Chapter 0 Makng Choces: The Method, MARR, and Multple Attrbutes INEN 303 Sergy Butenko Industral & Systems Engneerng Texas A&M Unversty Comparng Mutually Exclusve Alternatves by Dfferent Evaluaton Methods Dfferent problem types lend themselves to dfferent engneerng economy methods Dfferent nformaton s avalable from dfferent evaluaton methods Prmary crtera for what method to apply Speed Ease of performng the analyss See Tables 0- & 0-2 for a summary 2 Evaluaton Tmes Decson Gudelnes Equal lves of the alternatves LCM of lves Specfed study perod Infnty (captalzed cost) Select the alternatve wth: Numercally largest PW, FW, or AW value For ROR and B/C Apply the ncremental analyss approach 3 4 MARR Relatve to the Cost of Captal Establshng the MARR wthn the enterprse requres: Cost of equty captal (cost of corporate funds) Cost of debt captal (cost of borrowed funds) Debt Captal $$ acqured from borrowng outsde of the frm Equty Captal $$ acqured from the owners and retaned earnngs Cost of Captal and the MARR Establshed MARR s the sum of: (expressed as a % cost) Cost of captal + Expected return + Rsk factor MARR wll vary from frm to frm and from project to project Establshed MARR Mn. MARR ER + R CC + ER Rsk factor added (%) R Expected return added (%) ER Cost of captal (%) CC 5 6
Factors Impactng the MARR Perceved project rsk Hgher the rsk hgher the MARR for that project Investment opportunty Expanson opportunty may set a lower MARR Tax structure Hgher tax rate hgher MARR Lmted captal Tghter constrants on captal hgher MARR Market rates of other frms Compettors alter ther MARR - the frm could follow sut Debt-Equty Mx and WACC D/E rato (Debt to Equty mx) Ex.: 40-60 DE = {40% from debt, 60% from equty} Weghted Average Cost of Captal (WACC) WACC = (equty fracton)(cost of equty captal) + (debt fracton)(cost of debt captal) Example: WACC = 0.4(4%) + 0.6(9%) = 7.8% A varety of models exst that wll approxmate the WACC for a gven frm 7 8 WACC: Example 0.3 Source of Captal Amount ($) Cost (%) Common Stock $5 mllon 3.7% Retaned Earnngs $2 mllon 8.9% Debt from bonds $3 mllon 7.5% CS = 50%; RE = 20%; Bonds = 30% WACC = (0.50)(3.7) + (0.20)(8.9) + (0.30)(7.5) = 0.88% Ths frm s MARR must be > 0.88% Tax Implcatons (Detals n Chap.7) WACC values are computed: Before-tax bass After-tax bass After-tax cost of debt = (before-tax cost)(- T e ) Where T e represents the effectve tax rate composed of: Federal rate, State rate and Local rate(s) 9 0 Determnng Cost of Debt Captal Debt fnancng Loans Issuance of bonds Interest on loans and bonds are tax deductble n the US Interest payments from the frm to the lenders s tax deductble mportant cost consderaton Tax Savngs from Debt Fnancng The cost of fnancng by debt s lower than the actual nterest rate charged because of the tax deductblty of the nterest payments Assume T e = the effectve tax rate (%) Tax Savngs = ($ expenses)(t e ) Net Cash Flow = {$ expenses - $ tax savngs} NCF = expenses ( T e ) 2
Example of Tax Deductblty Impact on Cost of Debt Captal Assume a loan has a 0% nterest rate charged to the borrower The effectve tax rate s 30% The after-tax cost of borrowng at 0% s (0.0)( 0.30) = (0.0)(0.70) = 0.07 or 7% Observatons Due to tax deductblty the effectve cost s 7% after tax Hgher tax rates result n lower after-tax borrowng rates 3 4 Determnaton of the Cost of Equty Captal and the MARR Sources of equty captal. Sale of preferred stock (PS) 2. Sale of common stock (CS) 3. Use of retaned earnngs (RE) RE = past profts retaned wthn the frm Ths money belongs to the owners of the frm Types of Stock Preferred Stock: stock n a corporaton whch gves the shareholders prorty n payment of dvdends at a fxed rate (and dstrbuton of assets n case of dssoluton of the corporaton) over owners of "common" stock. Whle the assurance of frst chance at profts s a psychologcal and real beneft, preferred stock shareholders do not partcpate n hgher dvdends f the corporaton makes large profts, and usually cannot vote for drectors. Common Stock: stock n a corporaton n whch dvdends are calculated upon a percentage of net profts, wth dstrbuton determned by the Board of Drectors. Usually holders of common stock have votng rghts. The common shareholders gamble on hgher profts, and collectvely have votng control of the corporaton. 