Rationing Capital Among Competing Projects

Minggu 13

Capital Expenditure Project Proposals

Project Proposal is an engineering decisionmaking process for a given situation or problem Example :
Additional Manufacturing Facility Alternatives :

Lease an existing building Construct a New Building Contract for the manufacturing to be done overseas

Capital Expenditure Project Proposals (2)

The Question is how to choose between alternatives either its a Mutually Exclusive Alternatives or a Single Project Proposals.

Identifying and Rejecting unattractive alternatives

Eliminate from further consideration any alternative that fails to meet the minimum level of economic attractiveness.
CRITERIA FOR REJECTING UNNATTRACTIVE ALTERNATIVES
Reject alternative when Do NOT reject alternative when i > MARR PW benefits > PW cost

For Each alternative Compute Rate of Return, i Present Worth, PW

i < MARR PW benefits < PW cost

EUAC, EUAB
Benefit-cost ratio, B/C Net Present Worth, NPW

EUAC > EUAB

B/C < 1 NPW < 0

EUAC < EUAB

B/C > 1 NPW > 0

CRITERIA FOR CHOOSING THE BEST ALTERNATIVES FROM AMONG MUTUALLY EXCLUSIVE ALTERNATIVES

Analysis Method

Situation

Fixed input

Fixed output

Neither Input nor Output Fixed

Max PWbenefits Max (EUAB EUAC)

Present Worth Max PWbenefits Annual Cash Flow Max EUAB

Min PWcost Min EUAC

Benefit-Cost Ratio

Max benefitcost ratio

Max benefitcost ratio

Incremental benefit -cost ratio analysis required

Rationing Capital By Rate of Return

Example
Project 1 2 3 4 5 6 Cost 100 200 50 100 100 100 UAB 23.85 39.85 34.72 20 20 18 Useful life (years) 10 10 2 6 10 10 Salvage Value 0 0 0 100 100 100 Rate Of Return 20% 15% 25% 20% 20% 18%

7
8 9

300
300 50

19.464
47.4 7

4
10 10

0
100 50

10%
12% 14%

If A Capital Budget of $ 650 is available, which projects should be selected ?

30 %

25%

Computed Project Rate of Return

20%

Pick those with a higher rate of return. When the projects are arrayed by rate of return, as in figure, as follows, then Projects 3,1,4,5,6, and 2 is correct decision for the available budget of $650 Cut Off Rate Of Return

15%

10%

5% 3 50 1 150 4 250 5 350 6 450 2 650 9 700 8 1000 7 1300

Cumulative Cost of Projects

CutOff Rate of Return is the point where the money runs out to approving projects In other words, the minimum attractive rate of return to get a project accomplished is CutOff Rate of Return

MARR = Cutoff rate of return = Opportunity Cost

Rationing Capital by Present Worth Methods

Frequently, Capital Budgeting Problem is one where we will be unable to accept all desirable projects. Lorie and Savage showed that the proper technique is to use a multiplier, p, to decrease the attractiveness of an alternative in proportion to itsuse of the scarce supply of money.
NPW p (PW cost)

Multiplier p is adjusted until the total cost of the projects meeting the [NPW p (PW cost)] criterion equals the available money supply.

Project

Cost

UAB

Useful life (years) 10 10 2 6 10 10 4

Salvage Value

Computed NPW ($) 60.04 67.40 11.91 55.48 80.52 67.10 13.46

1 2 3 4 5 6 7

100 200 50 100 100 100 300

23.85 39.85 34.72 20 20 18 19.464

0 0 0 100 100 100 0

8
9

300
50

47.4
7

10
10

100
50

64.38
20.13

Project

Cost

Computed NPW ($)

Trial p = 0.20 NPW p (PW cost) Cost

Trial p = 0.25 NPW p (PW cost) Cost

1
2 3 4 5 6 7 8 9

100
200 50 100 100 100 300 300 50 1300

60.04
67.40 11.91 55.48 80.52 67.10 13.46 64.38 20.13

40.04
27.40 1.91 35.48 60.52 47.10 - 46.54 4.38 10.13

100
200 50 100 100 100

35.04
17.40 0.59 30.48 55.52 42.10 - 61.54

100
200

100 100 100

300 50 1000

- 10.62 7.63

300 50 650

For a value of p equal to 0.25, the best selection is computed to be Projects 1,2,4,5,6, and 9

Ranking Project Proposals

Rank Independent projects according to their value of net present worth divided by the present worth of cost. The appropriate interest rate is MARR (as a reasonable estimate of the cutoff rate of return)

Project

Cost

UAB

Useful life (years) 10 10 2 6 10 10 4 10 10

Salvage Value 0 0 0 100 100 100 0 100 50

Rate Of Return 20% 15% 25% 20% 20% 18% 10% 12% 14%

Comput ed NPW at 14.5% 22.01 3.87 6.81 21.10 28.14 17.91 -27.05 -31.69 -1.28

Cmoputed NPW/Cost 0.2201 0.0194 0.1362 0.2110 0.2814 0.1791 -0.0902 -0.1056 -0.0256

1 2 3 4 5 6 7 8 9

100 200 50 100 100 100 300 300 50

23.85 39.85 34.72 20 20 18 19.464 47.4 7

Ranked by NPW / Pwcost,

Project Cmoputed NPW/Cost

0.2814

1
4 6 3

0.2201
0.2110 0.1791 0.1362

2
9 7 8

0.0194
-0.0256 -0.0902 -0.1056

Its not a satisfactory ranking criterion and would have given a different ranking from the present wirth criterion