MAKING CHOICES: THE

METHOD, MARR, AND

MULTIPLE ATTRIBUTES
Engineering Economy
Lecture no. 8
Tuesday, September 26, 2017
 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.
4. Understand corporate risk with high- debt-to-equity mixes.
5. Understand Multiattribute analysis.
6. How to apply Multiattribute analysis.
 Basic Methods
The basic cash flow evaluation methods
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.
 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.
 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.
 Suggested Mutually Exclusive Methods

Evaluation Alternative Recommended 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 CFs or Cash
Lives Public Sect. AW Flows

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

Public Sect. B/C (AW,PW) CFs
Long to Cost/Rev.: AW or PW: Cash Flows or
Public Sect. B/C (AW) CFs
 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.
 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.
 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.
 Series to Evaluate
For:
PW, AW, FW, B/C ratio, or ROR:
Use the estimated future cash flows, or
The incremental cash flow.
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!
 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.
 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
firms 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.
 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.
 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.
 Debt and Equity Capital
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 %.
 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 firms 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.
 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.
 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!
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!
 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, due to
1. Project Risk;
2. Investment Opportunity;
3. Current Tax Structure;
4. Limited Capital;
5. Market rates at other corporations
 Before-Tax MARR
Assume a tax rate, Te applies
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.

A before-tax MARR will always be greater than

the after-tax MARR, assuming a positive tax rate
 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 firms
common stock could change downward.
Too much debtbad, badvery bad!
 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.
Specimen Cost of Capital Curve

The objective of a firms

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 firms common
stock.
30-50% debt is
realistic for most
firms.
 Example
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?
 Example: 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 Bonds 3 0.30 0.075 0.0225

Sum 10 1.00 --- 0.1088

WACC = 10.88%
 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 firms perspective.
 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!
 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.
Example
 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.
 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.
 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!
 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.
 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.
 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.
 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).
 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!
 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.
 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,
Public sector projects are best compared using
the B/C ratio, but economic equivalency is still
AW- or PW based.
 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.
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).
 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.
 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.