt and equity capital
become limited, the MARR is increased.
If the demand for limited capital exceeds
supply, the MARR may tend to be set even
higher. (Basic supply and demand at work)
The opportunity cost has a large role in
determining the MARR actually used.

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10.2 Market Rates at Other Corporations


Market rates at other corporations. If the
MARR increases at other corporations,
especially competitors, a company may
alter its MARR upward in response.
These variations are often based on
changes in interest rates for loans, which
directly impact the cost of capital.
Plus, Federal Reserve monetary policy and
changing interest rates charged to
member banks.

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10.2 Before-Tax MARR


Assume a tax rate, Te applies (34% for
example – for most U.S. corporations).
The before-Tax MARR is defined as:

MARRafter tax
MARRBeforeTax 
1 - Tax Rate
Some firms establish the MARR (after-tax) and then compute the
before-tax MARR to apply to economic studies where tax implications
are ignored.

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10.2 MARR Example


Assume a firm is in the 40% combined
state and federal tax bracket.
The financial management of the firm
specifies that a minimum 10% after-tax
MARR is to apply.
For projects where taxes are not
considered, the after-tax MARR would
then be:
0.10
MARRBeforeTax  = 0.1667 = 16.67%
1 - 0.40
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10.2 MARR – Before and After-Tax


A before-tax MARR will always be greater
than the after-tax MARR, assuming a
positive tax rate.
For additional information…

See Chapter 17.1

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.3
Debt-Equity Mix and Weighted
Average Cost of Capital

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10.3 Debt-to-Equity Mix (D-E)


D-E relates to:
 Percentages of debt and equity financing for a
firm.
 (40-60) would imply:
 40% of the capital structure is DEBT;
 60% of the capital structure is EQUITY.
D-E values should be well managed by the
firm, or else the price of the firm’s
common stock could change downward.
 Too much debt…bad, bad…very bad!

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10.3 Funding Projects


Projects are funded from a pool of capital.
The “pool” is comprised of:
 Debt capital;
 Equity capital including Retained Earnings.
The WACC is calculated by:
(Equity fraction)(Cost (%) of equity)
+ (Debt fraction)(Cost (%) of debt).
The “weights” are the fractions of debt
and equity.

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10.3 Capital Sources


Most, if not all firms have their own mix of
capital sources.
The WACC is some value between the
costs of debt and equity amounts.
Capital Components are:
 Common Stock;
 Preferred Stock;
 Retained Earnings;
 Debt Capital.

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10.3 Specimen Cost of Capital Curve

The objective of a firm’s


financial managers is
to “manage” the D-E
mix in order to stay in
“normal operating”
ranges so as not to
depress the price of
the firm’s common
stock.
30-50% debt is
realistic for most
firms.

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10.3 Example 10.3


A firm requires $10 million to finance a
new venture.
Capital to be raised by:
 New Common stock:
 $5 million at a cost of 13.7%
 Use of Retained Earnings:
 $2 million at a cost of 8.9%
 Issue new bonds (debt)
 $3 million at a cost of 7.5%.
What is the WACC for the $10 million?

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10.3 Example 10.3: WACC Calculation


Amount Ratio Wt.
Source (millions) Of Total Cost Cost

New 5 0.50 0.137 0.0685


common
stock
Retained 2 0.20 0.089 0.0178
Earnings
New 3 0.30 0.075 0.0225
Bonds
Sum 10 1.00 --- 0.1088

WACC = 10.88%
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10.3 WACCs…
Can be computed two ways:
 Using a before-tax cost of capital, or
 After-tax cost of capital.
An after-tax calculation is preferred:
 After-tax includes the tax deductibility of the
interest on debt capital.

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10.3 After-Tax Cost adjustments


Assume an effective tax rate – Te.
The after-tax cost is:

After-tax cost = (before-tax cost)(1 – Te)

The effective tax rate is a combination of federal, state,


and local taxes, and is reduced to a single percentage – Te

See Section 17.1 on Taxes

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10.3 The Next Section…


In this section we have referenced the
various components of capital.
Each component:
 Debt,
 Equity,
 Have their own costing models used to
approximate the respective costs of capital.
The next section reviews a few basic
costing models…

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.4
Determination of the Cost
of Debt Capital

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10.4 Debt Financing


“Debt” means borrowing.
Sources:
 Loans from financial institutions, and
 Issuing (floating) bonds (IOUs).
Each of these instruments has a cost:
 That cost to the firm is the interest paid on the
loans or owed on the bonds to the bond
holders.
Interest payments are tax deductible
from the firm’s perspective.

