Chapter 11: Brief Tutorials on Solver and Evolver — Multiperiod Capital Budgeting Example 11.1 This chapter introduces two optimization programs: Solver and Evolver. Both run as Excel addins with Evolver being able to handle a wider class of problems than Solver. First, we show how to use Solver to gain insights when solving a capital budgeting problem, then move to Evolver and solve a fixed-charged problem. Linear Optimization — Solver Multiperiod Capital Budgeting Companies often have more worthwhile projects under consideration than their financial resources allow them to undertake. In this situation, Excel's Solver can be used to determine the best combination of projects to fund subject to the constraint that each year the total money spent on the projects does not exceed the amount of available capital. A company has nine projects under consideration. Though they would like to fund each project, they are constrained by a $50 million budget for Year 1 and by a $20 million budget for Year 2. Figure 11.1 reports the capital (in millions) required by each project during the next two years along with the NPV (in millions) of each project. Note that the NPV values include all cost figures including the costs over the next two years. For example, Project One requires expenditures of $12 million during Year 1, $3 million during Year 2 and, if funded, will contribute $14 million in NPV. Which projects should the company choose to fund? a) If we assume that we may undertake a fraction of each project with the same fraction of NPV resulting, which projects should be funded?’ b) If we cannot undertake a fraction of a project, but must undertake all of a project or none of a project, which projects should be funded? ©) Suppose that, in addition to not allowing fractional funding, if Project Four is undertaken, then Project Five must also be undertaken, which projects should be funded? Chapter 11: Brief Tutorials on Solver and Evolver — Multiperiod Capital Budgeting 151Figure 11.1 Solution: Solution Part a) 4 2 3 Project Number: One Two Three Four ‘Five Six_ Seven’ Eight Nino ‘ ‘Year 1 Gosis: $12.00 $54.00 $6.00 $8.00 $30.00 $6.00 S400 $36.00 $1800 5 Year2Coss; $3.00 $7.00 $00 $200 $20.00 $0.00 $400 $5.00 $300, 8 NPV: $1400 $1700 $17.00 $15.00 $4000 $12.00 $1400 $1000 $1200 7 8 Funded? 4 4 1 z aa 1 1 1 9 10 Total NPV $181.00 1 2 3 Used ‘viable 14 Year 1$216,.00 <=” $5000 6 Year? $5400 <= $2000 To solve this problem without any model, managers rely on heuristics, which are simple rules for complex problems. Heuristics are helpful, but they cannot guarantee an optimal solution. An example heuristic here would be to choose the project with the largest NPV, and if there are funds left over, choose the project with the second largest NPV, and so on. Project Five's NPV is the largest and more than twice any other project's NPV. However, once we fund Project Five, we can include no other project as the entire second year budget is used while leaving $20 million of the first year budget unused. The first and most important step in modeling is to determine the objectives of the decision maker. In this problem, it is rather obvious that the objective is to maximize the sum of the individual project's NPVs (Total NPV), however, there are other possibilities, For example, we might want to maximize IRR (internal rate of return) or minimize payback or break-even time. Step 1: Building the Capital Budget Model 1.1 Open the file Capital Budget.xlsx. The Funded? numbers in row 8 represent the percentage of the project that is being funded. The 1’s show we are currently funding 100% of every project, which is infeasible as this violates the budget constraints. 1.2. In cell C10, enter =SUMPRODUCT(C8:K8,C6:K6). The SumProduct() function in Excel is used extensively in optimization problems, and here is calculating the Total NPV. SumProduct() works by first taking the pairwise products, then summing up: SUMPRODUCT(C8:K8,C6:Ké6) = C8*C6 + D8*D6 + ... + K8*K6. The SumProduct() can be taken of two rows (as it is here) or of two columns. It can also be used on 3 or more rows or columns. If every project were to be funded, the Total NPV is $151 million. 152 Linear Optimization — SolverFigure 11.2 1.3 In cell C14, enter =|SUMPRODUCT(CS8:K$8,C4:K4) and drag down to C15. Here we are calculating the yearly costs, and if we were to fund every project, then it would cost $216 million in Year 1 and $54 million in Year 2. 14 In D14, type <= and drag down to D15. Here we are simply representing the direction of the budget constraints, viz., Used < Available. 15 In E14, type $50 and ae in E15. These are the available eae sat obpce scxio mw | Te @ um ma Ome ot ° Ay Chengg Venice scons a Subeto we Coats: fSessnis ce seesens c j | ‘hogs } bee i | Pg j J bosarsave |) Gime canaries vores to-egsve Sect sag te Sepectt = as 0g od | eet tb nentnane engin er lace Spleen || fornes ser Preis, sd select be vbw anger Ser obi Ba eRe smeC Step 2: Using S Solver to Maximize Total NPV 2.1 To setup Solver, click the Data tab in Excel’s menu, and click on Solver along the right-hand side. If Solver is not shown in the menu, then you need to install it. See Excel’s help for instructions. Figure 11.2 shows Solver's dialog box. 2.2 In the Set Objective box, enter C10, as that is the location of the formula that calculates Total NPV. Click the Max radio button. 2.3. The decision variables, percentage of each project to fund, are entered in the By Changing Variable Cells box as C8:K8. Chapter 11: Brief Tutorials on Solver and Evolver — Multiperiod Capital Budgeting 153