Engineering Economic Analysis

Representative Valuesof MARRUsed in Industry 483

will reject. Like the first group, this group of firms also uses payback and rate of return

,analysis. When small capital investments (of about $500 or less) are considered, payback

period is often the only analysis technique used. The criterion for accepting a proposal

may be a before-tax payback period not exceeding 1 or 2 years. Larger investment projects

are analyzed by rate of return. Where there is a normal level of business risk, an after-tax

MARR of 12 to 15% appears to be widely used. The MARR is increased when there is

greater risk involved.

In Chapter 9 we saw that payback period is not a proper method for the economic anal-

ysis of proposals. Thus, industrial use of payback criteria isnotrecommended.Fortunately,

the trend in industry is toward greater use of accurate methods and less use of payback

period.

Note that the values ofMARR given earlier are approximations.But the values quoted

appear to be opportunity costs, rather than cost of borrowed money or cost of capital. This

indicates that firms cannot or do not obtain money to fund projects whose anticipated rates

of return are nearer to the cost of borrowed money or cost of capital. While one could make

a case that good projects are needlesslybeing rejected, one reason that firms operate as th~y

do is that they can focus limited resources of people, management, and time on a smaller

number of good projects.

One cannot leave this section without noting that the MARR used by enterprises is so

much higher than can be obtained by individuals. (Where can you get a 30% after-tax rate

of return without excessive risk?) The reason appears to be that businesses are not obliged

to compete with the thousands of individuals in any region seeking a place to invest $2000

with safety, whereas the number of people who could, or would want to invest $500,000 in

a business is far smaller.This diminished competition, combined with a higher risk, appears

to explain at least some of the difference.

Cost of Capital Spreadsheets, Cumulative Investments, and the Opportunity

Cost of Capital

As shown in earlier chapters, spreadsheets make computing rates of return dramatically

easier. In addition, spreadsheets can be used to sort the projects by rate of return and then

calculate the cumulative first cost. This is accomplished through the following steps..

1. Enter or calculate each project's rate of return.


2. Select the data to be sorted. Donotinclude headings, but do include all information
   on the row that goes with each project.


3. Select the SORT tool (found in the menu under DATA),identify the rate of return
   column as the first key, and a sort order of descending.Also ensure that row sorting
   is selected. Sort.


4. Add a column for the cumulative first cost. This column is compared with the
   capital limit to identify the opportunity cost of capital and which projects should be
   funded.

Example 15-4 illustrates these steps.

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