Criteria For Capital Investments

Criteria for Capital Investment: An Approach Through Decision Theory
Author(s): R. M. Adelson
Source: OR, Vol. 16, No. 1 (Mar., 1965), pp. 19-50
Published by: Operational Research Society
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Criteriafor Capital Investment:
An Approach through Decision Theory
R. M. ADELSON
The Distillers Company Ltd.
The arbitrary character of such' concepts as "Discounted Present Worth", which

are often advocated as methods of assessing and comparing investment oppor-
tunities, is discussed in Part 1 of this paper. It is also pointed out that, by their
nature, these concepts are not particularly well adapted to situations in which
"risk" is an important factor. In order to develop a method in which a logical
approach to risk can be adopted, an understanding of the basic problem of
Decision Making under Uncertainty is required. An introduction to this subject
forms Part 2 of this paper. In Part 3 the problem of Plant Investment under Risk
is considered, and a rational approach to this is developed. The importance of
the "portfolio" concept in such problems is particularly demonstrated.
1. CRITIQUE OF CONVENTIONAL METHODS

IT IS often said that one of managements' principal functions is to make
decisions. It is even more often said that operational research is an aid to
managerial decision-making. It is surprising, therefore, that there is so little
in the operational research'literaturewhich bears on what must be one of top
managements' principal headaches-the problem of where, and to what extent,
to invest capital.
The problem is a typical operational research one in that it requires
(a) making a model of the situation,
(b) finding the appropriate criterion and
(c) discovering how to manipulate the model in order to optimize the
criterion.
Typical too, perhaps, is the fact that the papers in the operational research
literature have concentrated on the first and last of these, the second being
treated as "given"-usually (e.g. McDowell') to maximize the "discounted
present worth at a given rate of interest". Hillier2, however, does mention other
criteria, and he, unlike McDowell, gives particular attention to one of the most
significant headache provoking factors in these problems-that of risk and
uncertainty.
Although the management-orientated financial and accounting literature on
this subject has paid considerable attention to the question of choosing a
criterion, we do not find any consensus of opinion here. Lawson3 (of the
University of Sheffield) favours the "Present Worth". Ashton4 (Treasurer,
Esso Petroleum Company) argues for what we shall call the "Internal Rate of
19
Operational Research Quarterly Vol. 16 No. 1
Return".t Both Ashton and Terborgh5strongly criticize the use of the "pay-back
period", which they say is commonly used as a criterion, and Ashton suggests
that another common approach, that of using the ratio of incremental net
profit in a representative year to capital outlay, is lacking in some important
respects. Terborgh dismisses all of these as "industrial folklore, handed down
from one generation of management to the next. They have no scientific
rationale, no legitimate intellectual parentage". He replaces them by his own
criterion-"next year profit advantage".
Judging by the relative number of occurrences in the literature, the present
worth and internal rate of return criteriawould appear to be the most important,
and it is therefore worth looking at these more closely. They are defined as
follows: Let V(t) be a rate of cash flow at time t and r be a "discount rate".
Then the "present worth" of the cash stream defined by V(t) is
V= XTfV(t)exp(-rt)dt,
where T is the life of the project.: If C is the cost of the project (all spent at
time zero), the present worth of the project is V- C. The internal rate of return
of a project is the (not necessarily unique) value of i which satisfies
exp(-it) dt = C.
STWV(t)
In his paper (loc. cit.) Lawson mentions both these criteria. He points out that
they will give different results from one another, and then rejects the latter of
them on the grounds that in order to obtain the calculated rate of return it is
necessary to re-invest all cash throw-offs from the projects at that rate of return,
and it might not always be possible to do this, especially where a project has
a particularly high internal rate of return. He therefore advocates the use of
present worth as the criterion for capital investment decisions. However,
Lawson appears to be in error here, since it is quite easy to show that if the
capital from a project is borrowed (as it generally is, even if it is called "retained-