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10.4 Tax Savings…


For corporations, interest during a tax
year is deductible from gross income in
order to compute “taxable income.”
Interest amounts paid create tax savings:
 Because the interest is tax deductible!
In general:

Tax Savings equate to:


(deductible expense)(effective tax rate)
= (expenses)(Te)

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10.4 Net Cash Flow After-Tax


Net Cash Flow After-Tax Is:

NCFAT = expenses – tax savings


=
expenses(1- Te)

Assume an effective tax rate of, say, 40%.


For every $1 of deductible expense the tax savings
equates to ($1)(Te) = ($1)(0.40) = $0.40.
So, every dollar of deductible expense saves the firm
40 cents in taxes!

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10.4 Example 10.4 (Really Good!)


Overview:
AT&T needs to raise $5 million by issuing
5,000 bonds with a face value of $1,000
each with a 10-year life.
The bonds are to be sold at a discount of
20% to aid in a faster sale.
AT&T is in a 50% tax situation (Te = 0.50)
Question?
What is the cost of debt capital before and after tax?
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10.4 Example 10.4


Bond interest:
 8% per year
 Interest is paid to the current bond holder at
the end of each year.
 Interest will equal:
 $1,000(0.08) = $80.
 AT&T pays each bond holder $80 at the end
of each year.
 The $80/bond represents interest paid by
AT&T, and
 Is tax deductible!

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10.4 Example 10.4 – Continued


Analytic set up:
Solve on a per bond basis;
Apply a Present Worth formulation;
Bond will sell for $1,000 (0.98) = $980
 Termed a “discount sale.”
 Commonly done in the financial community!

Write a PW Expression and set equal to “0.”


0 = 980 -80(P/A,i*,10) – 1000(P/F,i*,10)
Solve for i* by trial and error!
i* = 8.3%

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10.4 Spreadsheet Model: Example 10.4

=E7
=E11*(1-$B$7)

=IRR(E4:E14) =IRR(F4:F14)

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.5
Determination of the Cost of Equity
Capital and the MARR

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10.5 Sources of Equity Capital


Sale of Preferred Stock;
Sale of Common Stock;
Use (investment) of Retained Earnings.
 Remember, retained earnings represent past
after-tax profits retained in the firm;
 Represents $$ NOT distributed out to the
owners in the form of “dividends.”
 Retained earnings belong to the owners of the
firm and not the firm!

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10.5 Stock
Stock represents “ownership.”
Individuals generally buy stock in a
company in anticipation of the
appreciation of the price of the stock over
time.
Stock generally pays periodic dividends to
the current stock holder.
Dividends come from after-tax profits.

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10.5 Common Stock


Most common.
Represents voting rights for the holder.
May or may not pay any future dividends.
 Depends on whether or not the firm generates
a profit in a time period.
If the firm does well over time, the price
of a share of common stock should go up
in value, or split.

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10.5 Preferred Stock


More conservative investment than
common stock.
Carries a commitment to pay stated
dividends – if dividends are declared by
the board of directors of the corporation.
May or may not carry voting rights.
If the corporation liquidates and funds are
left over, then the preferred stockholder is
paid before a common stockholder.
 Carries a “preference.”

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10.5 Stock and Tax Savings


There are no tax savings for equity
capital.
Why?
Because the dividends paid out to the
current stockholders are NOT tax
deductible for the firm.

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10.5 Cost of Equity Capital – Preferred Stock


Cost of preferred equity is stated as a
dividend percentage.
Assume a share of stock is selling for
$200.
Assume the current dividend is $20/share
of stock.
Cost will be:
 $20/$200 = 0.10 = 10% for the Preferred
component.

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10.5 Cost of Common Stock


More difficult to estimate.
Current dividends paid (per share) is not a
good indicator of what the stock will cost
in the future.
Several “models” that are used by the
financial community:
 But, they are just “models.”
 We really do not how to precisely cost common
stock – we rely on certain models.

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10.5 Dividend Growth Model


Notation:
Let Re represent the estimated cost of
common stock.
The Dividend Growth Model is:
first-year dividend
Re   an expected growth rate.
price of the stock
DV1
Re  g [10.6]
p

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10.5 Dividend Growth Rate


The term “g” in equation [10.6] is:
 An estimate of the annual increase in returns
(dividends) the common stockholder may
receive in the future.
 “g” represents a compound growth rate the
corporation believes is required to attract
stockholders.

