Multiple Projects and Constraints
In the existing environment, an organisation
cannot consider a capital investment project individually
as certain pre-conditions require to be fulfilled.
Constraints: Project dependence, capital
rationing and project indivisibility are factors that restrict
isolated project selection. If the acceptance and rejection
of one influences the cash flow stream of the other or affects
the acceptance and rejection of others, then the two projects
are said to be economically dependent. The three types of
economic dependency are as follows:
1. Mutual exclusiveness
2. Negative dependency
3. Positive dependency (complementariness).
Capital rationing occurs when funds available
are not adequate to undertake all the projects that are
acceptable otherwise. It also arises because of internal
limitation or an external constraint.
A project cannot be accepted or rejected partially,
it is indivisible, and has to be accepted or rejected in
totality.
Methods for comparison: Factors like
economic dependency, capital rationing or project indivisibility
emphasise the need for comparison of projects. The methods
used for comparing projects are:
1. Method of ranking: Joel Dean originally
proposes a method of ranking. It consists of two steps:
(i) Ranking all the projects in decreasing
order of the NPV’s, IRR’s, or BCR’s. Assumptions
in these 4 methods are:
NPV method: The intermediate cash flow
is re-invested at a rate of return equal to the cost of
capital of the firm.
IRR method: Cash flow is re-invested at a rate of
return equal to or greater than the Fisherian rate of return.
BCR criterion: The intermediate funds are reinvested
at a rate of return greater than the Fisherian rate of return.
Accepting all projects in that order until
the capital budget is exhausted.
(ii) All combination of feasible projects
should be defined, given the capital rationing constraint
and project dependencies. Then choosing a combination having
the highest NPV is known as the feasible combination procedure.
Problems: There are two major problems related
to this method (i) because of the discounted cash flow criteria,
conflict arises in the ranking. (ii) Indivisibility of the
project.
2. Mathematical programming approach: Two
broad categories of equations are considered for formulations
in the mathematical programming approach:
(a) The objective function and (b) The constraint equations
The following three models are commonly
used:
(i) Linear programming model: Assumes that
the objective function and the constraint equation are linear
while the decision variables are continuous.
(ii) Integer linear programming model: It
is presupposed that decision variables assume a value of
0 or 1.
Advantages of the method: (a) It overcomes the problem of
partial projects which besets the linear programming model
and. (b) It is capable of handling virtually any kind of
project interdependency like mutual exclusiveness, contingency
and complementary.
(iii) Goal programming model: It solves the
programming problem of minimising the absolute deviation
from specific goals in order of the established priority
structure.
