8/14/2019 Module 7 Incremental Method
1/14
Module 7: Incremental Method
SI-4251 Ekonomi Teknik
Muhamad Abduh, Ph.D.
8/14/2019 Module 7 Incremental Method
2/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik2
Outline Module 7
MARR
Incremental Analysis
8/14/2019 Module 7 Incremental Method
3/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik3
The Minimum Attractive Rate of Return
The Minimum Attractive Rate of Return(MARR) is the rate at which an entity can
always invest. MARR is set as the result of apolicy decision by the entity, whichrepresents the entitys profit objective.
MARR is set a based on entitys view of futureopportunities along its financial situation: MARR too low may allow proposal that is
marginally productive or result in a loss.
MARR too high may result in rejectinginvestment that would have good returns.
8/14/2019 Module 7 Incremental Method
4/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik4
Establishing MARR
An entity (corporation) accumulates funds(capital) by means of two sources: debt
financing, equity financing, or the mix of the two
Debt financing refers to capital borrowed fromother party that will be paid back at stated
interest by a specific date. No direct risk involving the lender on repayment offunds and interest, or profits resulting from thefunds
(short, medium, long) terms loans, bonds, mortgage
Capital financing represents capital owner by thecorporation used to generate revenue. Sales of common or preferred stocks for public
corporations
Own money for private companies
Retained earning
8/14/2019 Module 7 Incremental Method
5/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik5
Establishing MARR For capital budgeting and alternative evaluation MARR (the
cost of capital) is set calculated independently for eachtype of financing
The interest rate paid for (cost capital) for mixed financing iscalculated from weighted proportion of source of financing
Weighted Average Cost of Capital:
WACC = ( ) (equity fraction x cost of equity) + ( ) (capital debt fraction x cost of
)debt capital:xampleA company is deciding to increase its capital in order to
. - -finance an alternative investment With a 40 60 D E mix with
. % %, .debt costing 8 5 and equity costing 10 calculate WACC
ACC = ( %)( . %) + ( %)( %) = . %40 8 5 60 10 9 4
8/14/2019 Module 7 Incremental Method
6/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik6
Establishing MARR
MARR is then set based on that cost, whichreflects the view and/or preference of the
entity (corporation) toward alternatives ofinvestment
The MARR varies from one alternative toanother, because of:
Project risk which should return higher thatMARR
Sensitivity of project area lowering MARR inone area may provide incentive to encourageinvestment in other area
Tax structure tax adds to the reduction of netincome
Capital-financing method demand supply for
8/14/2019 Module 7 Incremental Method
7/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik7
Incremental Analysis
With respects to MARR, where unlimitedinvestment opportunities yielding return at theMARR is extended into the future, it can beassumed that the proceeds produced by thecurrent investments can be invested at the
minimum attractive rate of return.The decision for selection of alternatives is based
on the analysis of the difference betweenmutually exclusive alternatives.
The incremental investment analysis considers allfeasible alternatives (that is yielding return >MARR), starting from the least cost investment.
8/14/2019 Module 7 Incremental Method
8/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik8
Incremental AnalysisFund of $ 1,500,000 is available for investment. MARR is set
at 15%
Alternative P: investment $ 1,000,000 @ 21% return
Alternative Q: investment $ 1,400,000 @ 18% return
Alternative R: investment $ 1,250,000 @ 20% return
Alternative
Investmen( )t $ K
Yield RemainingFund
($)K
Yield Total Return
Rate(%)
Return( )$ K
Rate(%)
Return( )$ K
Yield( )$ K
RoR(%)P ,1 000 21 .210 0 500 15 .75 0 .285 0 .19 0
Q ,1 400 18 .252 0 100 15 .15 0 .267 0 .17 8R ,1 250 20 .250 0 250 15 .37 5 .287 5 .9 2
8/14/2019 Module 7 Incremental Method
9/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik9
Incremental ROR Net Cash Flow Tabulation
Rate of return can be calculated from cash flowtabulation of individual alternative.
Selection of alternatives is done by sequentialcomparison of two alternatives, starting fromthe lowest to the next higher initial investment.