earnings") and the cash throw-offs are used first to pay interest at a rate i on
the outstanding capital, any surplus being used to reduce the outstanding
capital, then if i is chosen so that the capital is just paid off at the end of the
project life, this is the "internal rate of return". What happens to the money as
it is paid off is irrelevant. We must surely agree, therefore, with those who
maintain that the higher the internal rate of return of a project, the more
efficiently it is using capital. But how is one to interpret multiple solutions? to
the equation defining this return? However, the rate of return does avoid a
t Sometimes referredto as the "Discounted Cash Flow (or DCF) Rate of Return".
I Continuous discounting is used here for convenience in presentation. Conventional
accounting technique uses discrete time calculations. This distinction does not affect the
arguments here but it is worth noting that it can make considerable difference to certain
numericalresults.
? These can occur in cases where the net cash flow changes sign.
20
R. M. Adelson - Criteria for Capital Investment
problem raised by the present worth-the determination of the appropriate
discounting rate. To quote Lawson, ". . . this is a complicated aspect of capital
budgeting". Nevertheless, the more sophisticated treatments, e.g. those of
Hirshleifer6and White,7 generally favour the latter.
Behaviour in practice
In order to try to see how important the practical differences between these
criteria are, the author has investigated a model in which it is proposed to build
a plant to make a product, the market for which is expanding. The capital cost
of a plant of capacity C is proportional to Ctn, where n is of the order of 07.
Clearly in this situation it may sometimes be worth while anticipating the
future, and building a plant of somewhat larger capacity than the initial demand
envisaged, in order to take advantage of the reduced price per ton of capacity
of a larger plant. Typical results have been that if the plant capacity is chosen
to maximize the present worth, this capacity will be such to satisfy the market
expected in 3-4 years' time. Maximization of the internal rate of return,
however, would result in a plant being built for the market envisaged in 1I-2
years' time. Further, if (all other things being equal) the capital cost of a plant
of given size can be reduced this would tend to increase the size of plant built
in the former case and decrease it in the latter. It can be deduced from these
results that, in a competitive situation, if the firms involved maximize an internal
rate of return criterion, the market will eventually be served by a larger number
of smaller plants than would be the case if the firms all maximized present
worths. This must surely have considerable relevance to problems of economic
planning, etc.
Present worth
Although it appears to be gradually gaining acceptance, the present worth
approach and the way in which it is generally applied still leave some rather
gnawing doubts. Suppose, for instance, that a firm is to choose one investment
from among the four whose net cash flow rates against time are plotted in
Figure 1. When discounted at 6 per cent (assuming this to be the appropriate
rate) these cash streams all have the same present worth. A decision-maker of
the present worth school of thought should therefore find them all equivalent,
i.e. he should be indifferent as to which is chosen. Does this seem reasonable?
It is certainly true to say that under conditions of no risk, perfect liquidity and
a perfect capital market (i.e. unlimited supplies of capital can be lent or borrowed
at 6 per cent interest, with negligible costs of transaction) these are equivalent
because any one of the cash streams can, by appropriatetransactions,be converted
into any of the others. In this case it is legitimate to rank cash streams in order of
preference according to their present worths. It is hard to see the justification
for carrying this argument over to the case of industrial capital investment,
where, in general, all the above conditions are violated. Consider cash streams
21
B and C in Figure 1. Suppose a firm is faced with choosing between these two.
From which would it be better off in 10 years' time if it wishes to raise more
capital then; B, with its record of falling profits and poor outlook, or C with its
record of rising profits and bright outlook? Yet the two are equivalent on
1-6
E A
c 05 -
0-4
0-2 3-
01-
0 5 l0 15 20
Time, years
FIG. 1. Comparison of cash flows.
present worth calculations. If it is possible to find a reason for preferring one

