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Selection of a Minimum Attractive Rate of Return Click here for Streaming Audio To Accompany Presentation (optional). EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona. EGR 403 - The Big Picture.

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Selection of aMinimum Attractive Rate of ReturnClick here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department

Cal Poly Pomona

egr 403 the big picture
EGR 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 MARR

EGR 403 - Cal Poly Pomona - SA16

selecting a marr
Selecting a MARR
  • MARR is generally the maximum of the:
    • Cost of borrowed money
    • Cost of capital
    • Opportunity cost

EGR 403 - Cal Poly Pomona - SA16

sources of capital
Sources 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

cost of funds
Cost of Funds

Cost of capital is the after tax weighted ROR of borrowed funds from all sources.

EGR 403 - Cal Poly Pomona - SA16

investment opportunities
Investment Opportunities
  • There are many investment opportunities in an active firm and often limited capital.
  • Opportunity cost is the ROR of the best opportunity foregone.

EGR 403 - Cal Poly Pomona - SA16

adjusting marr to account for risk and uncertainty
Adjusting 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

selecting a marr8
Selecting 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

representative values of marr used in industry

Group

Small project

Large project

Struggling

Limited funds

One year payback

= 60 % ROR

One year payback

= 60 % ROR

Stable

Adequate funding

Payback with a variable life

12 to 15%

After-tax

Representative Values of MARR Used in Industry

In addition to these two factors,many other factors also affect interest rates: a public vs. a private organization, debt/equity position, risk posture, etc.

EGR 403 - Cal Poly Pomona - SA16