Capital Rationing Among Independent
Projects
Chapter 12 Selection from
Independent Projects Under
Budget Limitation
INEN 303
Sergiy Butenko
Industrial & Systems Engineering
Texas A&M University
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Independent Projects & Bundles
Some may not be purely independent
Constraints might exist:
A can be accepted only if B is accepted
Acceptance of A&B implies acceptance of C
Bundle is a collection (a subset) of
given independent projects
Bundle PW would then be the sum of PWs
of projects in that bundle
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Capital Budgeting Problem
Identify independent projects and find their PW at
MARR
A given budget constraint restricts the total
amount available for initial investments (i.e.
magnitude of NCF at 0 for each project)
Objective is to select a subset of projects that
satisfy budget constraint (and others if they exist)
and maximizes the total PW of the selected
subset of projects
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Independent projects - Selection of one project in the
set does not impact acceptance or rejection of any
other project
Independent projects tend to be quite different from
each other
Investment capital represents a scarce resource
Generally more projects are defined for funding
consideration than there are funds available
Some projects may be funded and some may not be
Assumptions
Equal service for the alternatives is not
necessary for independent projects
No life cycle beyond the estimated life of
each project
Each project invested only for 1 life cycle
Each project is selected entirely or not selected,
partial projects are not permitted
Number of Bundles
Given m projects (independent), how
many possible bundles are there?
Total No. of bundles = 2m (Includes DN)
If m = 4 then 24 = 16 bundles
If m = 6 then 26 = 64 bundles
If m = 10 then 210 = 1024 bundles
If m = 30 then 230 = 1,073,741,824
bundles to evaluate!
Manual solution is limited by this fact
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 Example of Bundling: m = 4 Step 1 Identify Feasible Set
Project Initial Investment $ Identify all possible combinations of
A -$10,000 the projects where each combination
represents an economically mutually
B -$5,000
exclusive bundle.
C -$8,000
Consider all possible combinations by
D -$15,000 taking the projects 1 at a time, two at a
-$38,000 Total time, etc and listing them
Assume a budget of $25,000 (budget Eliminate infeasible bundles - ones
max.) that violate budget or other constraints

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Bundles Ordered On Total Investment Step 2. Determine Bundle PW

PROJECT ID INVESTMENT
1 DN $0
2 B $5,000 Find the PW of each independent project
3 C $8,000 Eliminate those
4 A $10,000
mutually exclusive Find bundle PW for each feasible bundle as
5 BC $13,000
6 D $15,000 bundles that follows
7 AB $15,000 exceed the $25,000 PW of bundle is the sum of the PWs of indep.
8 AC $18,000 budget limitation.
9 BD $20,000 projects in that bundle
10 ABC $23,000 Bundles 13-16 are
11 CD $23,000
infeasible, they exceed the
Let J denote a bundle (subset of indep. proj.)
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13
AD
BCD
$25,000
$28,000 budget limitation of for eg. J = {A, C, E}
$25,000. Bundles 1 12
14 ABD $30,000
constitute the feasible set.
PWJ = PWA + PWC + PWE
15 ACD $33,000
16 ABCD $38,000

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Steps 3 Bundle Selection Example 12.1

Assume b = $20 million;
Number of projects = 5
Select the bundle with the largest bundle PW
Set = {A,B,C,D,E}
No. of bundles = 25 = 32 possible combinations.
Each project has a life of 9 years
Determine the optimal bundle of projects that will
maximize the PW of the total set of projects
selected

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Initial Investments for m = 5 Projects Initial Investments for m = 5 Projects
Amounts are in units of $1,000. Amounts are in units of $1,000.

Initial Ann. Net Life Initial Ann. Net Life

Project Investment Cash Flow Years Project Investment Cash Flow Years
A -$10,000 $2,870 9 A -$10,000 $2,870 9
B $15,000 $2,930 9 B $15,000 $2,930 9
C -$8,000 $2,680 9 C -$8,000 $2,680 9
D -$6,000 $2,540 9 D -$6,000 $2,540 9
E -$21,000 $9,500 9 E -$21,000 $9,500 9

E is removed at the very beginning since $21 million >

$20 million budget

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Feasible Bundles, NCF and PW Values Example 12.2: Unequal Lives Example

Project Initial Annual Net Project

Investment, $ Cash Flow, Life, Years
$/year
A $ - 8,000 $ 3,870 6

B - 15,000 2,930 9

C - 8,000 2,680 5

D - 8,000 2,540 4

24 = 16 bundles to evaluate; 8 are feasible.

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PW Analysis Summary Capital Budgeting Problem Formulation

Using Integer Programming (IP)
Formulate the problem as an Integer Program
Objective:
Max sum of PW of projects in the selected set
Subject to:
Capital budget constraint on the total initial
investments of the selected projects
Other constraints if they exist

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Notation for IP Formulation IP Formulation of the Problem
PW is found with proper
k = 1m are the m independent projects m signs!

PWk is the present worth of project k at MARR Maximize: PW x

k =1
k k =Z
NCFk0 is the initial investment of project k NCF is the magnitude
m

NCF
(magnitude)
Subject to: k0 kx b
b = capital budget limitation k =1
xk = decision variable for project k xk = 0 or 1 for k = 1,2, ... , m
xk = {0, 1}
Optimal bundle is constructed from the optimal solution of the
If xk = 1 then project k is accepted above problem, i.e. all projects with xk = 1 at optimum to the above
If xk = 0 then project k is rejected IP formulation

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IP for Example 12.3 Solution from Spreadsheet

Objective Function: X1 = 1
Max : 6646x1 -1019x 2 +984x 3 -784x 4 X2 = 0
Budget Constraint: X3 = 1
8000 x1 + 15000 x2 + 8000 x3 + 8000 x4 20,000 X4 = 0
Decision Variables: Objective function value Z = $7,630
$16,000 spent
x1 , x2 , x3 , x4 , binary (0,1)
Leaving $4,000 unspent

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Use of Excel Solver for IP Chapter Summary

Solver is an add-in optimization tool to Excel
See the format in Figure 12-6
Students are encouraged to compose their
own spreadsheet to evaluate this problem
A sample file is posted online
Capital represents a resource that must be
rationed
Constraints other than budget constraints
(A&B imply C, A only if B etc) may also be
present
Hand solution
Create mutually exclusive bundles
Determine the feasible bundles
Calculate PW of the jth bundle at the MARR
Select the bundle with the maximum present
worth

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Summary continued
For m projects there are 2m possible
combinations or bundles
Manual solution will work only for very small
problems
Larger problems require an integer
programming formulation and spreadsheet
solution

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