of these cash streams to another on grounds such as liquidity, difficulties in
raising capital, etc., it would appear that present worth is not an adequate
criterion for choosing between investments.
Although this does not seem to have been pointed out before, a further
difficulty which stands in the way of acceptance of the present worth type
of arguments is the fact that the weighting function (exponentially decreasing
with time) which is almost invariably used for discounting purposes is completely
arbitrary. No doubt the reader will be familiar with the traditional argument
which starts "Since a sum P invested now at a rate of interest r will grow to
P exp (rt) at time t, the sum which needs to be invested now in order to be worth
P at a time t is Pexp (- rt)."t This statement is, of course, true-by definition.
But it is worth asking where one can invest a sum P so that it will grow to
Pexp(rt) at time t. Certainly money invested in a bank deposit account or
building society will grow in this way-subject to the minor proviso that the
t See 2nd footnote, page 20.
22
interest rate may be changed from time to time. However, money invested in
National Savings Certificates;Industrial Equities; Premium Bonds or Industrial
Productive Capacity does not, in general, grow according to this formula. It
is also worth noting that in the former cases investments only grow according
to the exponential formula because the institutions in question have decreed
that they shall do so. This particular formula seems to have been chosen not
because it had been shown to be the best one for the job, but solely on the
grounds of simplicity. The fact that certain investments of this type (e.g.
National Savings Certificates) use a different growth formula is some evidence
that the exponential one is not necessarily the best. Yet a different formula
for growth implies a different formula for discounting, which in turn would
produce a different ranking of investment projects. Thus it would appear that
the use of present worth as a means of choosing between investments is no less
arbitrarythan, say, the use of payback period. For all the advocacy of the former
and denigration of the latter that is found in the literature, the superiority of
the one over the other has not been proved.
Risk and uncertainty

Since discounting, as generally defined, is truly relevant only to situations
of perfect liquidity and no uncertainty, it is not surprising to find that most
attempts to incorporate risk into these criteria have resulted in considerable
confusion. Most writers have been satisfied to treat risk intuitively, or pretend
it does not exist. Very few have really got to grips with the problem of defining
and measuring it. Thus one might allow for risk by "shortening the expected
life of the asset, in the calculation" or "estimating earnings very conservatively".
Another common suggestion (with present worth) is to use a higher discounting
rate for the riskier project. How does one determine the appropriate rate for a
given project? The usual answer is "let the market decide". Lawson says, "The
price a firm finds it necessary to pay to attract capital depends, among other
things, on the risks attaching to the firm." This is no doubt true. He goes on
to say, "An array of investments of equal risk will pay the same rate of interest."
This latter statement is either a definition of "risk" (in which case, as we shall
see later, it is not a very good one) or it requires substantiation. Without an
independent measure ofrisk (which Lawson does not offer) this is impossible.
The statement is therefore meaningless. Ashton's argument, though essentially
the same, is a little more tortuous. "Projects that show a higher (internal) rate
of return (than the weighted average of the next composite increment of capital
raised by the company, assuming money to be drawn from various sources in
proportions dictated by the necessity of keeping respectable financial ratios)
are prima facie desirable." Ashton is making a point here which Lawson over-
looks, that is that the "market" invests money in management, not projects.
It is management's responsibility to weigh the risks of any individual project
(and hence to determine the discount rate ?).
23
Exercises
The reader is now invited to try his hand on the following exercises:
(1) Calculate the internal rate of return of a "Premium Bond" and discuss the relative
merits of these and National Savings Certificatesas Christmaspresents.
(2) Lunartite is a mineral which might be present in large or small quantities on the
surface of the Moon. Consideration is being given to building a plant which will
convert this into mundovite, a use for which is almost certain to be found in due
course. The plant will cost ?1M, which will be a complete write-off if the Russians
are first to land a man on the Moon, but will probably net a clear 10M if the
Americans are first there. Calculate the present worth of this project, and state
whether you would risk your money or reputation on it. [Hint: For assistance in
determining the appropriate discounting rate, attention is drawn to Professor
Williams's statement, "With uncertainty, the very conception of a rate of interest
that equates supply and demand for investment loans is misleading."8]
The remainder of this paper will be largely concerned with the problem of
developing a rational approach to risk in investment decisions. As an example,
the question of choice of optimum plant size to meet an uncertain demand will
be discussed, but the approach developed is, of course, much more general.
Part 3 is based on Markowitz's work,'7 and consequently on Savage's statistical
ideas. What follows in Part 2 is intended to be a very rough-and-ready account
of some of the latter, neither rigorous nor complete. However, it must be pointed
out that there are other schools of thought here, notably Shackle, a discussion
of whose work will be found in the book containing Reference 8. Readers
familiar with the argumentsleading up to the postulation of the "utility function"
are invited to turn their attentions straight to Part 3.
2. DECISION MAKING UNDER UNCERTAINTY

