Chapter 10

Project Financing
and Noneconomic
Attributes
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

10-1 © 2012 by McGraw-Hill All Rights Reserved

 LEARNING OUTCOMES
1. Explain cost of capital and MARR
2. Calculate weighted average cost of capital
3. Estimate cost of debt capital
4. Estimate cost of equity capital
5. Understand high D-E mix and risk
6. Develop weights for multiple attributes
7. Apply weighted attribute method to
alternative evaluations

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 Cost of Capital and MARR
Cost of capital is the weighted average interest rate paid based
on debt and equity sources

 Debt capital represents borrowing outside company

 Equity capital is from owners’ funds and retained earnings
MARR is set relative to cost of capital

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 Factors Affecting MARR
Project risk: higher risk leads to higher MARR
Investment opportunity: in order to capture perceived opportunity, MARR
may be temporarily lowered
Government intervention: gov’t actions such as tariffs, subsidies, etc.
can cause companies to raise or
lower MARR
Tax structure: rising corporate tax rates lead to higher MARR
Limited capital: as capital becomes limited, MARR increases
Rates at other corporations: competition can cause companies to
raise or lower MARR

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 D-E Mix and Weighted Average COC
Debt-to equity (D-E) mix identifies percentages of debt and
equity financing for a corporation
WACC = (% equity)(cost of equity)
+ (% debt)(cost of debt)

This figure
Illustrates WACC

If the percentage of equity capital

from each source is known,
each component of WACC
is separately calculated
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 Example: WACC Calculation
A company that specializes in producing cold-weather clothing and
accessories is expanding its ski-jacket and boot-sock manufacturing
facilities. The company plans to borrow $2.5 million at 7% interest, issue
stock worth $4 million worth at 5.9%, and use $1.5 million of retained
earnings at 5.1% to finance the project. Determine the company’s WACC.

Solution: Equity sources are stock and retained earnings

Total project cost = 4 + 1.5 + 2.5 = $8 million

WACC = 4/8(5.9% + 1.5/8(5.1%) + 2.5/8(7%)

= 6.09%

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 Cost of Debt Capital
Debt capital -- Funds received by borrowing; loans or issuance of bonds

This is important: Interest payments are tax deductible as a corporate

operating expense

Example: For a company that has an effective tax rate of 35%, the after-tax cost
of a i = 10% interest loan is, in fact, less than 10%:
i(1 – Te) = (0.10)(1 – 0.35) = (0.10)(0.65) = 0.065 or 6.5%

The general equations involved in finding the cost of debt capital are:
Tax savings = (expenses)(effective tax rate) = (expenses)(Te )
Net cash flow = expenses – tax savings = (expenses)(1 – Te )

Set up PW or AW equation of net cash flows and solve for i*

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 Example: Cost of Debt Capital

If a company borrows $50,000 at 8% per year with annual

interest only payments and a balloon of $50,000 after 5 years,
what is the after-tax cost of debt capital? Assume Te = 44%

Solution: Annual interest is 50,000(0.08) = $4000

After-tax net cash flow for interest only payment = 4000(1 – 0.44)
= $2240
0 = 50,000 - 2240(P/A,i*,5) – 50,000(P/F,i*,5)
Solve for i* i* = 4.48%
Note: This is a tax rate of 4.48% vs. the 8% rate for the loan
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 Cost of Equity Capital
Equity capital obtained from 4 possible sources:
(1) Sale of preferred stock (2) Use of retained earnings
(3) Owner’s private capital (4) Sale of common stock

Important: No tax advantage or tax savings for equity capital

Calculating the cost of different equity capital sources

For preferred stock: Cost of capital is stated dividend percentage

For retained earnings and owner’s funds: Cost is common stock cost
(next slide)

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 Cost of Equity Capital from Common Stock
Two ways to determine cost of common stock capital:
1. Valuation of common based on stock price and dividends
2. Capital asset pricing model (CAPM)
1. Valuation of common stock
Re = DV1/P) + g
Where: Re = cost of equity capital from common stock P = price of stock
DV1 = dividend in year 1 g = expected dividend growth rate
2. CAPM
Re = Rf + β(Rm – Rf)
Where: Rf = return on safe investment β = volatility of company’s
stock
10-10measured by© 2012
Rm = return on stocks indexby McGraw-Hill All Rights Reserved
 Example: Selection Based on Financing Plans
Good approach to set MARR: between corporation’s
cost of equity capital and WACC. Treat risk separately
Corporate MARR is historically set midway between cost of equity capital, which
averages 4% per year, and the WACC for a major project. A project needs $3M
start-up capital. Financing plan 1 borrows 100% lent at 0.5% per month. Plan 2
uses 50% equity and 50% borrowed funds. Which plan requires the lower
MARR?
Solution: Effective annual cost of debt capital = (1 + 0.005)12 – 1 = 0.0617
Effective annual cost of equity capital = 4%