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10.5 Example Situation


A firm desires to start a new operation in
South America.
Sell new common stock and raise $2.5
million in equity capital.
Assume the price, p, for the stock is
$20/share:
Assume the corporation presumes that a
$1/share dividend will be paid this year,
and
 A 4%/year dividend growth rate is anticipated.

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10.5 Example:
What is cost, using the Dividend Growth
Model, for this situation?
 Calculate Re as:
 Re = 1/20 + 0.04 = 0.09 = 9%

Remember, this is only an estimate and


follows from the assumed model!

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10.5 A Second Model: CAPM


Capital Asset Pricing Model (CAPM).
Fact of Life:
 Stock prices vary over time;
 Higher returns are demanded by some
corporation’s stocks relative to other
corporations. (Expected returns vary.)
 Researchers devised what is termed a
valuation model to accommodate the
variations.

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10.5 CAPM
CAPM has two components:
1. A risk-free return,
2. A premium above the risk-free
return.
The Re using the CAPM model is:

Re  risk-free return + premium above risk-free return.


Re  R f   ( Rm  R f ) [10.7]

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Re = Rf + (Rm –Rf)
10.5 CAPM – Elements
Re = estimated cost of common stock using
the CAPM model.

 = the volatility coefficient of a


corporation’s stock relative to other stocks
in the same market.

Rm = return on stocks in a predefined


market portfolio measured by a prescribed
index.

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10.5 The Rf Term Re = Rf + (Rm –Rf)


The risk-free return – Rf:
 Normally the currently quoted U.S. Treasury
Bill rate.
 Investment in U.S. Treasury Bills is considered
one of the safest investments one can make.
 Virtually a risk-free investment.
 Backed by the good faith of the U.S.
Treasury!

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10.5 (Rm – Rf) Term Re = Rf + (Rm –Rf)

The premium paid above the safe or risk-


free rate.
The  “value”:
 Indicator of how the stock is expected to vary
(up or down) compared to some pre-selected
portfolio of stocks:
 The portfolio represents stocks in a similar
market or sector of the issuing corporation.
 Normally use the Standard and Poor’s 500
Stock Index (S&P 500).

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Re = Rf + (Rm –Rf)
10.5 The  Coefficient
The  coefficient is a multiplier.
 values range from 0 upward.
  < 1 indicates less volatility:
 Less of a premium for risk.
  > 1:
 Expect large price movements;
 Hence a greater risk premium is added.

 = 0: Risk-Free! (No risk of premium


required.)
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10.5 Expected Return Using CAPM

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10.5  Implications
High  values – higher risk premiums are
required.
A risk-free investment:
 U.S. Treasury Bills…
 Will have  values very low, or = 0.
 values are periodically published for
most publicly-held corporations.

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10.5 Example 10.6


A firm is looking at developing a new
software technology:
The firm wants to develop and market the
technology.
Must raise additional capital to accomplish
the development.
Thinking about selling new common stock to
raise the required capital.
IF the cost of new equity capital is below
15%, the firm may undertake the venture
with a new stock offering.

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10.5 Example 10.6


The firm’s historical  is 1.70
Current U.S. Treasury Bills are paying 7%.
For this type of firm and the type of
business the firm is engaged in:
 A 5% risk premium is deemed acceptable.
 Compute Re for this firm using the CAPM
model.
Re = 7% + 1.7(5%) = 15.5% > 15%.
Suggestion:
Fund with a mix of debt and equity capital.

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10.5 Setting the MARR


The MARR must cover the cost of the
committed capital to the specific
alternatives under review.
If a firm has a mixture of debt and equity,
then the WACC establishes the minimum
“floor” for the MARR.
Common Approach:
 Cost of Equity < MARR < WACC

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10.5 Another “Approach”


Some firms set the MARR:
 Above the WACC rate:
 Prevents the firm from increasing the MARR to
account for various risk levels that may be
assigned to a proposed project.
 Other firms may set the MARR, then change it
upward for a specific “high-risk” project –
termed a Risk-adjusted MARR.
There is NO universally accepted
(followed by all firms) method for setting
the appropriate MARR!

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.6
Effect of Debt-Equity Mix on
Investment Risk

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10.6 D-E Reviewed


Fundamental Rule:
 The more debt capital a firm relies on, the
levels of risk are increased for all projects the
firm may elect to undertake.
 Too much debt in the capital structure is bad!
 Too much equity can be equally bad, too!
 A healthy firm strives to achieve a reasonable
balance of debt to equity.
 This is why financial managers make big
salaries!

