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Optimizing Minimum Attractive Rate of Return: Capital Allocation Theory

This presentation covers EGR 403's Capital Allocation Theory, exploring accounting, time value of money concepts, analysis methods, benefit-cost ratios, and more. Learn about selecting a MARR, sources of capital, adjusting for risk and uncertainty, and assessing investment opportunities. Discover the importance of cost of funds and adjusting MARR for inflation and project viability. Gain insights into optimizing return rates for small and large projects with limited funds and representative MARR values used in the industry.

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Optimizing Minimum Attractive Rate of Return: Capital Allocation Theory

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  1. 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

  2. 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

  3. 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

  4. 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

  5. Cost of Funds Cost of capital is the after tax weighted ROR of borrowed funds from all sources. EGR 403 - Cal Poly Pomona - SA16

  6. 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

  7. 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

  8. 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

  9. 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

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