Lecture slides to accompany

Engineering Economy, 8thth edition

Leland Blank, Anthony Tarquin

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 Chapter 10

Project Financing and Non-Economic

Attributes

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 • LEARNING OUTCOMES
1. Explain cost of capital and MARR
2. Calculate weighted average cost of capital
3. Estimate cost of debt capital
4. Estimate cost of equity capital
5. Understand high D-E mix and risk
6. Develop weights for multiple attributes
7. Apply weighted attribute method to
alternative evaluations

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 • Cost of Capital and MARR
Cost of capital is the weighted average interest rate paid based on
debt and equity sources

Debt capital represents borrowing outside company

Equity capital is from owners’ funds and retained earnings
MARR is set relative to cost of capital

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 • Factors Affecting MARR
Project risk: higher risk leads to higher MARR
Investment opportunity: in order to capture perceived opportunity, MARR
may be temporarily lowered

Government intervention: gov’t actions such as tariffs, subsidies, etc.

can cause companies to raise or lower MARR

Tax structure: rising corporate tax rates lead to higher MARR

Limited capital: as capital becomes limited, MARR increases
Rates at other corporations: competition can cause companies to raise
or lower MARR

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 • D-E Mix and Weighted Average COC
Debt-to equity (D-E) mix identifies percentages of debt and
equity financing for a corporation
•WACC
  (% equity)(cost of equity)
(% debt)(cost of debt)

This figure
Illustrates WACC

If the percentage of equity capital

from each source is known,
each component of WACC
is separately calculated
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 • Example: WACC Calculation
A company that specializes in producing cold-weather clothing and
accessories is expanding its ski-jacket and boot-sock manufacturing
facilities. The company plans to borrow $2.5 million at 7% interest, issue
stock worth $4 million worth at 5.9%, and use $1.5 million of retained
earnings at 5.1% to finance the project. Determine the company’s WACC.

•Solution:
  Equity sources are stock and retained earnings
Total project cost 4 1.5 2.5 $8 million
WACC (common stock fraction)(cost of common stock capital)
(preferred stock fraction)(cost of preferred stock capital)
(retained earnings fraction)(cost of retained earnings capital)
(debt fraction)(cost of debt capital)

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 • Cost of Debt Capital
Debt capital -- Funds received by borrowing; loans or issuance of bonds
This is important: Interest payments are tax deductible as a corporate
operating expense

•  
Example: For a company that has an effective tax rate of 35%, the after-tax cost
of a i 10% interest loan is, in fact, less than 10%:

•The  general equations involved in finding the cost of debt capital are:
Tax savings (expenses)(effective tax rate) (expenses)(Te )
Net cash flow expenses tax savings (expenses)(1 Te )
Set up PW or AW equation of net cash flows and solve for i*
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 • Example: Cost of Debt Capital
•If a  company borrows $50,000 at 8% per year with annual interest
only payments and a balloon of $50,000 after 5 years, what is the
after-tax cost of debt capital? Assume Te 44%

•Solution:
  Annual interest is 50,000(0.08) $4000
After-tax net cash flow for interest only payment 4000(1 0.44)
$2240

Solve for i*
Note: This is a tax rate of 4.48% vs. the 8% rate for the loan

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 • Cost of Equity Capital
Equity capital obtained from 4 possible sources:
(1) Sale of preferred stock (2) Use of retained earnings
(3) Owner’s private capital (4) Sale of common stock

Important: No tax advantage or tax savings for equity capital

Calculating the cost of different equity capital sources

For preferred stock: Cost of capital is stated dividend percentage

For retained earnings and owner’s funds: Cost is common stock cost
(next slide)

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 • Cost of Equity Capital from Common Stock
Two ways to determine cost of common stock capital:
1. Valuation of common based on stock price and dividends
2. Capital asset pricing model (CAPM)

•1. Valuation
  of common stock

Where: Re cost of equity capital from common stock P price of stock

DV1 dividend in year 1 g expected dividend growth rate
2. CAPM

Where: Rf return on safe investment β volatility of company’s stock

Rm return on stocks measured by index

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 • Example: Selection Based on Financing Plans
Good approach to set MARR: between corporation’s
cost of equity capital and WACC. Treat risk separately

Corporate MARR is historically set midway between cost of equity capital, which
averages 4% per year, and the WACC for a major project. A project needs $3M start-
up capital. Financing plan 1 borrows 100% lent at 0.5% per month. Plan 2 uses 50%
equity and 50% borrowed funds. Which plan requires the lower MARR?
•Solution:
  Effective annual cost of debt capital (1 0.005)12 1 0.0617
Effective annual cost of equity capital 4%

•   Plan 1 – 100% debt: •   Plan 2 – 50% equity; 50% debt:

Plan 2 requires a lower MARR

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 • Debt-Equity Mix and Risk
As proportion of debt capital increases, overall cost of capital decreases

Because interest on debt capital offers a tax advantage

Corporations that become highly leveraged (large D-E mixes) have increased
risk and more difficulty in obtaining project funding

Investors take more risk and lenders are leery to provide funds

Best: balance between debt and equity funding

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 • Multiple Attribute Analysis
Attributes other than the economic one are considered in most
alternative selections, e.g., public and service sector projects
Steps necessary to identify and use multiple attributes are:
• Identification of attributes
• Determination of importance weight of each attribute
• Assignment of a value rating to each attribute
• Alternative evaluation using a technique that accommodates several
attributes

