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Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Engineering Economy

Chapter 13: The Capital Budgeting

Process

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The objective of Chapter 13 is to

give the student an understanding

of the basic components of the

capital budgeting process so that

the important role of the engineer

in this complex and strategic

function will be made clear.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Capital financing and allocation

functions are primary components of

capital budgeting.

• Capital financing determines funds needed from

investors and vendors—in the form of additional

stock, bonds, loans—and funds available from

internal sources.

• Capital allocation is where the competing

engineering projects are selected. The total

investment is constrained by decisions made in

capital financing.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Management must make the decisions

for the financing/allocation connection

• Companies establish the allocation proposal

process.

• Management must select projects that ensure a

reasonable return to investors, to motivate

additional investment when required.

• In summary, these decisions are how much and

where financial resources are obtained and

expended.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

A company has a variety of sources

available for capital funds. These

sources expect an attractive return.

Type of Security

Average Annual

Return, Rm

Standard Deviation

of Returns

Treasury Bills 3.8% 4.4%

Long-term U.S. Bonds 5.8 9.4

Corporate Bonds 6.2 8.7

S&P 500 Stocks 12.2 20.5

Small-firm Stocks 16.9 33.2

Source: R.G. Ibbotson Associates, Chicago, IL., 2003.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Debt capital represents borrowed money.

• Companies can borrow money from lenders (e.g.

banks) or can issue bonds or debentures.

• Creditors get interest, bondholders get dividends

and face value at maturity.

• The cost of bond financing depends on the bond

rating, which is dependent on the financial health

of the company.

• Investors have a risk-free alternative of U.S.

government treasure bills. This risk-free rate of

return is denoted RF.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Interest paid on corporate debt is tax

deductible. This savings can be handled

in two different ways.

• Interest can be deducted each year before taxes are

computed. This approach adds more computation,

and it is generally difficult to assign debt

payments to a specific project.

• The most commonly used is to modify the MARR

to account for the tax deductibility of the debt.

• The cost of debt capital is denoted ib.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

We can reflect the use of a modified

MARR in the equations below.

where

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Equity capital represents money already

in the firm.

• This can be capital held by stockholders through company stock.

• It can also be earnings retained by the company for reinvestment purposes.

• The percentage cost of equity funds, ea, can be estimated in many ways, perhaps the best of which is using the capital asset pricing model (CAPM).

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The CAPM asserts that the best

combinations of risk and return lie along

the security market line, SML.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The CAPM reveals that the return, RS, on

any stock depends on its risk relative to

the market. The risk premium of any

stock is proportional to its beta.

where

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The graph below illustrates this

relationship.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The cost of equity, ea, is estimated as RS.

A company has a beta value of 2.4, with no long

term debt. If the market premium is 8.4%, and the

risk-free rate is 2%, what is the company’s cost of equity?

so,

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Acme has a beta value of 0.7. They have no long-term debt.

What is their cost of equity, based on the Capital Asset

Pricing Model? Use a risk-free rate of 1% and RM = 9.2%.

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The Weighted Average Cost of Capital

(WACC) represents the average cost of

all funds available to the firm.

Where

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

In the first fiscal quarter of 2009 Dell Computer

showed total debt of $1.98mil and total equity of

$3.55mil. Assume Dell’s beta is 2.2, the cost of debt is 7%, and Dell’s effective income tax rate is 0.35. What is the WACC?

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Each company may have an “optimal” mix of debt and equity, minimizing the

WACC.

• One task of a company treasurer is to

identify and maintain this mix.

• A constant debt/equity mix is difficult to

maintain over time.

• The separation principle specifies that the

investment decisions (project selection) and

financing decisions should be separated.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Establishing the minimum attractive rate

of return (MARR).

• If risks are roughly normal, the WACC is an

appropriate hurdle rate (i.e., MARR).

• WACC is a floor on the MARR, which should be

increased to reflect more risk.

• Management may choose to set the MARR based

on many factors, such as conserving capital in

anticipation of large future opportunities, or

encouraging new ventures. This may also be

differential across divisions.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Opportunity costs and MARR

• In this chapter we focus on independent projects.

• The opportunity cost viewpoint is a direct result of

capital rationing, when limited funds are available

for competing proposals.

• Prospective projects (of similar risk) are ranked in

order of profitability. The cut-off point falls such

that the capital is used on the better (more

profitable) projects.

• Firms may set two or more MARR levels,

analyzing within particular risk categories.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Establishing the MARR using

prospective project profitability.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Selecting projects that are not mutually

exclusive has multiple considerations.

• Those projects that are most profitable should be

selected, allowing for

– intangibles and nonmonetary considerations

– risk considerations

– availability of capital

• In certain cases monetary return is of minor

importance compared to other considerations, and

these require careful judgment.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Investment proposals can be classified in

any number of different ways, some of

which are given below.

• Kinds and amounts of

scarce resources used

• Tactical or strategic

• The business activity

involved

• Priority—essential,

necessary, desirable,

or improvement

• Type of benefits

expected

• Facility replacement,

facility expansion, or

product improvement.

• The way benefits are

affected by other

proposed projects

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

There can be many possible degrees of

dependency among projects.

