Selection of a Minimum Attractive Rate of Return Click here for Streaming Audio To Accompany Presentation (optional)EGR 403 - The Big PictureSelecting a MARRSources of CapitalCost of FundsInvestment OpportunitiesAdjusting MARR to Account for Risk and UncertaintySlide 8Representative Values of MARR Used in IndustrySelection of aMinimum Attractive Rate of Return Click here for Streaming Audio To Accompany Presentation (optional)EGR 403 Capital Allocation TheoryDr. Phillip R. RosenkrantzIndustrial & Manufacturing Engineering DepartmentCal Poly PomonaEGR 403 - Cal Poly Pomona - SA16 2EGR 403 - The Big Picture•Framework: Accounting & Breakeven Analysis•“Time-value of money” concepts - Ch. 3, 4•Analysis methods–Ch. 5 - Present Worth–Ch. 6 - Annual Worth–Ch. 7,7A,8 - Rate of Return (incremental analysis)–Ch. 9 - Benefit Cost Ratio & other methods•Refining the analysis–Ch. 10, 11 - Depreciation & Taxes–Ch. 12 - Replacement Analysis–Selection of the MARREGR 403 - Cal Poly Pomona - SA16 3Selecting a MARR•MARR is generally the maximum of the:–Cost of borrowed money–Cost of capital–Opportunity costEGR 403 - Cal Poly Pomona - SA16 4Sources of Capital•Money generated from the operation of the firm (retained profits and cash flow generated from depreciation).•External sources of funds:–Short term borrowing - banks (generally unsecured).–Long term borrowing - banks, insurance companies, pension funds, bonds (secured).–Permanent - sale of company stock.EGR 403 - Cal Poly Pomona - SA16 5Cost of FundsCost of capital is the after tax weighted ROR of borrowed funds from all sources.Total capital invested (millions) 100.00$ Tax rate 40%Capital Structure %RORInterest paidTaxesAT Interest costBank loan 20% 20.00$ 9% 1.80$ 0.72$ 1.08$ Mortgage bonds 20% 20.00$ 7% 1.40$ 0.56$ 0.84$ Common stock and retained earnings60% 60.00$ 11% 6.60$ -$ 6.60$ 9.80$ 1.28$ 8.52$ Cost of capital 8.52%EGR 403 - Cal Poly Pomona - SA16 6Investment Opportunities•There are many investment opportunities in an active firm and often limited capital.•Opportunity cost is the ROR of the best opportunity foregone.Capital available 1,200.00$ Project NumberCostEstimated RORSelect ProjectsCapital to be InvestedROR of Rejected Projects2 50.00$ 45% 1 50.00$ 4 100.00$ 40% 1 100.00$ 3 50.00$ 38% 1 50.00$ 5 200.00$ 35% 1 200.00$ 1 150.00$ 30% 1 150.00$ 6 100.00$ 28% 1 100.00$ 8 250.00$ 25% 1 250.00$ 9 300.00$ 20% 1 300.00$ 7 200.00$ 18% 0 -$ 18%11 400.00$ 15% 0 -$ 15%10 300.00$ 10% 0 -$ 10%12 1,200.00$ 8% 0 -$ 8%1,200.00$ Opportunity cost 18%EGR 403 - Cal Poly Pomona - SA16 7Adjusting MARR to Account for Risk and Uncertainty•Increase MARR to avoid marginal projects.•Assess the projects using techniques other than economic analysis.Additionally, MARR might be adjusted to reflect imminent inflation.EGR 403 - Cal Poly Pomona - SA16 8Selecting a MARR•MARR is generally the maximum of the:–Cost of borrowed money–Cost of capital–Opportunity cost•If a project we are considering does not generate a greater return than these would cost, then we should put our money into these rather than the project.EGR 403 - Cal Poly Pomona - SA16 9Representative Values of MARR Used in Industry12 to 15%After-taxPayback with a variable lifeStableAdequate fundingOne year payback= 60 % ROROne year payback= 60 % RORStrugglingLimited fundsLarge projectSmall projectGroupIn addition to these two factors,many other factors also affect interest rates: a public vs. a private organization, debt/equity position, risk posture,
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