Engineering Economic Analysis

~ ~ u._ .-.

AdjustingMARRto Account forRiskand Uncertainty 481

Conclusion

Based on a business-risk MARR of 10%, the two alternatives are equivalent. Recognizing some

greater risk of failure for Alt.BmakesAthe preferred alternative. If the MARR is increased to

15%, to add a margin of safety against risk and uncertainty, the computed decision is to select

B. Since Alt.Bhas been shown to be less desirable thanA,the decision, based on a MARR

of 15%, way be an unfortunate one. The difficulty is that the same risk adjustment (increase
the MARR by 5%) is applied to both alternatives even though they have different amounts
of risk.

The conclusionto be drawn from Example 15-3is that increasing the MARR to compensate

for risk and uncertainty is only an approximate technique and may not always achieve the

desired result. Nevertheless,it is common practice in industry to adjust the MARR upward

to compensate for increased risk and uncertainty.

Inflation and the Cost of Borrowed Money Adjusting MARRto Account for Risk and Uncertainty

As inflation varies, what is its effect on the cost of borrowed money? A widely held view has

been that interest rates on long-term borrowing, like 20-year Treasury bonds, will be about

3% more than the inflation rate. For borrowers this is the real-that is, after-inflation--cost

of money,and for lenders the real return on loans. If inflationrates were to increase, it would

follow that borrowing rates would also increase. All this suggests a rational and orderly

situation, about as we might expect.

Unfortunately, things have not worked out this way. Figure 15-3 shows that the real

interest rate has not always been about 3% and, in fact, there have been long periods

1985 1990 1995 2000

Year

FIGURE 15-3 The real interest rate.The interest rate on 20-year Treasury bondsminusthe inflation

rate,f, as measured by changes in the Consumer Price Index.

10

8

6

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4

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£^0

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-4

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1975 1980