5 6 Cost of Equty Captal For preferred stock, R e = (fxed percentage of orgnal stock prce.e fxed dvdend) / (orgnal stock prce - dscount) For common stock, a dvdend growth model (valuaton model) s used Basc model frst-year dvdend R e = + expected growth rate prce of the stock DV R e = + g P g s the estmated annual ncrease n returns to the shareholders Captal Asset Prcng Model -- CAPM Cost of equty captal from common stock, R e = rsk-free return + rsk-premum R e = R f + β(r m R f ) β = volatlty of frm s common stock relatve to other stocks (β = s the norm) R m = return on stocks n a defned market portfolo as measured by a prescrbed ndex R f = quoted US Treasury Bll rate (consdered a safe nvestment) (R m R f ) = premum pad above the safe or rsk-free rate 7 8
Effect of Debt-Equty Mx on Investment Rsk As the proporton of debt ncreases calculated cost of captal tends to decrease Due to tax advantages of debt captal But..leverage offered by larger percentage of debt captal ncreases the rsks of fundng future projects wthn the company Too much debt s a bad thng Objectve strve for a balance between debt and equty fundng Read Secton 0.6 9 20 Too Much Debt.. Use of larger percentages of debt captal ncreases the rsk that s assumed by Investors (owners) and Lenders Over tme, nvestor confdence n the frm may dmnsh and the value of the stock could well declne Dffcult to attract new nvestment funds Lenders wll charge hgher and hgher nterest rates to hedge the rsk Multple Attrbute Analyss: Identfcaton and Importance of Each Attrbute Refer back to Chapter and 7-steps n Fgure 0-5 Up to now we have focused on one attrbute of a decson makng problem Economc attrbute! Complex problems possess more than one attrbute Multple attrbute analyss s often requred Quanttatve attrbutes Subjectve attrbutes 2 22 Identfcaton of Key Attrbutes Must ID the key attrbutes Comparson Input from experts Surveys Group dscusson Delph methods Tabulate and then agree on the crtcal mx of subjectve and objectve attrbutes Importance of Each Attrbute Determne the extent of mportance of each attrbute Imples some form of weghtng w Gven m attrbutes we want: m W =.0 Weghts for each attrbute = Value ratngs V j Tabular format of attrbutes vs. alternatves 23 24
Weghtng Methodologes Equal Weghtng All defned attrbutes are assgned equal weghts Default model May or may not be approprate Rank Order m attrbutes are ranked n order of ncreasng mportance ( = least mportant; 2, 3,.) W = /(+ +m) Weghted Rank Order m attrbutes ranked n order of mportance scores s s W = m s = Value Ratng of Attrbutes Each alternatve s assgned a value ratng V j for each attrbute Can apply a scale of 0-00 Can apply a Lkert Scale 4-5 gradatons (prefer an even number of choces)e.g. Very Poor (0-2) Poor (3-5) Good (6-8) Very good (7-0) 25 26 Evaluaton Measure for Multple Attrbutes Weghted Attrbute Method For alternatve j, R j = Sum{=..m} W V j Check equaton [0.] p369. Is t correct? Selecton gudelne Choose the alternatve wth the largest R j value Assumes ncreasng weghts mean more mportant attrbutes Increasng V j mean better performance for a gven alternatve 27 28 Chapter Summary Best methods for economc evaluaton PW and AW at the stated MARR Publc projects Use the B/C rato The nterest rate used s based upon the cost of captal, mx between equty and debt, and rsk levels Multple attrbutes ncorporate more than just economc measures and permt the ncorporaton of crtera that are not quanttatve 29