Attribute identification – Some methods are:

• Comparison with similar studies that involve multiple attributes
• Input from experts
• Surveys of constituencies
• Small group discussions
• Delphi method to develop consensus
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 • Sample Attributes
Many attributes are commonly identified
• Safety
• Repair time
• Personnel needs
• Economics (used exclusively thus far to evaluate alternatives)
• Risk

Risk is a routinely identified attribute. Identification of type of risk to consider is

vital to considering it thoroughly in the evaluation. Some types of risk are:
• Variation in specific parameters (estimate variation in n, AOC, etc.)
• Project funding (debt vs. equity capital)
• Market dynamics (effect on success of project in the future)
• Environmental impacts and government regulations

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 • Importance Weight of Attributes
A weight Wi (between 0 and 1) is assigned to each attribute i to
express its extent of importance relative to other attributes
Weights are normalized to sum to 1.0 as follows:
importance scorei importance scorei
Weight calculation: Wi  n

S
 importance score
i 1
i

Arrange attributes, weights, and alternatives in a table

Weights for each

attribute

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 • Procedures to Assign Weights
Equal
•   weighting – All attributes considered of equal importance
All weights are Wi 1/m for i 1, 2, …, m attributes
Rank order – Attributes ranked by constantly increasing importance
(1 least, m most important)
W1 1/S, W2 2/S, …, Wm m/S, where S sum of weights 1 through m
Weighted rank order – Most important attribute score is 100; others scored
between 0 and 100. Let si score for each attribute i; weights are

si
Wi  m

s
i 1
i

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 • Procedures to Assign Weights

Pairwise comparison – Attributes are compared to each other.

Importance comparison scale can be defined as follows:

0 if attribute is less important than one compared to

1 if attribute is equally important as one compared to
2 if attribute is more important than one compared to

Example:
Attribute i 1 Cost 2 Constructability 3 Environment
Cost n/a 0 1
Constructability 2 n/a 1
Environment 1 1 n/a
Sum of scores 3 1 2
Weight Wii 0.500 0.167 0.333

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 • Value Rating of Alternatives by Attribute
•   This step concentrates on alternatives
Each alternative is assigned a value rating for each attribute
Can apply scale of 0-10, 0-100, 1 to 1, or Likert Scale (4 or 5 graduations)
If You Value the Give It a Rating between
Alternative as the Numbers
Very poor 0–2
Poor 3–5
Good 6–8
Very good 9–10

Example: 3 alternatives and 4 attributes using weighted rank order method for
attributes (0 to 100) and value ratings for alternatives (0 to 10)

Value ratings
Vij for attribute
i and alternative
j
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 • Evaluation Measure for Multiple Attributes
Weighted Attribute Method ─ A single-dimension measure to
select one alternative from several, considering multiple attributes
R j  sum of (weight  value rating)
m
  Wi  Vij
i 1

•Where:
  j 1, …, n alternatives
Rj evaluation measure for alternative j
Wi importance weight of attribute i
Vij value rating of attribute i for alternative j

Selection guideline
Choose alternative with largest Rj value
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 • Example: Weighted Attribute Method
Three alternative software systems are available that schedule and
dispatch long-haul trucks from warehouses to destinations. Six evaluation
attributes are of varying importance, as shown by Wi scores below. Value
ratings Vij are the average ratings of a 7-person committee. Use the
weighted attribute method to select the best system.
Value rating, Vij Value rating, Vij Value rating, Vij
(0 to 100 basis) (0 to 100 basis) (0 to 100 basis)
Attribute, i Weight, Wi System 1 System 2 System 3
Payback period 0.11 75 50 100
Initial investment 0.22 60 75 100
Response time 0.20 50 100 20
User interface 0.18 100 90 40
Maintenance 0.11 75 100 10
support
Upgradability 0.18 100 100 75
TOTALS 1.00
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 • Example: Weighted Attribute Method (Cont.d)
Value rating, Vij Value rating, Vij Value rating, Vij Value rating, Vij Value rating, Vij Value rating, Vij
and Evaluation and Evaluation and Evaluation and Evaluation and Evaluation and Evaluation
measure, Rj measure, Rj measure, Rj measure, Rj measure, Rj measure, Rj

Attribute, i Weight, Wi System 1 System 1 System 2 System 2 System 3 System 3

Payback period 0.11 75 8.25 50 5.50 100 11.00
Initial investment 0.22 60 13.20 75 16.50 100 22.00
Response time 0.20 50 10.00 100 20.00 20 4.00
User interface 0.18 100 18.00 90 16.20 40 7.20
Maintenance support 0.11 75 8.25 100 11.00 10 1.10
Upgradability 0.18 100 18.00 100 18.00 75 13.50
TOTALS 1.00 75.70 87.20 58.80

n
Use formula for Rj measure to determine: R j   WV
i ij
j 1

•  
Select system 2
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 • Summary of Important Points
Cost of capital is weighted average of debt and equity funding
There is a tax savings with debt capital because interest is
deductible; nothing is tax deductible for equity capital
High D-E mixes mean higher risk for lenders and investors; project
funding becomes more problematic
Multiple attribute analysis brings other factors (besides cost) into the
decision-making process
Four different techniques for assigning weights to attributes
Likert scale is good for assigning value ratings to alternatives
n
Multiple attribute evaluation measure is R j   WV
i ij
j 1

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