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- Chapter 3 Generation and Screening of Project Ideas
- Chapter 11 Project Risk Analysis
- Prasanna Chandra
- Chapter 4 Market and Demand Analysis
- Chapter 18 Financing of Projects
- The Cost of Capital
- Chapter 14 Social Cost Benefit Analysis
- Chapter Generation and Screening of Project Ideas
- Project Management
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- Mb0045 - Financial Management
- Basic Finance
- Capital Budgeting
- KELLER_Single Row Layout Models
- Session4-5_CapitalBudgeting

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Outline

Constraints

Method of Ranking

Mathematical programming approach

Linear programming model

Integer linear programming model

Goal programming model

Constraints

Project dependence

Mutual exclusiveness

Negative economic dependency

Positive economic dependency

Capital rationing

Project indivisibility

Methods of Ranking

indivisibility, a need arises for comparing projects in order to

accept some and reject others. What approaches are available

for determining which projects to accept and which projects to

reject? Basically,two approaches are available: (i) the method of

ranking, and (ii) the method of mathematical programming.

Fairly simple, the method of ranking consists of two

steps (i) Rank all projects in a decreasing order according to

their individual NPVs IRRs or BCRs (iii) Accept projects in that

order until the capital budget is exhausted.

The method of ranking, originally proposed by Joel

Dean is seriously impaired by two problems: (i) conflict in

ranking as per discounted cash flow criteria, and (ii) project

indivisibility

The following procedure may be used for selecting the set of

1. Define all contributions of projects which are feasible,

given the capital budget restriction and project

interdependencies

2. Choose the feasible combination that has the highest

NPV

A mathematical programming model is formulated in terms of two broad

categories of equations: (i) the objective function, and (ii) the constraint

equations. The objective function represents the goal or objective the

decision maker seeks to achieve. Constraint equations represent restrictions

arising out of limitations of resources, environmental restrictions, and

managerial policies which have to be observed. The mathematical model

seeks to optimise the objective function subject to various constraints

The objective function and constraint equations are defined in

terms of parameters and decision variables. Parameters represent the

characteristics of the decision environment which are given. Decision

variables represent what is amenable to control by the decisions makers.

Out of the wide variety of mathematical programming models, we shall

discuss three types:

Linear programming model

Integer programming model

Goal programming model

The most popular mathematical programming model, the

linear programming model is based on the following

assumptions

The objective function and the constraint equations are

linear

constraint equations are defined with certainty.

The objective function is unidimensional

The decision variables are considered to be continuous

Resources are homogenous. This means that if 100 hours

equally productive.

Rationing Problem

The general formulation of a linear programming model for a

capital rationing problem is :

Maximise

n

j=1NPVj Xj

Subjectnto

j

=1CFjt Xj Kt (t = 0,1,.m)

0 Xj 1

Where NPVj

Xj

The following features may be noted.

1. All the input parameters NPVj, CFjt , Kt are

assumed to be known with certainty.

2. The Xj decision variables are assumed to be continuous

restriction (1)

3. The NPV calculation is based on a cost of capital

figure which is known with certainty.

The principal motivation for the use of integer linear

programming approach are: (i) It overcomes the problem of

partial projects which besets the linear programming model

because it permits only 0 or 1 value for the decision

variables (ii) It is capable of handling virtually any kind of

project interdependency.

The basic integer linear programming model for capital

budgeting under capital rationing is as follows:

Maximise

Subject to

n

Xj NPVj

j =1

n

CFjt Xj Kt (t = 0,1,.m)

j =1

Xj

= (0,1)

linear programming model and the basic linear programming

model discussed earlier is that the integer linear programming

model ensures that a project is either completely accepted

(Xj =1) or completely rejected (Xj= 0).

in the Model

By constraining the decision variables to 0 or 1, the integer

linear programming model can handle almost any kind of

project interdependency. To illustrate, let us see how the

in the integer linear programming model:

Mutual exclusiveness

Contingency

Complementariness

Throughout this text we have assumed that the principal goal of

financial management is to maximise the wealth of shareholders, which,

under conditions of perfect capital market, can be realised by selecting

the set of capital projects that maximise net present value.

However, in the real world, capital market imperfections (like capital

rationing, differences in lending and borrowing rates, etc.) exist.

Further, empirical observation show that managers pursue a multiple

goal structure which includes, inter alia, the following:

Growth and stability of dividends

Therefore, a realistic representation of real life situations should reflect

the multiple goals pursued by the management. The goal programming

approach, a kind of mathematical programming approach, provides a

methodology for solving an optimisation problem that involves

multiple goals

1961, has been extended by Ijiri, Ignizio, and others.

To use the goal programming model, the decision maker must:

2. Provide a target value for each of his goals.

The goal programming methodology seeks to solve the

programming problem by minimising the absolute deviations

from the specific goals in order of the priority structure

established. Goals at priority level one are sought to be

optimised first. Only when this is done will the goals at priority

level two be considered; so on and so forth. At a given priority

level, the relative importance of two or more goals is reflected

in the weights assigned to them.

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