Before embarking on the following brief survey of part of this field, it is perhaps
worth reflecting on the function of a "criterion". An analogy can be drawn
between "criterion" and "statistic". Both are scalar functions of data, intended
to summarize complex situations. The values of the function are, in the former
case, supposed to represent relative preferences, and in the latter case to tell us
something about the value of a parameter in a statistical model. Suppose one
has a sample of size n from a Normal distribution of known variance, whose
mean is to be investigated. There are many "statistics" (i.e. functions of the
data) which can be used to do this. For instance one might calculate the mean
of the sample
in
X-- E Xi
nl i=1
or the mid-range of the sample, xrn I(x = x1),where x5 and xl are the smallest
and largest values in the sample respectively; or the median, i.e. the number
which is such that half the observations fall below it, and half above, etc.
How does one decide which to use? This is done by stating some arbitrary
24
conditions, which seem intuitively to be sensible, which we would like the
statistic to satisfy. For example, the statistic should:
(a) be relatively efficient, i.e. contain a large proportion of the information
contained in the sample, relevant to the parameter in question;
(b) have a distribution which is known or easily determined, and we might
add to this:
(bb) have a distribution which is relatively insensitive to the assumption of
Normality of the parent population;
(c) be easy to calculate;
(d) be unbiased.
Now it can be shown that relative to these conditions, the sample mean, x,
has a lot to recommend it. For instance, with respect to (a) it is sufficient, i.e.
contains all the information in the sample concerning the value of the population
mean. This is not true of any other statistic. With respect to (b) its distribution
is Normal, and (bb) this is virtually true whatever the form of the present
population, if n is greater than about 10 (Central Limit Theorem). It is quite
easy to calculate (c) (but notice that in small samples xm is easier), and (d) it
is unbiased. We are prepared to forgive its slightly inferior performance under
(c) as it performs so well under the other considerations. If ease of calculation
had been an overriding factor, xrn would probably be used.
The considerations which must be brought to bear to decide between decision-
making criteria are of the same general nature. We can now turn to the problem
of "Decision Making Under Uncertainty".
The problem
In its simplest form the basic decision problem under uncertainty can be
expressed as follows. The decision-maker is faced with a number of alternative
decisions D1,D29..., Dn, and a number of possible "states of the world"
S1, S2, ..., Sna.Both the D's and S's are defined in such a way as to make them
mutually exclusive and exhaustive setst so that one and only one S will prevail
(although which one is not known), and one decision D must be selected from
among those listed. Associated with each decision-state of the world combination
there is a unique "pay-off" which we assume can be calculated (although, as the
previous discussion has shown, this begs some questions). If the pay-off for
decision Di with state S, is aij then the structureof the problem can be expressed
as an array of pay-offs (or pay-off matrix) as shown in Table 1 where the rows
correspond to decisions, and the columns to states of the world. Our problem
is to find a "criterion", i.e. a means of summarizing each possible decision
into a single number (cf. "statistic") so that they can be ranked in order of
preference.
t In practice, both these sets are likely to be large, if not infinite. We shall see, however,
that some criteria do not require all the states to be explicitly specified.
25
Operational Research Quarterly Vol. 16 No. I
In order to make the ensuing discussion more explicit, reference will be made
to the following simple example. A company is considering investing in a plant
to make a new product. It is known that if the Americans land on the Moon
first, the market will be 10,000 tons per annum. However, if the British are first
TABLE 1. A DECISION MATRIX
State
Decision S1 S2 S3 ... SI-, S1
D, al,, a,,, al,3 .. a,, n-l a,, I

