Module 7: Incremental Method

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Outline Module 7

MARR Incremental Analysis

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Module 7: Incremental MethodThe

MARR Incremental Analysis

Outline

Minimum Attractive Rate of Return

The Minimum Attractive Rate of Return (MARR) is the rate at which an entity can always invest. MARR is set as the result of a policy decision by the entity, which represents the entitys profit objective. MARR is set a based on entitys view of future opportunities along its financial situation:

MARR too low may allow proposal that is marginally productive or result in a loss. MARR too high may result in rejecting investment that would have good returns.
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

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Establishing MARR

An entity (corporation) accumulates funds (capital) by means of two sources: debt financing, equity financing, or the mix of the two Debt financing refers to capital borrowed from other party that will be paid back at stated interest by a specific date.

No direct risk involving the lender on repayment of funds and interest, or profits resulting from the funds (short, medium, long) terms loans, bonds, mortgage

Capital financing represents capital owner by the corporation used to generate revenue.

Sales of common or preferred stocks for public corporations Own money for private companies Retained earning

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Establishing MARR

For capital budgeting and alternative evaluation MARR (the cost of capital) is set calculated independently for each type of financing The interest rate paid for (cost capital) for mixed financing is calculated from weighted proportion of source of financing Weighted Average Cost of Capital:

WACC = (equity fraction) x (cost of equity capital)

+ (debt fraction) x (cost of debt capital)
Example: A company is deciding to increase its capital in order to finance an alternative investment. With a 40-60 D-E mix with debt costing 8.5% and equity costing 10%, calculate WACC.

WACC = (40%)(8.5%) + (60%)(10%) = 9.4%

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Establishing MARR

MARR is then set based on that cost, which reflects the view and/or preference of the entity (corporation) toward alternatives of investment The MARR varies from one alternative to another, because of:

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Project risk which should return higher that MARR Sensitivity of project area lowering MARR in one area may provide incentive to encourage investment in other area Tax structure tax adds to the reduction of net income Capital-financing method demand supply for capital Rates used by other firms (competitors)
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Incremental Analysis

With respects to MARR, where unlimited investment opportunities yielding return at the MARR is extended into the future, it can be assumed that the proceeds produced by the current investments can be invested at the minimum attractive rate of return. The decision for selection of alternatives is based on the analysis of the difference between mutually exclusive alternatives. The incremental investment analysis considers all feasible alternatives (that is yielding return > MARR), starting from the least cost investment.

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Incremental Analysis
Fund of $ 1,500,000 is available for investment. MARR is set at 15% Alternative P: investment $ 1,000,000 @ 21% return Alternative Q: investment $ 1,400,000 @ 18% return Alternative R: investment $ 1,250,000 @ 20% return

Alternative

Investment ($ K)

Yield
Rate (%) Return ($ K)

Remaining Fund ($ K)

Yield
Rate (%) Return ($ K)

Total Return
Yield ($ K) RoR (%)

P
Q R

1,000
1,400 1,250

21
18 20

210.0
252.0 250.0

500
100 250

15
15 15

75.0
15.0 37.5

285.0
267.0 287.5

19.0
17.8 19.2

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Incremental ROR Net Cash Flow Tabulation

Rate of return can be calculated from cash flow tabulation of individual alternative.

Selection of alternatives is done by sequential comparison of two alternatives, starting from the lowest to the next higher initial investment. For positive cash flow, start with do nothing alternative
Net cash flow (difference between two cash flow) is to be used to calculate incremental ROR

Net cash flow = cash flow B - cash flow A = 0 iAB

7-9 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Incremental Investment: Net Cash Flow Tabulation

Cash Flow A Initial cost End of year 1 End of year 2 End of year 3 End of year 3 Salvage value PW C/F @ 10% Higher initial cost - 125,000,000 -9,800,000 +21,750,000 +45,900,000 +88,750,000 +75,000,000 Cash Flow B - 157,750,000 +2,800,000 +11,000,000 +65,500,000 +82,750,000 +95,000,000 Cash Flow (B-A) -32,750,000 12,600,000 -10.750,000 19,600,000 -6,000,000 20,000,000

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Example

Three alternatives investment are being considered at MARR 12%

X Initial cost Yearly expenses Yearly revenues Salvage value period (yearly cash flow) - 650,000,000 - 135,000,000 330,000,000 45,000,000 5 195,000,000 Y -540,000,000 -123,500,000 321,000,000 52,000,000 5 197,500,000 Z -720,000,000 -130,000,000 357,500,000 202,000,000 5 227,500,000

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Solution
Y comparison Incremental cost, P Incremental C/F, Incremental SV, A SV do nothing to Y -540,000,000 195,000,000 45,000,000 X Z

Present Worth C/F @ MARR Incremental i*

Decision

PWNet-C/F = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0

For i = 12% (P/A, 12, 5) = 3.6048 For i = 10% (P/A, 10, 5) = 3.7908 For i = 15% (P/A, 15, 5) = 3.3522
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(P/F, 12, 5) = 0.5674 (P/F, 10, 5) = 0.6209 (P/F, 15, 5) = 0.4972

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Solution
Y X Z

comparison
Incremental cost, P

do nothing to Y
-540,000,000

Y to X
-110,000,000

Y to Z
-180,000,000

Incremental C/F, Incremental SV,

A SV

195,000,000 45,000,000 ? > 12% Select Y

2,500,000 7,000,000 ? < 12% Retain Y

32,500,000 157,000,000 ? > 12% Select Z

Present Worth C/F @ MARR Incremental i* Decision

PWNet-C/F = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0

For i = 12% (P/A, 12, 5) = 3.6048 For i = 10% (P/A, 10, 5) = 3.7908 For i = 15% (P/A, 15, 5) = 3.3522
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(P/F, 12, 5) = 0.5674 (P/F, 10, 5) = 0.6209 (P/F, 15, 5) = 0.4972

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Homework #7
A ready-mix concrete producer is considering to install a new mixer system: Operating characteristics System A System B System C
Installed cost ($) Annual Operating cost ($) Annual production (cm) Unit price ($/cm) Overhaul cost ($/ 2 years) 2,250,000 320,000 10,500 122.50 220,000 2,950,000 495,000 21,200 122.50 245,000 2,750,000 401,500 19,900 122.50 295,000

Salvage value ($)

Useful life (year)

221,500
4

308,000
6

367,500
6

a) develop net cash flow tabulation b) if the company has set MARR at 12%, which system should be installed? c) if all alternatives are to use MARR, will you recommend otherwise?
7-14 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.