Engineering Economic Analysis

524 RATIONING CAPITAL AMONG COMPETING PROJECTS

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rate of return. When the MARR is different from the cutoff rate of return, incorrect decisions

may occur. This will be illustrated in the next section.

RATIONING CAPITAL BY PRESENT WORTH METHODS

Throughout this book we have chosen from among project alternatives to maximize net

present worth. If we can do the same thing for a group of projects, and we do no~exceed

the availablemoney supply, then the capital budgeting problem is solved.

But more frequently in capital budgeting problem we will be unable to accept all

desirable projects. We, therefore, have a task not previously encountered. We must choose

the best from the larger group of acceptable projects.

Lorie and Savagel showed that a proper technique is to use a multiplier,p,to decrease

the attractiveness of an alternative in proportion to its use of the scarce supply of mon~y.

The revised criterion is

NPW - p(PWof cost) (17-1)

wherepis a multiplier.

If a value ofpwere selected (say, 0.1), then some alternatives with a positive NPW

will have a negative [NPW - p(PWof cost)]. This new criterion will reduce the number

of favorablealternatives and thereby reduce the combined cost of the projects meeting this

more severe criterion. By trial and error, the multiplierp is adjusted until the total cost

of the projects meeting the [NPW - p(PWof cost)] criterion equals the available money

supply-the capital budget..

Use the present worth method to determine which of the nine independent projects of

Example 17-2 should be included in a capital budget of $650,000. The minimum attractive rate

of return has been set at 8%..

Project

1 2 3 4 5 6 7 8 9

Cost

(thousands)

$100

200

50

100

100

100

300

300

50

Uniform

Annual Benefit

(thousands)

$23.85

39.85

34.72

20.00

20.00

18.00

94.64

47.40

7.00

Useful

Life

(years)

10

10

2

6

10

10

4

10

10

Salvage

Value

Jthousands)

$ 0

o

o

100

100

100

o

100

50

Computed

NPW

(thous~ds)

$60.04

67.40

11.91

55.48

80.52

67.1.0

13.46

64.38

20.-13

1 Lorie, J. and L. Savage, ''Three Problems in Rationing Capital,"Journal of Business,October 1955,

pp.229-239.

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