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10.6 Highly Leveraged Firms


Firms that engage in large debt-to-equity
positions hurt themselves.
Too much debt:
 Harder to get loans – already over-extended!
 If new loans are granted, then the loan interest
rates are increased by the lenders.
 The firm ends up owning less of itself, and
banks and lending institutions control the
destiny until the debt is retired or reduced.

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10.6 Example 10.8

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10.6 Large Debt Percentages


A firm that continues to borrow to fund
projects:
 Increases the risk taken by the lenders and
stockholders;
 Long-term confidence is eroded over time.
 The firm is headed for trouble even if the
current stock price is high.
The healthy firm maintains a reasonable
balance between debt and equity over
time! {30% - 40%}…or so.

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Tarquin Graw
Hill
CHAPTER 10

10.7
Multiple Attribute Analysis:
Identification and Importance of
Each Attribute

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10.7 Attributes of a Problem


Up to now:
 We have considered only one attribute:
 Economic
 PW, FW, AW, ROR, B/C,…
However, other attributes are present in
project analysis.
We now consider:
 Non-economic issues relating to a given problem.

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10.7 Multiple Attribute Consideration

Go back to Figure 1-1 and take another


look!

4-1 Identify the attributes for decision making.


Identify the
4-2 Determine the relative importance (weights)
selection
of attributes. criteria
4-3 For each alternative, determine each (one or more
attribute’s value rating. attributes).

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10.7 Problem Evaluation (Figure 1-1)

5. Evaluate each
5. Evaluate each alternative using a alternative:
Multiple-attribute technique. Use sensitivity
Use sensitivity analysis for key analysis.
attributes.
6. Select, then

7. Execute.

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10.7 Noneconomic Issues

Tend to be the intangibles associated with


a project assessment problem.
These elements may be virtually
impossible to assign numerical values.
 Engineers tend to go “crazy” when confronted
with non-numerical issues!

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10.7 Total Project Analysis

Objective: Make Decisions


 Hopefully – Quality Decisions!
We must then consider:
 Economic
 Other tangibles, and
 Intangibles.
Which promotes the inclusion of
MULTIPLE ATTRIBUTE Analysis.

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10.7 Attribute Identification

Key: The identification of the important


attributes of a problem.
There exist several methods for
structuring the process of identification.
 Some are better than others;
 No one widely accepted method – take you
pick, so to speak.
We summarize five approaches.

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10.7 Identification of Key Attributes

Seek inputs from others where possible.


Comparison with similar studies.
Inputs from “experts” who have the
relevant past experience.
Structured surveys from those who will be
impacted by the ultimate decision.
Small group discussions, teams, nominal
group techniques, focus groups, etc.
Apply Delphi methods.

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10.7 Delphi Method

Identify the experts in the area.


Solicit their individual opinions separately.
Evaluate the opinions and cycle back
through the same process by narrowing
down the questions.
A progressive procedure, but has to be
managed.

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10.7 United Airlines (UA) Approach

UA seeks to purchase 5 new Boeing 777s


for expanded routes to the Far East.
Boeing’s design permits approximately
8,000 options for each plane.
UA needs to determine required options
prior to contracting for the purchase.
Engineering studies reveal that about 150
options are advantageous to UA.

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10.7 UA Approach . . .

UA is faced with:
 Quantative parameters, and
 Noneconomic attributes.
UA conducts a Delphi study;
 From 25 key UA personnel,
 Along with data from recent purchases from
Boeing.
They defined 10 key attributes for options
selection.

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10.7 UA Approach . . .

Four of the 10 are:


 Repair time;
 Safety: mean time to failure of flight-critical
components.
 Economic: Revenue generated from each
option.
 Crewmember needs – pilots and flight
attendants.

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10.7 A Common Attribute: RISK

Risk is not considered a stand-alone


attribute!
Risk tends to be a part of most of the
other attributes.
Risk will never go away, but we have
methods for incorporation of risk levels
into an analysis.

See Chapters 18 and 19

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10.7 Attribute Weights

A problem can be defined in part by


identification of the important attributes of
the problem.
Some attributes may be more important
than other attributes.
We assign weights to each of the
attributes (subjective process).

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10.7 Attribute Weights . . .

