ENGR 3360U Winter 2014

Unit 15
MARR Selection
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 15 MARR Selection

Change Record
2014-I-01 Initial Creation

15-2

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
1-3

Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2014-I-01

10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Unit 15 Road Map

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15.1 Capital and its cost to an organization

15.2 Opportunity Costs
15.3 Choosing the MARR
15.4 Capital budgeting

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

15.1 Cost of Funds

Borrowed Money

One factor that will determine MARR is the

cost of borrowing money.

Cost of Capital

The money a firm uses is drawn from the firms

overall capitalization.
This is also called the weighted cost of capital
(WACC).

Inflation and the cost of borrowed money

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The cost of borrowed money also fluctuates

with inflation.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

WACCy Example

A firm has the following financial situation:

Common shares require a ROR (dividend) of 11%
Bonds are sold at 7%
Money can be borrowed at 9%
Taxes are 40%
What is its WACC?

ROR
Annual
20M
loan 9%
1.8M
20M
bonds
7%
1.4M
60M
shares
11%
6.6M
100M
9.8M
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Assume firm has a 40% tax rate.

After-tax Bank loan = 9%(1 - 0.40) = 5.4%
After-tax Bonds
= 7%(1 - 0.40) = 4.2%
Dividends are not Tax-deductible
CoC = 20M(5.4%) + 20M(4.2%) + 60M(11%)
= 8.52M for the 100M
%CoC = 8.52/100 = 8.52%
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Example 15.2 Possible Projects

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Proj #

Cost

eROR

150k

30%

50k

45%

50k

38%

100k

40%

200k

35%

100k

28%

200k

18%

250k

25%

300k

20%

10

300k

10%

11

400k

15%

12

Unlimited (bonds)

8%

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

What if?
You had only 800K which would you
choose?
Rank by RoR
2,4,3,5,1,6
Opportunity cost would be proj 8 (250K)

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

15.2 Opportunity Cost

A firm may have a broad range of investment
opportunities.
Two factors:

Source of money available for projects

Firms investment opportunities

Investments need to be selected.

Want to ensure that all the selected projects are better than
the best rejected project
Best rejected project is called the:
Opportunity Cost = cost of best opportunity foregone on the best
rejected project

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Example 15-3
If $650K is available, what is
the Opportunity Cost of Capital?

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P#

Cost Ks

UAB Ks

Life

SV

cRoR%

100

23.85

10

20

200

39.85

10

15

50

34.72

25

100

20

100

20

100

20

10

100

20

100

18

10

100

18

300

94.64

10

300

47.4

10

100

12

50

10

50

14

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Solution: rank by RoR

3>1>4>5>6>2
OC = 14% (project 9)

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

15.3 Selecting the MARR

Minimum Attractive Rate of Return (MARR)

A lower boundary for MARR must be the cost of

the money invested in a project.
MARR should not be less than the cost of capital.
MARR should not be less than the rate of return
on the best opportunity foregone.

MARR should be equal to the largest of:

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Cost of borrowed money

Cost of capital
Opportunity Cost

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

MARR
MARR may be adjusted based on perceived
risk.

Higher risk may require a higher MARR to

determine the validity of an alternative.

Companies under a normal level of risk have

typical MARR rates of 12%15%.
However, much higher rates are common for
different industries, such as technology startups short of capital or petroleum, where the
risks maybe much higher.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Risk increases MARR

Additional rate applies to
06%
equipment replacement
08%
new equipment
10%
new product, normal market
12%
new product, related market
14%
new product, new market
16%
new product, foreign market

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

15.4 Capital Budgeting

Firms do not have access to unlimited
funding to invest in projects.

Example: Suppose 20 projects exceed the

MARR and there is limited funding so not all
projects with be funded.

Some firms will Rank projects based on the

biggest bang for the buck.

Rank projects based on maximum $ return:

Present worth/Present worth of Cost

However, it is more common for firms to

rank projects based on rate of return.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Capital Budgeting, contd.

The amount of an investment can also change
ranking.

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Example: Suppose there are 6 possible projects.

There is enough money for funding only the top two
projects because one of the projects is very
expensive.
OR
There is enough money for funding four projects in
some other order (1, 2, 3, 5, and 6 for example).

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Summary
There are different sources of capital
available to a firm.

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Money generated from operation

Debt: Borrowed money
Equity: Sale of equity like common or
preferred shares

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Summary, contd.
Selecting a MARR involves the following
considerations:

Cost of borrowed money

Cost of capital
Opportunity cost

MARR should be equal to the highest one

of these.
Risk can adjust MARR.

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Higher risk translates to a higher MARR.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 15 MARR Selection

Summary, contd.
Capital is not unlimited.
Capital may be rationed among competing
project opportunities.
Projects can be ranked based on rate of
return.

Reminder: Maximizing rate of return is NOT

necessarily the same as maximizing NPW.

NPW can be used to rank opportunities at

the opportunity cost of capital for NPW to

be maximized.

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco