CHOOSE AMONG INVESTMENT

ALTERNATIVES
PREPARED BY: ENGR. OWEN FRANCIS A. MAONGAT
ES 123 INSTRUCTOR
 1- SETTING THE MARR
In Chapter 6 we introduced the MARR as the smallest yield rate at which a proposed investment
would be acceptable. How is this cut-off rate arrived at?
1. The MARR may be set equal to the interest rate that is available at a local savings bank or. other
institution. The MARR then becomes the "opportunity cost of money," in that it measures the
opportunity lost from not placing money in the bank.
2. For most businesses, the savings bank rate would be lower than their usual overall rate of return
on investment. Thus, the MARR is sometimes set equal to the firm's current average return on total
investment.
3. The MARR may be purposely set higher than either the bank rate on savings or the firm’s current
return on investment. It may be set according to the firm's long-range profit goals, so as to achieve a
desired future growth rate; it may be set at a high ,level to encourage the search for more profitable new
ventures; it may be chosen large to offset the high degree of risk attached to the investment.
Under option 1 and (within the law of averages) under option 2, the MARR is an attainable
rate;i.e., there are investment alternatives that actually achieve that rate. However, under option 3, the
MARR is a target rate, with no guaranteed means of realization.
• Example 9.1 The ABC Company is currently earning an average before-tax return of 25% on its total investment. The
board of directors of ABC is considering three proposals as given in Table 9-1.

• Proposal A is for a new machine that will replace one of their older, worn-out pieces of equipment; this machine is vital
to ABC's production. Proposal B is for a plant expansion. Proposal Cis for an addition to ABC's product line. There is a
high probability that this product could fail in the marketplace, resulting in the loss of most of the $50 000 initial
investment. The board feel that they would need at least a 40% rate of return on this project to compensate for its
additional riskiness. Which of these three proposals are acceptable?
• Only proposal A is acceptable (NPVA > 0).
The ROR method leads to the same conclusion: linear interpolation in
Appendix A gives

• and only i: exceeds the associated MARR. Because NPVs and NPVc, though negative, are
small in magnitude (causing i: and i; to be just under their associated MARRs), the ultimate
decisions concerning proposals B and C may have to be made on the basis of other
considerations, such as ABC's long-term product strategies and the company's ability to raise
capital. If capital is scarce, proposal A must be given the highest priority since ABC's
continued profits appear to depend on that piece of machinery.
• Example 9.2 The XYZ Company has $50 million which can be invested in
proposal A (i: = 17%) or in proposal B (iz = 29%); or else it can exercise the
do-nothing alternative and invest the $50 million in modernizing current
operations. A target MARR of 35% has been established by XYZ's
management to achieve their long-range plans and strategies. The XYZ
Company currently earns an average of 25% on its total investment in plant and
equipment, some of which is very old. Which alternative should XYZ pursue?
For the do-nothing alternative, i* = 25%; thus, none of the three
alternatives meets the desired 35% MARR. If the company is serious about the
35% MARR, then additional alternatives should be sought. Proposal B, which has
an ROR slightly better than the current average rate of return on total investment,
would clearly enhance the company's average rate of return. In addition, given
that some of the company's plant and equipment is "very old," using the available
$50 million for refurbishing this old plant and equipment might also improve the
company's average rate of return. One reasonable strategy would be to spend part
of the $50 million on new plant and equipment, and then to search for higher-
profit proposals (e.g., a 35% ROR) on which to spend the balance.
2 - PROJECT SELECTION AND BUDGET ALLOCATION

• Determining the best way to allocate a given budget among several competing projects is
a commonly encountered problem because often there are more worthwhile project
proposals and ideas than can be funded with the available monies. The solution principle
is to evaluate each project in terms of present worth or some similar measure, and to
choose that set of projects for which the sum of the measures is a maximum, subject to the
budget constraint.
• Independent Projects
Two or more proposals or projects are independent when the acceptance or rejection of any
one of them does not entail the acceptance or rejection of any other. For instance, a proposal
to air-condition the company offices and a proposal to undertake an advertising campaign
for a new product would usually be considered independent. For independent projects, the
following selection algorithm will always maximize the financial return on the available
monies.
Step 1 Compute i* for each project.