D2 a2,l a2,2 a2,, . a2, n-1 a2, I
Dm-1 am-1i1 am-1,2 a,,-1,3 ... am-,.1 -, am-,. ,

Dm ami am,2 am,3 am.n-1 am, I
to the Moon, the market will be 15,000 t.p.a.; if the Chinese, then 20,000 t.p.a.;
if the French, then 25,000 t.p.a. and if the Russians, 30,000 t.p.a. (5 states of
the world). There are 5 possible decisions: build a 10,000 t.p.a. plant, build a
15,000 t.p.a. plant ... build a 30,000 t.p.a. plant. Table 2 shows the pay-off
matrix which the decision-maker has drawn up.
As there is no objective statistical evidence by which to weigh the likelihoods
of the states of the world (the "experiment" has not been conducted before), the
decision-maker might decide that a "good" criterion would be one that works
independently of this. Moreover, since this situation is clearly "risky" the
TABLE 2. AN EXAMPLE OF A DECISION PROBLEM
Size of Size of market

plant 10,000 15,000 20,000 25,000 30,000
10,000 13,000 8,000 6,000 3,000 0

15,000 10,000 20,000 15,000 12,000 10,000
20,000 0 10,000 30,000 25,000 20,000
25,000 -10,000 0 20,000 40,000 30,000
30,000 -20,000 - 10,000 10,000 20,000 50,000
criterion should be "conservative", i.e. tend to reduce the risk. Also it seems
reasonable to ask that the criterion itself be objective, i.e. the decision obtained
should not depend on who is making it. A criterion satisfying these three
requirements is the "Maximin" rule. This says: "For each decision, consider
what is the worst that could happen: Choose that decision for which this is best."
In terms of the example, the worst that could happen if D1 is chosen (D1 is
the decision to build a 10,000 t.p.a. plant, etc.) is 0 pay-off; if D2 is chosen,
?10,000 pay-off; if D3, 0 pay-off;if D4, - ?10,000 pay-off; if D5, - ?20,000
26
pay-off. The best of these is D2, since this guarantees at least ?10,000. Thus
according to this criterion a plant of capacity 15,000 t.p.a. should be built.
Although this might seem perfectly reasonable in this context, it can be criticized.
Suppose the pay-off matrix had been as shown in Table 3. D2 is still chosen. It
TABLE 3. A DECISION PROBLEM ILLUSTRATING ULTRA CONSERVATISM OF MAXIMIN RULE
State
Decision S1 S2 S3 S4 S5
DI 106 103 103 103 103

D2 104 2 x 104 104 104 104
D3 0 106 106 106 106
D4 0 0 106 106 106
D5 0 0 106 106 106
guarantees ?10,000, but at best is ?20,000. With any of the other decisions
there is the possibility of a gain of ?1,000,000. Since this rule does not take
such possibilities into account, it is generally considered to be too conservative
as a general decision-making criterion.
In order to combat this criticism, Savage suggested the "Minimax Risk"
criterion. For each possible state of the world calculate the "risk" (or "regret")
of each decision as the difference between the pay-off for that decision and the
TABLE 4. THE "RISK" MATRIX
State
Decision S1 S2 S3 S4 S5
D1 0 12,000 24,000 37,000 50,000