A weight is a dimensionless number


between 0 and 1.
Weights are assigned by a person or
groups of individuals with knowledge of
the problem at hand.
If group weighting is applied, the group
must come to agreement as to the value of
the assigned weight.
 At times that can be difficult!

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10.7 A Tabular Approach

Assume we have “n” alternatives.


Assume “m” attributes have been
identified.
We structure a simple format (table) as
shown on the next slide.
 See Table 10-3.

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10.7 Format for Multiple Attribute Evaluation


Alternatives

Attributes Weights 1 2 3 ... n

1 W1
2 W2
3 W3 Value ratings
. . Vij
. .
m Wm

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10.7 Attribute Weights

The assigned weights, Wi, should:


 Sum to 1.00.
 Normalized weights:
m

W
i 1
i  1.00

Each attribute’s importance score is


divided by the sum S over all attributes.

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10.7 Weight Calculation

The weight calculation is:


importance scorei
Wi  m
[10.8]

 importance score
i=1
i

importance scorei
 [10.9]
S
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10.7 Methods for Assigning Weights

1. Equal Weighting.
 All attributes are assumed to carry equal
weight (not often realistic!).
2. Rank Order.
 The m attributes are first ranked in order of
perceived importance.
3. Weighted Rank Order
Place the m attributes in order of importance,
but differentiation between attributes is now
possible.

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10.7 Equal Weighting

All attributes are considered to be of equal


importance;
No rationale to distinguish the more
important attributes – if any.
Each weight will be 1/m per attribute.
Good first-start approach:
 However, in practice some attributes tend to be
more important that others.

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10.7 Rank Order

Popular Approach!
The defined attributes are ranked by the
analyst in order of increasing importance.
A score of “1” is assigned to the least
important attribute:
“m” is assigned to the perceived most
important attribute.
Weights:
 1/m, 2/m, . . . , m/m. {Consistent weighting}

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10.7 Weighted Rank Order

First – rank the attributes in order of


perceived importance.
Select the most important attribute:
 Assign it a score of, say, 100.
 Then score all other attributes a score between
0 and 100.
 The score for each attribute is denoted – si.

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10.7 Weighted Rank Order

Given the si assignments, calculate the Wi


as:
si
Wi  m
[10.10]

si 1
i This is perhaps
the best overall
method and
permits maximum
flexibility.
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10.7 The Boeing Example: Weights Assigned

Example of how weights can be determined from scores.


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10.7 Value Rating of Each Attribute – Vij’s


This is the final step in the process.
Each alternative is awarded a value rating
termed:
 V ij ;
Can apply a scale of 0 – 100;
Apply a Likert Scale approach.

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10.7 Likert Scale Approach

Scale with 4 to 5 graduations.


Example:
 [Very Poor; Poor; Good; Very good];
Or,
 A scale of [ 0 – 5] – “0” the “worst.”
 Or [ 0 – 10] – “0” the worst.
Or
 [ -1 to +1] or [ -2 to +2 ]: can yield negative
scores for really undesirable alternatives.

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10.7 Likert Scales…

Preference for use:


 Try to have 4 choices for the scale (even
number)
 This is to permit the central tendency of “fair”
to not be overrated!
 The scale [ 0 – 5 ] is fairly common along with
the [ 0 – 10] approach.
Return to the Boeing problem.
 See Table 10-4…

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10.7 The Boeing Problem – Revisited

Assume the weights have been determined


and,
A value rating score of [0 – 10] is to be
applied;
And, we have 3 competing alternative
designs for the aircraft that are to be
purchased.
Attributes are:
 Safety, Repair, Crew Needs, and Economic

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10.7 The Value Assignments: Table 10-4

Assume the evaluation team determines


on a scale of [0 – 10] the values shown in
Table 10-4 (subjective of course).

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10.7 The Boeing Problem – Revisited

Subjective score
between [ 0 – 10 ]
assigned! For A1

Computed
rank scores
for each
Alternative.

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10.7 The Boeing Problem – Review

1. These are the calculated weights:

Subjectively
assigned!
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10.7 The Boeing Problem – Values Assigned

These are the assigned [0 – 10]


subjectively assigned values to Alt. 1 for
each assigned attribute:

Attribute Weights
Alternative 1
Safety 0.500 6
Repair Time 0.250 9
Crew Needs 0.125 5
Economic 0.125 5

Sum of scores/weights 1.000 6.5

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10.7 The Boeing Problem – Max Rating

Assigned values and the ratings for each


of the three alternatives.