Step 2 Eliminate any project whose i*-value is less than the MARR (if no MARR exists, omit this tep).

Step 3 Arrange the surviving proposals from step 2 in descending order of i*-value.

Step 4 Select proposals from the top of this list downward, until an additional selection would exceed the
available funds or the budget.

• If, as often will be the case, some funds remain at the end of step 4, there are three options: (i) if one or
more of the remaining projects is divisible into subprojects, then these subprojects may be funded, using
the above algorithm, until the available funds are exhausted; (ii) the remaining funds may be invested in
the do-nothing alternative, at the MARR (for an attainable MARR) or at some rate less than the MARR
(for a target MARR); (iii) the remaining funds are simply "left over."
EXAMPLE 9.3 THE BK COMPANY IS CONSIDERING FIVE PROPOSALS FOR NEW EQUIPMENT, AS INDICATED
IN TABLE 9-2. EACH PIECE OF EQUIPMENT HAS A LIFE OF 100 YEARS. TREATING THAT PERIOD AS
INFINITE, THE ROR WILL BE THE INTEREST RATE AT WHICH I IS THE CAPITALIZED EQUIVALENT OF THE
PERPETUAL SERIES OF PAYMENTS R; HENCE, (7.8) GIVES THE THIRD ROW OF TABLE 9-2. THE BK
COMPANY HAS ESTABLISHED A MARR OF 11% AND HAS A BUDGET OF $325 000. WHICH PROPOSAL(S)
SHOULD THE COMPANY SELECT?
• Using the selection algorithm, we obtain the following list:

• Proposal 2 is acceptable from the standpoint of the MARR criterion, but insufficient funds
are available to include it. Thus, proposals 3, 5, and 4 are selected, and $25 000 is left
unspent from the $325 000 budget.
 MUTUALLY EXCLUSIVE PROJECTS

• A set of projects are mutually exclusive if at most one of them may be accepted. It is
thus a question of picking the single economically best project (or of rejecting them all).
For mutually exclusive projects, the selection algorithm given below will always yield
the maximum total return on the total amount invested. First, we shall need some
terminology. Let I denote the investment cost of a project, and R the measure of
revenues @resent worth, EUAS, etc.) from the project. We shall say that project 1
dominates project 2 if Il 5 I2 and Rl r Rz. Clearly, a dominated project can never be the
best of a mutually exclusive set. Further, for any two projects-a standard and a
challengeraefine the incremental rate of return of the challenger as
• Step 1 Eliminate any project whose investment exceeds the budget.

• Step 2 Arrange the surviving projects in ascending order of investment (break any investment ties arbitrarily). Now
eliminate any project that is dominated by another project; the candidates that remain will be in ascending order both of
investment and of return. Compute i* for each candidate.

• Step 3 Eliminate from further consideration any candidate having i* < MARR.

• Step 4 From the surviving candidates, select as the standard the candidate which has the smallest investment.

• Step 5 Compute the incremental rate of return of the challenger that immediately succeeds thestandard in the list of
candidates.

• Step 6 If hi* I MARR, eliminate this challenger from further consideration and repeat step 5 for the next challenger; if Ai*
> MARR, eliminate the old standard from further consideration, replace it with this challenger as the new standard, and
repeat step 5.

• Step 7 Select the one surviving candidate: it is the best alternative.

