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Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR Lecture No. 62 Chapter 15 Contemporary Engineering Economics Copyright © 2006
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Contemporary Engineering Economics, 4 th edition, © 2007 Review – What is MARR? MARR – Minimum Attractive rate of Return: The required return necessary to make a capital budgeting project such as building a new factory worthwhile (profitable).
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Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR - Overview Choice of MARR when Project Financing is Known: Use i e as your MARR. Choice of MARR when Project Financing is Unknown: Use k as your MARR Choice of MARR under Capital Rationing: It depends on the lending and borrowing opportunities
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Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.8 Choice of MARR when Project Financing is Known To calculate the net present worth of the project, use the cost of equity (i e ) as the discount rate. Explicit accounts for debt flows
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Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.9 Choice of MARR when Project Financing is Unknown Without explicitly treating the debt flows, make a tax adjustment to the discount rate, using the weighted cost of capital k.
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Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR under Capital Rationing
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Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.10 Determining an Appropriate MARR as a Function of the Budget Project Cash Flow IRR AOAO A1 1-$10,000$12,00020% 2-10,00011,50015 3-10,00011,00010 4-10,00010,8008 5-10,00010,7007 6-10,00010,4004 Borrowing rate (k) = 10% Lending rate (l) = 6%
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Contemporary Engineering Economics, 4 th edition, © 2007 An Investment Opportunity Schedule Ranking Alternatives by the ROR
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Contemporary Engineering Economics, 4 th edition, © 2007 MARR as a Function of Budget Available Budget Project Selected Correct MARR to Use $40,0001,2,3, and 48% $60,0001,2,3, 4 and 5 MARR = l = 6% $01 and 2MARR = k = 10% k = 10% l = 6%
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Contemporary Engineering Economics, 4 th edition, © 2007 A Choice of MARR under Capital Rationing
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Contemporary Engineering Economics, 4 th edition, © 2007 Summary The selection of an appropriate MARR depends generally upon the cost of capital—the rate the firm must pay to various sources for the use of capital. 1. The cost of equity (i e ) is used when debt-financing methods and repayment schedules are known explicitly. 2. The cost of capital (k) is used when exact financing methods are unknown, but a firm keeps it capital structure on target. In this situation, a project’s after-tax cash flows contain no debt cash flows such as principal and interest payment
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