“If the results of the first project would by the acceptance of the second

project

then the second project is said to be

the first project.”

be technically possible or would result

in benefits only

a prerequisite of

have increased benefits a complement of

not be affected independent of

have decreased benefits a substitute of

be impossible or would result in no

benefits

mutually exclusive with

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Organizing for capital allocation

• Organizations generally have a formal project

selection process that progresses through the

organizational levels.

• Clearly “good” proposals, or proposals clearly executing corporate policies, can be approved at

the division level, within certain funding limits.

• Proposals requiring a commitment of a large

amount of funds are sent to higher levels in the

organization (see the table on the next slide).

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

An example of a required organizational

approval structure.

If the total investment is . . .

More than But less than Then approval is required

through

$50 $5,000 Plant manager

$5,000 $50,000 Division vice president

$50,000 $125,000 President

$125,000 -- Board of directors

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The process of communicating and

“selling” project proposals is important.

• Good communication is required regardless of the

strength of the project proposal.

• Consider the needs of the decision maker.

• Provide investment requirements, measures of

merit, and other benefits, and

– bases and assumptions used for estimates

– level of confidence in the estimates

– how would the outcome be affected by variation?

• A corporate-wide proposal structure is helpful.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

For improved capital budgeting, conduct

postmortem reviews (postaudits).

• It helps determine if planned objectives of the

project were obtained.

• It determines if corrective action is needed.

• It improves estimating and future planning.

• It provides an unbiased assessment of project

results compared to the proposed outcomes.

• Postaudits are inherently incomplete, so care

should be used decisions based on these results.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Budgeting for capital investments is a

difficult managerial challenge.

• Just because a project is “attractive” doesn’t mean it should be undertaken.

• Capital budgets, while perhaps with a one- or two-

year horizon, should be supplemented with a long-

range capital plan.

• Technological and market forces change rapidly.

• Decisions must be made regarding investing now

or “saving” some funds to invest in the future (e.g., next year), postponing returns.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Lease vs. buy vs. status quo decisions

• Leases allow the firm to use available capital for

other uses.

• Leases are legal obligations very similar to debt,

reducing the ability to attract further debt capital

and increasing leverage.

• One should not compare only lease and buy, but

also the status quo (do nothing), separating to the

extent possible the equipment and financing

decisions.

• Always consider tax implications.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

One way to allocate capital among

independent projects is to create MEAs

from the set of projects and use familiar

equivalent worth methods.

• Project risks should be about equal

• Enumerate all feasible combinations (those

that meet any budget constraints).

• The acceptance of the best MEA will

specify those projects in which to invest.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

With a budget of $150,000, which of the

following independent projects should

Mitselfik, Inc. invest in?

Independent project Initial capital outlay PW

A $70,000 $18,000

B $45,000 $12,000

C $40,000 $11,000

D $50,000 $14,000

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The set of feasible projects.

Combination Capital required Total PW

A $70,000 $18,000

B $45,000 $12,000

C $40,000 $11,000

D $50,000 $14,000

AB $115,000 $30,000

AC $110,000 $29,000

AD $120,000 $32,000

BC $85,000 $23,000

BD $95,000 $26,000

CD $90,000 $25,000

BCD $135,000 $37,000*

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Selecting independent projects B, C, and

D results in the greatest PW.

• Project combinations ABC, ABD, ACD,

and ABCD are not feasible because of the

capital constraint.

• Management must decide how best to

allocate (or not allocate) the remaining

$15,000.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Other important managerial

considerations and complications.

• Projects have different lives, and different cash

flow commitments.

• Projects have differing levels of risk.

• The long-term capital plan must be considered.

• The overall risk of the firm must be considered.

• The corporate strategic plan may favor one part of

the company over another for investment.

• Much, much more. . .

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Capital allocation problems can be

modeled as linear programs.

• “Brute force” evaluation of all independent alternatives, especially when the number of

alternatives is very large, is cumbersome at best.

• Linear programming can be used to determine an

optimal portfolio of projects.

• Linear programming is a mathematical procedure

for maximizing (or minimizing) a linear function

subject to one or more linear constraints. We will

present the formulation of problems, but not the

solution, which is beyond our scope.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The objective function of the capital

allocation problem.

where

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Typical constraints are limitations on

cash outlays in each period, and

interrelationships among projects. Let

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Limitations on cash outlays for period k.

If projects p, q, and r are mutually

exclusive, then

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

If project r can be undertaken only if project s has

already been selected, then

If projects u and v are mutually exclusive and

project r is dependent (contingent) on the

acceptance of u or v, then

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Consider six projects under

consideration with the information

below. Formulate the linear

programming selection model.

Project

Initial investment

cash flow ($000s)

PW ($000s) at

MARR

A -75 15

B1 -50 11

B2 -30 9

C1 -50 13

C2 -60 14

C3 -15 5

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Consider that B1 and B2 are mutually

exclusive, and C1, C2, and C3 are

mutually exclusive. C2 and C3 are each

contingent on A. The budget for new

projects this year is $130,000.

Objective function: Maximize Net PW

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Constraint on initial investment.

B1 and B2 are mutually exclusive.

C1, C2, and C3 are mutually exclusive.

C2 and C3 are contingent on A.

No fractional projects are allowed.