Example 9.4 the KLN company is attempting to determine the economically best size of processor machine for
their facilities. The six alternative machine sizes which are feasible are as given in table 9-3. Each machine has a
life of 100 years and no salvage value, so that i* = RII, as in example 9.3. The company has a total capita
budget of $350 000 and a MARR of 15%. Which machine should they buy?
 The extended machine is unacceptable according to step 1 of the selection algorithm, and the economy
the machine is unacceptable according to step 3. The application of steps 5 and 6 to the four surviving candidates I shown
in Table 9-4; step 7 gives Delux as the winner.
• Let us examine the logic of the selection algorithm, on the assumption that the company can realize 15%
(the MARR) by implementing the do-nothing alternative. Consider the first comparison in Table 9-4.
Super costs AI = $100 000 more than Regular, and yields AR = $11 000 more per year. If the company
chose Super, it would, in effect, be making $ 11,000 a year on a $100000 investment; that is, it would be
investing at rate mAi* = 11%, whereas it could be earning MARR = 15%. Choosing Super would thus
entail an opportunity loss of
(15% - llOh)($lOO 000) = $4000
per year
• Or, looked at in a slightly different way, if the Regular machine is purchased, at a saving of $100 000, the
company will earn $25 000 a year on the machine, plus 15% x $100 000 = $15 000 a year on the do-
nothing alternative. This is a total annual return of $40 000 on a total investment of $200 000. The same
total investment in the Super machine will earn only $36 000 a year. In this first comparison, it so
happens that the economically superior machine has the larger i*-value. Note however, that the eventual
winner, Delux, has a smaller i*-value than Regular. As we have seen, when purchase prices differ, a mere
comparison of i*-values is not decisive; one must also consider what will be done with any funds left
over from the purchase of the cheaper machine.
 OTHER INTERRELATIONSHIPS BETWEEN PROJECTS
• A project may be contingent upon some other project, in the sense that the acceptance or
rejection of one may result in the corresponding acceptance or rejection of the other. For
example, the purchase of a new computer storage disk may be contingent on the purchase
of a new computer.
• Some projects may be joint, in that either both are accepted or both are rejected. For
instance, though they may be purchased separately, the tractor and trailer of a rig for
highway hauling of steel are normally joint items. Some projects may be financially
interdependent; i.e., approval of one exhausts the available funds and thus precludes
approval of the other.
• Joint projects should be treated as a single, total project or investment. Contingent
projects should be evaluated both jointly and separately. The basic investment should first
be evaluated alone. The contingent items should then be brought in and their effect on the
total investment evaluated. Financial interdependences are usually resolved by
considering the irreducibles, those factors to which a dollar value cannot be attached.
 EXAMPLE 9.5 WHICH PROJECT(S) IN TABLE 9-5 SHOULD BE APPROVED, IF THE
BUDGET IS $150 000 AND THE MARR IS 15%?

• This is an instance of financial interdependence. Because of the $150 000 budget, selecting project A an
either B, C, or D precludes selecting any others; selecting E precludes selecting any others; and selecting
B and C and D precludes selecting any others. Thus, there are five alternatives (investment portfolios),
each representing a total investment of $150 000 and each with an ROR of 20%. The choice among them
must be made on the basis of the intrinsic characteristics of the projects, the need for a diversified
portfolio, and other irreducible factors.
 3 - THE REINVESTMENT FALLACY

• It is implicitly assumed in the NPV, EUASIEUAC, and ROR methods that any cash
inflows generated by an investment are reinvested, at the rates MARR, MARR, and i*,
respectively. If such an assumption does not hold, and if the assets being compared have
unequal service lives, fallacious results may be obtained.
 EXAMPLE 9.6 CONSIDER TWO COMPETING PROJECTS, FOR WHICH MARR = 16%:

• Here, C is the initial investment, A is the annual net cash inflow, and n is the service life of the asset. The ROR method
yields:
• Hence, according to the MARR, project A is acceptable and project B is not. However, suppose that the
cash flows can be reinvested at 25%, compounded annually. Thus, the $23 000 annual cash inflows from
project A are actually equivalent to a future value

nine years hence, and the annual cash inflows from project B are actually equivalent to a future value

$35 000(F/A, 25%, 4) (FIP, 25%, 5) = $615 900

nine years hence. Thus (the initial investments being equal) project B is actually the preferred
alternative.
• The reinvestment fallacy can be avoided if the MARR is set at the reinvestment rate (whose value, however,
may be very difficult to predict) and if future values based on this MARR are compared, as in Example 9.6.
As for the matter of unequal lives, it can sometimes be ignored, and the NPV, EUAC, or ROR method
applied notwithstanding. For other situations, a replacement method that assumes that each asset, at the end
of its useful life, is replaced with a new asset identical in kind, may be more appropriate. This method will
be employed in Chapter 10.