Plan 1 – 100% debt: Plan 2 – 50% equity; 50% debt:

WACC1 = 6.17% WACC2 = 0.5(4%) + 0.5(6.17%) = 5.09%
MARR1 = 0.5(4% + 6.17%) = 5.09% MARR2 = 0.5(4% + 5.09%) = 4.55%
Plan 2 requires a lower MARR
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 Debt-Equity Mix and Risk
As proportion of debt capital increases, overall cost of capital decreases
Because interest on debt capital offers a tax advantage

Corporations that become highly leveraged (large D-E mixes) have

increased risk and more difficulty in obtaining project funding

Investors take more risk and lenders are leery to provide funds

Best: balance between debt and equity funding

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 Multiple Attribute Analysis
 Attributes other than the economic one are considered in most
alternative selections, e.g., public and service sector projects
 Steps necessary to identify and use multiple attributes are:
Identification of attributes
Determination of importance weight of each
attribute
Assignment of a value rating to each attribute
Alternative evaluation using a technique that
accommodates several attributes
Attribute identification – Some methods are:
 Comparison with similar studies that involve multiple attributes
 Input from experts
 Surveys of constituencies
 Small group discussions
 Delphi method to develop consensus
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 Sample Attributes
 Many attributes are commonly identified
 Safety
 Repair time
 Personnel needs
 Economics (used exclusively thus far to evaluate alternatives)
 Risk

Risk is a routinely identified attribute. Identification of type of risk to

consider is vital to considering it thoroughly in the evaluation. Some types of
risk are:
 Variation in specific parameters (estimate variation in n, AOC, etc.)
 Project funding (debt vs. equity capital)
 Market dynamics (effect on success of project in the future)
 Environmental impacts and government regulations
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 Importance Weight of Attributes
A weight Wi (between 0 and 1) is assigned to each attribute i to
express its extent of importance relative to other attributes
Weights are normalized to sum to 1.0 as follows:

Arrange attributes, weights, and alternatives in a table

Weights for each

attribute

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 Procedures to Assign Weights
Equal weighting – All attributes considered of equal importance
All weights are Wi = 1/m for i = 1, 2, …, m attributes

Rank order – Attributes ranked by constantly increasing importance (1 =

least, m = most important)
W1 = 1/S, W2 = 2/S, …, Wm = m/S, where S = sum of weights 1 through m

Weighted rank order – Most important attribute score is 100; others

scored between 0 and 100. Let si = score for each attribute i; weights are

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 Procedures to Assign Weights
Pairwise comparison – Attributes are compared to each other.
Importance comparison scale can be defined as follows:
0 if attribute is less important than one compared to
1if attribute is equally important as one compared to
2if attribute is more important than one compared to

Example:

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 Value Rating of Alternatives by Attribute
This step concentrates on alternatives
Each alternative is assigned a value rating for each attribute
Can apply scale of 0-10, 0-100, -1 to +1, or Likert Scale (4 or 5
graduations)

Example : 3 alternatives and 4 attributes using weighted rank order method for
attributes (0 to 100) and value ratings for alternatives (0 to 10)

Value ratings
Vij
for
attribute i and
alternative j
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 Evaluation Measure for Multiple Attributes
Weighted Attribute Method ─ A single-dimension measure to
select one alternative from several, considering multiple attributes

Where: j = 1, …, n alternatives
Rj = evaluation measure for alternative j
Wi = importance weight of attribute i
Vij = value rating of attribute i for alternative j

Selection guideline
Choose alternative with largest Rj value
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 Example: Weighted Attribute Method
Three alternative software systems are available that schedule and
dispatch long-haul trucks from warehouses to destinations. Six evaluation
attributes are of varying importance, as shown by Wi scores below. Value
ratings Vij are the average ratings of a 7-person committee. Use the
weighted attribute method to select the best system.

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 Example: Weighted Attribute Method

Use formula for Rj measure to determine:

R1 = 0.11(75) + 0.22(60) + 0.20(50) + 0.18(100) + 0.11(75) + 0.18(100) = 75.70

R2 = 87.20 Select system 2
R3 = 58.80 10-21 © 2012 by McGraw-Hill All Rights Reserved
 Summary of Important Points
Cost of capital is weighted average of debt and equity funding
There is a tax savings with debt capital because interest is
deductible; nothing is tax deductible for equity capital
High D-E mixes mean higher risk for lenders and investors;
project funding becomes more problematic
Multiple attribute analysis brings other factors (besides cost)
into the decision-making process
Four different techniques for assigning weights to attributes
Likert scale is good for assigning value ratings to alternatives
n

Multiple attribute evaluation measure is R j   WV

i ij
j 1

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