Engineering Economic Analysis

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518 RATIONING CAPITAL AMONG COMPETING PROJECTS

So fromthis cabinetofficer'spoint of view,the Crusaderhad to go. The Anny had

spent a long timejustifying the Crusader project to Congress under one set of requirements

but change in Defense Policy meant that money needed to be freed up for different projects:

We have until now dealt with situations where, at some interest rate, we choose each-

project's best mutually exclusivealternative.Thus, we were assuming that there is an ample

amount of money to make all desiredcapital investmentsin these projects. But the conceptof

scarcity of resources is fundamentalto a free market economy.It is through this mechanism

that more economically attractive activities are encouraged at the expense of less desirable

activities. For industrial firms, there are often more ways of spending money than there is

money that is available. The result is that we must select from available alternatives the

more attractive projects and reject-or, at least, delay-the less attractive projects.

This problem of rationing capital among competing projects is one part of a two-pan

problem called capital budgeting. In planning its capital expenditures, an industrial firm

is faced with two questions: "Where will money for capital expenditures-come from?"

and, "How shall we allocate available money among the various competing projects?" In

Chapter 15 we discussed the sources of money for capital expenditures as one aspect in

deciding on an appropriate interest rate for economic analysis calculations. Thus, the first

problem has been treated.

Throughout this book, we have examined for any given project two or more feasi-

ble alternatives. We have, therefore, sought to identify in each project the most attractive

alternative. For the sake of simplicity, we have looked at these projects in an isolated

setting-almost as if a firm had just one project it was considering. In the business world,

we know that this is rarely the case. A firm will find that there are a great many projects.that

are economically attractive. This situation raises two problems not previously considered:

1. Howdo yourankprojectsto showtheirorderof economicattractiveness?.


2. What do you do if there is not enough money to pay the costs of all economically
   attractive projects?
   In this chapter we will look at the typical situation faced by a firm: multiple attractive
   projects, with an inadequate money supply to fund them all. To do this, we review our
   concepts of capital expenditure situations and available alternatives. Then we su~arize
   the various techniques that have been presented for determining whether an alternative.
   is economically attractive. First we screen all alternatives to find those that merit further
   consideration. Then we will select the best alternative from each~ject, as~umingthat
   there is no shortage of money.The next step will be the addition of a budget constraint.
   If we find that there is not enough money to fund the best alternativefrom each project,
   we will have to do what we can with the limited amount of money available. It will become
   important that we have a technique for accurately ranking the various competing projects
   in order of economic attractiveness.All this is designed to answer the question, How shall
   we allocate available money among the various competing projects-?---

Capital Expenditure Project Proposals 17 RATIONINGCAPITALAMONG COMPETINGPROJECTS

At the beginning of the book, we described decision making as the process of selecting the

best alternative to achieve the desired objective in a given situation or problem. By carefully

defining our objective and the model, the given situation is reduced to one of selecting the

best from the feasible alternatives. In this chapter we call the engineering decision-making

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