Alternative 1 Alternative 2 Alternative 3


6 4 8
9 3 1
5 6 6
5 9 7

6.5 4.625 5.875

Select the alternative with the highest rating score – A1

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CHAPTER 10

10.8
Evaluation Measure for Multiple
Attributes

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10.8 Scoring the Alternatives

Given m attributes and n alternatives;


With the Wi ‘s determined;
And the values – Vij ‘s assigned by the
analysts, then:
A rating score – Rj – for the j-th
alternative is determined by:n

R j  WV
i ij
j 1
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10.8 Scoring the Alternatives

The Vij ‘s are the subjectively assigned


scores to the j-th alternative for the i-th
attribute, and
Weighted by the i-th weight previously
assigned.
n
R j  WV
i ij
j 1
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10.8 Scoring the Alternatives

The rating for the j-th alternative is a


dimensionless number.
Select the alternative with the highest Rj
value.

Choose the alternative with the largest Rj value.


This measure assumes that increasing weights –
Wi mean more important attributes and increasing
ratings Vij – imply better performance of an alternative.

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10.8 Example 10.10

3 Alternatives;
6 attributes – scores shown below.
Attriibute Importance
i Score
1 50
2 100
3 100
4 80
5 50
6 70
450

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10.8 Example 10.10: Normalized Weights

Normalized weights for the 6 attributes.


Attriibute Importance Normalized
i Score Weights
1 50 0.11
2 100 0.22
3 100 0.22
4 80 0.18
5 50 0.11
6 70 0.16
Sums 450 1.00

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10.8 Example 10.10 Vij’s

Assigned values for the 3 alternatives.

Attriibute Alternative Alternative Alternative


i 1 2 3
1 75 50 100
2 60 75 100
3 50 100 20
4 100 90 40
5 85 100 10
6 100 100 75

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10.8 Example 10.10

Final Rankings: Select Alternative 2

Attriibute Importance Normalized Alternative Alternative Alternative


i Score Weights 1 2 3
1 50 0.111 8.3 5.6 11.1
2 100 0.222 13.3 16.7 22.2
3 100 0.222 11.1 22.2 4.4
4 80 0.178 17.8 16.0 7.1
5 50 0.111 9.4 11.1 1.1
6 70 0.156 15.6 15.6 11.7
Sums 450 1.00 76.6 89.1 60.7

Alternative A2 has the highest rating

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10.8 MA Approach

Flexible and popular technique;


Applied to virtually any analysis of
alternatives so long as:
 The analysts are prepared to take the time to
perform the weighting and value assignments.
 Relies on subjective judgments.

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Chapter Summary

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10. Summary

The best method to economically


evaluate and compare mutually exclusive
alternatives is usually either the AW or
PW method at the stated MARR.

The choice depends, in part, upon the


equal lives or unequal lives of the
alternatives, and the pattern of estimated
cash flows, as summarized in Table 10-1.

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10. Summary

Public sector projects are best compared


using the B/C ratio, but economic
equivalency is still AW- or PW based.
Once the evaluation method is selected,
Table 10-2 (also printed on the inside the
rear cover with section references) can be
used to determine the elements and
decision guideline that must be
implemented to correctly perform the
study.

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10. Summary

If the estimated ROR at which of the


selected alternative is needed:
 It is advisable to determine i* by using the
Excel IRR function after the AW or PW method
has indicated the best alternative.

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10. Summary

The interest rate at which MARR is


established depends principally upon:
 The cost of capital and the mix between debt
and equity financing.
 The MARR should be set at least equal to the
weighted average cost of capital (WACC).

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10. Summary

The interest rate at which MARR is


established depends principally upon the
cost of capital and the mix between debt
and equity financing.
The MARR should be set equal to the
weighted average cost of capital (WACC).
Risk, profit, and other factors can be
considered after the AW, PW, or ROR
analysis is completed, and prior to final
alternative selection.

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10. Summary

If multiple attributes, which include more


than the economic dimensions of a study,
are to be considered in making the
alternative decision:
 The attributes must be identified and their
relative importance assessed.
Then each alternative can be value-rated
for each attribute.

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10. Summary

The evaluation measure is determined


using a model such as the weighted
attribute method, where the measure is
calculated by Equation 10.11.

The largest value indicates the best


alternative given all of the subjective
inputs.

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ENGINEERING ECONOMY Fifth Edition Mc


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CHAPTER 10

End of Slide Set

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