For positive cash flow, start with do nothingalternative
Net cash flow (difference between two cash flow)is to be used to calculate incremental ROR
=Net cash flow cash flow B - cash flow = 0 i A B
8/14/2019 Module 7 Incremental Method
10/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik10
Incremental Investment:Net Cash Flow Tabulation
ash Flow A ash Flow B ( - )ash Flow B AInitial cost - , ,125 000 000 - , ,157 750 000 - , ,32 750 000
End of year 1 - , ,9 800 000 + , ,2 800 000 , ,12 600 000
End of year 2 + , ,21 750 000 + , ,11 000 000 - . ,10 750 000
End of year 3 + , ,45 900 000 + , ,65 500 000 , ,19 600 000End of year 3 + , ,88 750 000 + , ,82 750 000 - , ,6 000 000
Salvage value + , ,75 000 000 + , ,95 000 000 , ,20 000 000
/ %PW C F @ 10
Higher initial cost
8/14/2019 Module 7 Incremental Method
11/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik11
Example
Three alternatives investment are beingconsidered at MARR 12%
X Y Z
Initial cost - 650,000,000 -540,000,000 -720,000,000
Yearly expenses - 135,000,000 -123,500,000 -130,000,000
Yearly revenues 330,000,000 321,000,000 357,500,000
Salvage value 45,000,000 52,000,000 202,000,000
period 5 5 5
(yearly cash flow) 195,000,000 197,500,000 227,500,000
8/14/2019 Module 7 Incremental Method
12/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik12
Solution
PW- /Net CF = - + ( / , *, ) + ( / , *, ) =
P A P A i 5 SV P F i 5 0
= % ( / , , ) = .For i 12 P A 12 5 3 6048 ( / , , ) = .P F 12 5 0 5674
= % ( / , , ) = .For i 10 P A 10 5 3 7908 ( / , , ) = .P F 10 5 0 6209
= % ( / , , ) = .For i 15 P A 15 5 3 3522 ( / , , ) = .P F 15 5 0 4972
Y X Z
comparison do nothing to Y
Incremental cost, P -540,000,000
Incremental C/F, A 195,000,000
IncrementalSV, SV 45,000,000
Present Worth C/F @ MARR
Incremental i*
Decision
8/14/2019 Module 7 Incremental Method
13/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik13
Solution
PW- /Net CF = - + ( / , *, ) + ( / , *, ) =
P A P A i 5 SV P F i 5 0
= % ( / , , ) = .For i 12 P A 12 5 3 6048 ( / , , ) = .P F 12 5 0 5674
= % ( / , , ) = .For i 10 P A 10 5 3 7908 ( / , , ) = .P F 10 5 0 6209
= % ( / , , ) = .For i 15 P A 15 5 3 3522 ( / , , ) = .P F 15 5 0 4972
Y X Z
comparison do nothing to Y Y to X Y to Z
Incremental cost, P -540,000,000 -110,000,000 -180,000,000
Incremental C/F, A 195,000,000 2,500,000 32,500,000
IncrementalSV, SV 45,000,000 7,000,000 157,000,000
Present Worth C/F @ MARR ? ? ?
Incremental i* > 12% < 12% > 12%
Decision Select Y Retain Y Select Z
8/14/2019 Module 7 Incremental Method
14/14
Muhamad Abduh, Ph.D.SI-4251 Ekonomi Teknik14
Homework #7
A ready-mix concrete producer is considering to install a new
mixer system:
a) develop net cash flow tabulation b) if the company has set MARR at 12%, which system
should be installed?
c) if all alternatives are to use MARR, will yourecommend otherwise?
Operating characteristics System A System B System C
( )Installed cost $ , ,2 250 000 , ,2 950 000 , ,2 750 000
( )Annual Operating cost $ ,320 000 ,495 000 ,401 500
( )Annual production cm ,10 500 ,21 200 ,19 900
( / )Unit price $ cm .122 50 .122 50 .122 50( / )Overhaul cost $ 2 years ,220 000 ,245 000 ,295 000
( )Salvage value $ ,221 500 ,308 000 ,367 500
( )Useful life year 4 6 6