Chapter 15: Selection of a Minimum Attractive Rate of Return

15-1 The interest rates on these securities vary greatly over time, making it impossible to predict rates. Three factors that distinguish the securities: Municipal Bond Corporate Bond Bond Duration 20 years 20 years Bond Safety Safe Less Safe

The importance of the non-taxable income feature usually makes the municipal bond the one with the lowest interest rate. The corporate bond generally will have the highest interest rate. 15-2 As this is a situation of neither input nor output fixed, incremental analysis is required. Cost Benefit Rate of Return C- D $25 $4 9.6% B- C $50 $6.31 4.5% B- D $75 $10.31 6.2% D- A $25 $5.96 20%

Using the incremental rates of return one may determine the preferred alternative at any interest rate. For interest rates between:
0% B 4.5% C 9.6% D 20% A

The problem here concerns Alternative C. C is preferred for 4.5% < Interest Rate < 9.6%.

15-3 Lease: Pay $267 per month for 24 months. Purchase: A = $9,400 (A/P, 1%, 24) = $9,400 (0.0471) = $442.74 Salvage (resale) value = $4,700 (a) Purchase Rather than Lease Monthly payment = $442.71 - $267 = $175.74 Salvage value = $4,700 - $0 = $4,700 Rate of Return PW of Cost = PW of Benefit

$175.74 (P/A, i%, 24) = $4,700 (P/A, i%, 24) = $4,700/$175.74 = 26.74 i = 0.93% per month Thus, the additional monthly payment of $175.74 would yield an 11.2% rate of return. Leasing is therefore preferred at all interest rates above 11.2%. (b) Items that might make leasing more desirable: 1. One does not have, or does not want to spend, the additional $175.74 per month. 2. One can make more than 11.2% rate of return in other investment. 3. One does not have to be concerned about the resale value of the car at the end of two years. 15-4 Investment opportunities may include: 1. Deposit of the money in a Bank. 2. Purchase of common stock, US Treasury bonds, or corporate bonds. 3. Investment in a new business, or an existing business. 4. (and so on.) Assuming the student has a single investment in which more than $2,000 could be invested, the MARR equals the projected rate of return for the investment.

15-5 Venture capital syndicates typically invest money in situations with a substantial amount of risk. The process of identifying and selecting investments is a time-consuming (and hence costly) process. The group would therefore only make a venture capital investment where (they think) the rate of return will be high- probably 25% or more.

15-6 The IRR for each project is calculated using the Excel function = RATE (life, annual benefit, -first cost, salvage value), and then the table is sorted with IRR as the key. Projects A and B are the top two projects, which fully utilize the $100,000 capital budget. The opportunity cost of capital is 12.0% if based on the first project rejected. Project A B D C IRR 13.15% 12.41% 11.99% 10.66% First Cost $50,000 $50,000 $50,000 $50,000 Annual Benefits $13,500 $9,000 $9,575 $13,250 Life 5 yrs 10 yrs 8 yrs 5 yrs Salvage Value $5,000 $0 $6,000 $1,000

15-7 The IRR for each project is calculated using the Excel function = RATE (3, annual benefit, -first cost) since N = 3 for all projects. Then the table is sorted with IRR as the key. Do projects 3, 1 and 7 with a budget of $70,000. The opportunity cost of capital is 26.0% if based on the first project rejected. Project 3 1 7 5 4 2 6 IRR 36.31% 29.92% 26.67% 26.01% 20.71% 18.91% 18.91% Cumulative First Cost $10,000 $30,000 $70,000 $95,000 $100,000 $130,000 $145,000 First Cost $10,000 $20,000 $40,000 $25,000 $5,000 $30,000 $15,000 Annual Benefit $6,000 $11,000 $21,000 $13,000 $2,400 $14,000 $7,000

15-8 The IRR for each project is calculated using the Excel function = RATE (life, annual benefit, -first cost, salvage value), and then the table is sorted with IRR as the key. With a budget of $500,000, the opportunity cost of capital is 19.36% if based on the first project rejected. Projects 3, 1, 4, and 6 should be done. Project 3 1 4 6 2 7 5 15-9 The IRR for each project is calculated using the Excel function = Rate (life, annual benefit, -first cost), and then the table is sorted with IRR as the key. The top 6 projects required $260K in capital funding, and the opportunity cost of capital based on the first rejected project is 8.0%. Project E H C G I B D IRR 15.00% 13.44% 12.00% 10.97% 10.00% 9.00% 8.00% Cumulative First Cost $40,000 $100,000 $130,000 $165,000 $240,000 $260,000 $285,000 First Cost $40,000 $60,000 $30,000 $35,000 $75,000 $20,000 $25,000 Annual Benefit $11,933 $12,692 $9,878 $6,794 $14,058 $6,173 $6,261 Life (years) 5 8 4 8 8 4 5 IRR 28.65% 24.01% 21.41% 20.85% 19.36% 16.99% 15.24% Cumulative First Cost $100,000 $300,000 $350,000 $500,000 $800,000 $1,200,000 $1,450,000 First Cost $100,000 $200,000 $50,000 $150,000 $300,000 $400,000 $250,000 Annual Benefit $40,000 $50,000 $12,500 $32,000 $70,000 $125,000 $75,000 Life (years) 5 15 10 20 10 5 5

A F

7.01% 5.00$

$300,000 $350,000

$15,000 $50,000

$4,429 $11,550

4 5

15-10 The IRR for each project is calculated using the Excel function = RATE (life, annual benefit, -first cost, salvage value), and then the table is sorted with IRR as the key. With a budget of $100,000, the top 5 projects should be done (6, 5, 4, 1, and 7). The opportunity cost of capital based on the first rejected project is 16.41%. Project 6 5 4 1 7 3 2 IRR 26.16% 22.50% 21.25% 19.43% 19.26% 16.41% 16.00% First Cost $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Annual Benefits $5,800 $4,500 $4,500 $4,000 $4,000 $3,300 $3,200 Life (years) 10 25 15 20 15 30 20 Salvage Value $0 -$20,000 $0 $0 $10,000 $10,000 $20,000