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Multiple Projects and Constraints

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

Because of economic dependency, capital rationing, or project


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

Feasible Combination Approach


The following procedure may be used for selecting the set of

investments under capital rationing.


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

Mathematical Programming Approach


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

Linear 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

All the coefficients in the objective function and


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

of direct labour are available, each of these hours is


equally productive.

Linear Programming Model of a Capital


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

= net present value of project j

Xj

= amount of project j accepted

CFjt = cash outflow required for project j in period t

Kt = capital budget available in period t


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

but limited by a lower restriction (0) and an upper


restriction (1)
3. The NPV calculation is based on a cost of capital
figure which is known with certainty.

Integer Linear Programming Model


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)

It may be noted that the only difference between this integer


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).

Incorporating Project Interdependencies


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

following kinds of project interdependence are incorporated


in the integer linear programming model:

Mutual exclusiveness
Contingency
Complementariness

Goal Programming Model


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 in sales and market share

Growth and stability of reported earnings


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

This approach, originally proposed by Charnes and Cooper in


1961, has been extended by Ijiri, Ignizio, and others.
To use the goal programming model, the decision maker must:

1. State an absolute priority order among his goals


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.