Capital Budgeting Essay
Capital Budgeting Essay
(Derived from Chapter 17: Long-Term Investment Analysis)
Title: The Lorie-Savage Problem
BUS 505 – Multinational Economics of Technology
Table of Contents
1.0 Introduction – Lorie-Savage Problem 3
1.1 Thesis Statement 3
2.0 Supporting Research 4
3.0 Conclusions and Recommendations 6
References 7
1.0 Introduction – Lorie-Savage Problem The Lorie-Savage problem is a problem introduced in 1955 that addresses the issue in how to allocate capital (or resources) among competing investment opportunities with constraints on the available resources. (Lorie & Savage, 1955, p. 229) In defining this problem, Lorie-Savage structures it by outlining three separate scenarios:
1) Given the cost of capital, what group of investments should be selected?
2) Given a fixed sum for capital investment, what group of investment proposals should be undertaken?
3) How to select the best among mutually exclusive alternatives? Lorie-Savage go on to state that the traditional method used at the time to drive investment decisions and maximize company profits and net worth is the rate-of-return method (now more commonly known as the internal-rate-of-return (IRR) method). It is clear that the authors have some reservations with this method part of their journal article is dedicated in proving that IRR has severe flaws and at times will not result in maximizing the net worth of a company from IRR based investment decisions. (Lorie & Savage, 1955, p. 239)
1.1 Thesis Statement The research below will demonstrate that the Lorie-Savage problem shows that the IRR method has severe flaws and therefore investment decisions should be made utilizing alternate, superior methods; the summarized research below will demonstrate this thesis statement. These methods are the modified-internal-rate-of-return (MIRR) and net-present-value (NPV). Also additional methods using a technique known as ‘genetic programming’ has also shown to have superior
(Derived from Chapter 17: Long-Term Investment Analysis)
Title: The Lorie-Savage Problem
BUS 505 – Multinational Economics of Technology
Table of Contents
1.0 Introduction – Lorie-Savage Problem 3
1.1 Thesis Statement 3
2.0 Supporting Research 4
3.0 Conclusions and Recommendations 6
References 7
1.0 Introduction – Lorie-Savage Problem The Lorie-Savage problem is a problem introduced in 1955 that addresses the issue in how to allocate capital (or resources) among competing investment opportunities with constraints on the available resources. (Lorie & Savage, 1955, p. 229) In defining this problem, Lorie-Savage structures it by outlining three separate scenarios:
1) Given the cost of capital, what group of investments should be selected?
2) Given a fixed sum for capital investment, what group of investment proposals should be undertaken?
3) How to select the best among mutually exclusive alternatives? Lorie-Savage go on to state that the traditional method used at the time to drive investment decisions and maximize company profits and net worth is the rate-of-return method (now more commonly known as the internal-rate-of-return (IRR) method). It is clear that the authors have some reservations with this method part of their journal article is dedicated in proving that IRR has severe flaws and at times will not result in maximizing the net worth of a company from IRR based investment decisions. (Lorie & Savage, 1955, p. 239)
1.1 Thesis Statement The research below will demonstrate that the Lorie-Savage problem shows that the IRR method has severe flaws and therefore investment decisions should be made utilizing alternate, superior methods; the summarized research below will demonstrate this thesis statement. These methods are the modified-internal-rate-of-return (MIRR) and net-present-value (NPV). Also additional methods using a technique known as ‘genetic programming’ has also shown to have superior
References: Berry, R. H., & Manongga, D. H. (2006). Integrating genetic algorithms and spreadsheets: a capital budgeting application. Intelligent Systems in Accounting, Finance & Management , 14 (3), 87-97. Brealey, R. A., Myers, S. C., & Allen, F. (2008). Principles of Corporate Finance. New York, NY, USA: McGraw-Hill Companies Inc. Brown, R. J. (2006). Sins of the IRR. Journal of Real Estate Portfolio Management , 12 (2), 195-199. Huang, X. (2008). Mean-variance Model for Fuzzy Capital Budgeting. Computers & Industrial Engineering , 55 (1), 34-47. Kaplan, S. (1966). Solution of the Lorie-Savage and Similar Integer Programming Problems by the Generalized Lagrange Multiplier Method. Operations Research , 14 (6), 1130-1136. Kierulff, H. (2008). MIRR: A Better Measure . Business Horizons , 51 (4), 321-329. Lorie, J. H., & Savage, L. J. (1955). Three Problems in Rationing Capital. The Journal of Business , 28 (4), 229-239. Osbourne, M. J. (2010). A resolution to the NPV–IRR debate? The Quarterly Review of Economics and Finance , 50 (2), 234-239. Trick, M. (1998). A Tutorial on Integer Programming. Retrieved April 05, 2011, from Michael Trick 's Operations Research Page, Carnegie Mellon University: http://mat.gsia.cmu.edu/orclass/integer/node2.html#SECTION00020000000000000000