Development of a microcomputer-based capital budgeting algorithm for the dynamic decision environment

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Virginia Polytechnic Institute and State University

The capital budgeting process is conducted in a dynamic, uncertain environment. In each period of the process, a manager has only estimated values for system parameters, project costs, and project returns. The manager must consider project firm's capital among interdependencies the available in allocating the projects. After completing the allocation process in one period, the chosen projects are funded until the end of the next period. These projects are then considered along with new projects and the process is repeated again. The capital budgeting decision in one period is therefore only one of a long sequence of such decisions, all of which are made in a dynamic, uncertain environment.

The algorithm presented in this study models the dynamic environment of uncertainty. The algorithm utilizes a future worth of net return criterion in conducting the decision. Available projects may be estimated as discrete point estimates or as combinations of continuous functions. All projects under consideration need not have the same life; unequal-lived projects may be considered. After the optimal combination of projects is identified, four sensitivity analyses may be run to analyze the effect of any uncertainty in that period. The dynamic environment may then be analyzed by simulating the environment which would be faced when the decision is made .again at the end of the next period. Any of the system parameters and estimates of the continuing projects may be altered in that period to reflect the changes in the last period's estimates.

An example is provided to illustrate the workings of the algorithm.