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Lecture 4

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4 views

Lecture 4

Uploaded by

Muhammad
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 5

Minimum Attractive Rate of Return


• The Minimum Attractive Rate of Return (MARR) is a reasonable
rate of return established for the evaluation and selection of
alternatives. A project is not economically viable unless it is
expected to return at least the MARR. MARR is also referred
to as the hurdle rate, cutoff rate, benchmark rate, and minimum
acceptable rate of return.
• For any investment to be profitable, the investor (corporate or
individual) expects to receive more money than the amount of capital
invested. In other words, a fair rate of return, or return on investment,
must be realizable. The definition of ROR in Equation [1.4] is used in
this discussion, that is, amount earned divided by the principal.
MARR Cont..
MARR cont…
Cost of capital
• To develop a foundation-level understanding of how a MARR value is
established and used to make investment decisions,
• Although the MARR is used as a criterion to decide on investing in a
project, the size of MARR is fundamentally connected to how much it
costs to obtain the needed capital funds.
• It always costs money in the form of interest to raise capital. The
interest, expressed as a percentage rate per year, is called the cost of
capital.
• As an example on a personal level, if you want to purchase a new
widescreen HDTV, but do not have sufficient money (capital),
Cost of capital
• you could obtain a bank loan for, say, a cost of capital of 9% per year and pay
for the TV in cash now.
• Alternatively, you might choose to use your credit card and pay off the balance
on a monthly basis. This approach will probably cost you at least 15% per year.
• Or, you could use funds from your savings account that earns 5% per year and
pay cash. This approach means that you also forgo future returns from these
funds.
• The 9%, 15%, and 5% rates are your cost of capital estimates to raise the
capital for the system by different methods of capital financing. In analogous
ways, corporations estimate the cost of capital from different sources to raise
funds for engineering projects and other types of projects.
Equity financing and debt financing
• In general, capital is developed in two ways—equity financing and debt
financing. A combination of these two is very common for most projects.
• Equity financing: The corporation uses its own funds from cash on hand,
stock sales, or retained earnings. Individuals can use their own cash,
savings, or investments. In the example above, using money from the 5%
savings account is equity financing.
• Debt financing: The corporation borrows from outside sources and repays
the principal and interest according to some schedule. Sources of debt
capital may be bonds, loans. Individuals, too, can utilize debt sources, such
as the credit card (15% rate) and bank options (9% rate) described above
Weighted Average Cost Of Capital (WACC)

• Combinations of debt-equity financing mean that a weighted average


cost of capital (WACC)results. If the HDTV is purchased with 40%
credit card money at 15% per year and 60% savings account funds
earning 5% per year, the weighted average cost of capital is 0.4(15)
0.6(5)=9% per year.
• For a corporation, the established MARR used as a criterion to accept
or reject an investment alternative will usually be equal to or higher
than the WACC that the corporation must bear to obtain the
necessary capital funds. So the inequality must be correct for an
accepted project.
Opportunity cost
• The opportunity cost is the rate of return of a forgone opportunity
caused by the inability to pursue a project. Numerically, it is the
largest rate of return of all the projects not accepted (forgone) due to
the lack of capital funds or other resources. When no specific MARR is
established, the de-facto MARR is the opportunity cost, i.e., the ROR
of the first project not undertaken due to unavailability of capital
funds.
Factors: How Time and Interest Affect Money
Single-Amount Factors (F/P and P/F)
Single-Amount Factors (F/P and P/F) cont…
Single-Amount Factors (F/P and P/F)
cont..
Single-Amount Factors (F/P and P/F)
cont..
Single-Amount Factors (F/P and P/F) cont..
Single-Amount Factors (F/P and P/F)
cont..
• Problem
•
Uniform Series Present Worth Factor and Capital
Recovery Factor (P/A and A/P)
Uniform Series Present Worth Factor and Capital
Recovery Factor (P/A and A/P) cont….
Uniform Series Present Worth Factor and Capital
Recovery Factor (P/A and A/P) cont…
Uniform Series Present Worth Factor and Capital
Recovery Factor (P/A and A/P) cont…
Uniform Series Present Worth Factor and Capital
Recovery Factor (P/A and A/P) cont…
• Problem:

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