Engineering Economic Analysis

--,

476 SELECTIONOF AMINIMUMATTRACTIVERATEOF RETURN

Dividends paid on the ownership in the finn (common stock + retained earnings) are not taX

deductiple. Combining the three components, the after-tax interest cost for the $\00 million of

capital is:

$20 million (5.4%) + $20 millioll (4.2%) + $60p:)jllion OJ %) .. $8.52rp.illion

.. $8.52II1illion

Cost of.capItal ..>';';,.;..~ """ ... 8.52%

iz:... ..

In an actual situation, the cost of capital is quite difficult to compute. The fluctuation

in the price of common stock, for example, makes it difficultto pick a cost, and because of.

the fluctuatingprospects of the finn, it is even more difficultto estimate the future benefits

purchasers of the stock might expect to receive. Given the fluctuating costs and prospects

of future benefits, what rate of return do stockholders require? There is no precise answer,

but we can obtain an approximate answer. Similar assumptions must be made for the other.

components of a finn's capitalization..

INVESTMENT OPPORTUNITIES

An industrial finn can invest its money in many more places than are available to an

individual. A finn has larger amounts of money, and this alone makes certain kinds of

investment possible that are unavailable to individual investors, with their more limited

investment funds. The U.S. government, for example, borrows money for short tenns of

90 or 180 days by issuing certificates called Treasury bills that frequently yield a .greater

interest rate than savings accounts. The customary minimum purchase is $25,000..

More important, however,is the fact that a finn conducts a business, which itself offers

manyinvestmentopportunities.Whileexceptionscan be found,a goodgeneraliza~onis.

that the opportunities for investment of money within the finn are superior to the invest-

ment opportunities outside the finn. Consider the available investment opportunities for a

particular finn as outlined in Table 15-1. Figure 15-1 plots these projects by rate ofretum

versus investment. The cumulative investment required for all projects at or above a given

rate of return is given in Figure 15-2.

Figures 15-1 and 15-2 illustrate that a finn may have a broad range of investment

opportunities availableat varying rates of return and with varying lives and uncertainties. It

may take some study and searching to identify the better investment projects available to a

finn. If this is done, the available projects will almost certainly exceed the money the firm

budgets for capital investment projects.

Opportunity Cost Concept

We see that there are two aspects of investing that are basically independent. One factor is

the source and quantity of money availablefor capital investmentprojects. The other aspect

is the investment opportunities themselves that are available to the firm.

These two situations are typically out of balance, with investment opportunities ex-

ceeding the available money supply. Thus some investment opportunities can be selected