Capital Budgeting Essay
(Derived from Chapter 17: Long-Term Investment Analysis)
Title: The Lorie-Savage Problem
BUS 505 – Multinational Economics of Technology
Table of Contents
Introduction – Lorie-Savage Problem
1.1 Thesis Statement
Conclusions and Recommendations
1.0 Introduction – Lorie-Savage Problem
The Lorie-Savage problem is a problem introduced in 1955 that addresses the issue in how to allocate capital (or resources) among competing investment opportunities with constraints on the available resources. (Lorie & Savage, 1955, p. 229) In defining this problem, Lorie-Savage structures it by outlining three separate scenarios: 1) Given the cost of capital, what group of investments should be selected? 2) Given a fixed sum for capital investment, what group of investment proposals should be undertaken? 3) How to select the best among mutually exclusive alternatives?
Lorie-Savage go on to state that the traditional method used at the time to drive investment decisions and maximize company profits and net worth is the rate-of-return method (now more commonly known as the internal-rate-of-return (IRR) method). It is clear that the authors have some reservations with this method part of their journal article is dedicated in proving that IRR has severe flaws and at times will not result in maximizing the net worth of a company from IRR based investment decisions. (Lorie & Savage, 1955, p. 239) 1.1 Thesis Statement
The research below will demonstrate that the Lorie-Savage problem shows that the IRR method has severe flaws and therefore investment decisions should be made utilizing alternate, superior methods; the summarized research below will demonstrate this thesis statement. These methods are the modified-internal-rate-of-return (MIRR) and net-present-value (NPV). Also additional methods using a technique known as ‘genetic programming’ has also shown to have superior results over IRR.
2.0 Supporting Research
As stated previously, the general solution methods for the Lorie-Savage problem are rate-of-return (or internal rate of return (IRR)) and net-present value (NPV) with additional techniques using genetic algorithms was found that also addresses the Lorie-Savage problem.
Lorie-Savage state in their journal article their reservations on using IRR and provide examples to support that notion, in particular the situation of ranking of mutually exclusive projects. (Lorie & Savage, 1955, pp. 236-239) The flaws with the IRR method can be described in one way by relating it to the concept of Jensen’s Inequality, discovered in 1906, that states that for convex functions, the function of the expectation is always less than or equal to the expectation of the function itself. IRR is a curved function of cash flow, but the simulated values for the calculated IRR is expected to be linear, thus producing inherent biases. Jensen’s Inequality proves that these inherent biases will emerge when simulating IRR, which can lead to incorrect decisions unless these biases are identified and reported up front and early. (Brown, 2006, p. 197)
However, all is not lost with the IRR method. The modified-internal-rate-of-return (MIRR) method has been introduced that takes an additional step beyond the IRR method as it takes into account the risk of reinvestment, as well as adjusting the discount rate for those reinvestments given the risk provided. This is a significant improvement beyond the original IRR method, which also has advantages over NPV, primarily due to the fact that the reinvestment of future cash flows is specifically addressed. (Kierulff, 2008, pp. 328-329)
In writing their paper Lorie-Savage essentially changed the opinion in the academic world in showing the advantages of NPV over IRR. (Osbourne, 2010, p. 234) This was achieved by employing an implementation of trial and error using ‘Lagrange Multipliers’ with...
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