D2 3,000 0 15,000 28,000 40,000
D3 13,000 10,000 0 15,000 30,000
D4 23,000 20,000 10,000 0 20,000
D5 33,000 30,000 20,000 20,000 0
pay-off for the best decision. Draw up a new matrix in which these risks are
entered, instead of the original pay-offs. Find the maximum risk for each
decision, and choose the decision for which this is least. To illustrate, the best
decision if S1 pertains(Table 2) is D1. The "risk" of D2 is 13,000- 10,000 = 3000.
The risk of D3 is 13,000-0 = 13,000, etc. If S2 pertains, the best decision is D2.
The risk of D1 is 12,000, etc. Thus the risk matrix is as shown in Table 4. Each
decision is evaluated by noting the highest risk associated with it. This is
?50,000 for D1; ?40,000 for D2, etc. The decision for which this is smallest
is D4. Thus use of this criterion suggests building a 25,000 t.p.a. plant.
27
Although the above criterion does consider possible gains, it suffers from the
interesting phenomenon of being counter to the principle of "Independence of
Irrelevant Alternatives". This is an intuitive principle of behaviour which can
be stated roughly as follows. "If, after a choice of the 'best' has been made from
the set of possible decisions, a further possible decision which was not included
in the original set, is discovered, then either this new decision is now 'best'
and should be taken, or it is not, and one should stick to the original decision.
It would not appear to be reasonable, when presented with the new decision,
to take now a different decision from among those originally considered." The
converse should also be satisfied, and we shall show from the example that the
Minimax Risk principle does not do so. Suppose, after D4 is chosen, D5 is
removed from the set (e.g. we are now told that insufficient capital would have
been available to build a 30,000 t.p.a. plant anyway). "Independence of
Irrelevant Alternatives" would assert that this does not matter. We should
continue to claim that as D4 was "best" out of D1... D5, D4 is still "best" out of
D1.. . D4. If, however, a new risk matrix is produced from Table 2 with the last
TABLE 5. NEW "RISK" MATRIX
State
Decision S1 52 S3 S4 S5
D1 0 12,000 24,000 37,000 30,000

D2 3000 0 15,000 28,000 20,000
D3 13,000 10,000 0 15,000 10,000
D4 23,000 20,000 10,000 0 0
row removed, we get Table 5, from which it can be seen that the best decision
under this criterion is now D3. Thus the Minimax Risk criterion obviously has
some psychotic tendencies, and it too is best avoided.
There have been many other attempts to produce a satisfactory criterion
satisfying our first requirement,i.e. that it should be able to operate in situations
where there is a lack of any objective evidence concerning the states of the
world. The most well known of these invokes the "Principle of Insufficient
Reason". Suppose first that the states of the world were such that objective
evidence were available or obtainable by experiment, which could be expressed
as a probability distribution over these states. In this case one might calculate
the "expected value" of each decision:
n
E(Di) =E aijP(Sj)
j=1
where P(Sj) is the probability of state Sj pertaining, and rank the decisions in
order of expected value. Leaving aside, for the moment, the question of whether
28
this is a reasonable thing to do, the Principle of Insufficient Reason states that
in a situation in which objective evidence is not available, one should treat all
the states as equally likely, i.e. if there are n states, the "probability" of each
is to be taken as 1/n. Quite clearly, any attempt to put this into practice would
lead to nonsensical results, since the probability of each state would depend
on the way the states are defined, and this itself is to some extent arbitrary. For
instance one could take any column of Table 2 and replace it by a number of
identical ones. For example the first column could be replaced by two columns
corresponding to states "An American is first on the Moon and he takes size
nine socks" and "An American is first on the Moon and he does not take size
nine socks". The pay-offs would be the same irrespective of the size of the
astronaut's feet. The maximin and minimax risk criteria are insensitive to such
obviously irrelevant distinctions and for these the two states can be lumped
together as they were originally. The Insufficient Reason criterion is, however,
affected by these distinctions. This seems undesirable, so we reject this also.
So far, all attempts to find a criterion which is objective and which can be
used in the absence of objective evidence concerning the states of the world have
failed. That is, the criteria that have been produced have all been open to
objection on other grounds, as demonstrated above.t It seems that the only way
to progress further is to abandon one or more of the conditions that were
originally laid down for the criterion to satisfy. The most obvious candidate
is the requirementof objectivity. Although this is a step which many statisticians
have been reluctant to take, there is a growing school of thought (the present
father of which is Savage'0) which accepts this step as logical and necessary.
The argument put forward by this school is that one can "assign" a probability
to an event which reflectsthe decision-maker'sbelief about the relative likelihood
of the event's occurrence. Savage has shown that, for a given person, it is
possible to treat these probabilities in the same way as one would treat
"objective" probabilities, that is, they obey the same rules of transformation,
etc.? Moreover, if a person has some definite ideas concerning who will get
to the Moon first, these must be based on some sort of evidence or experience
(e.g. observation of the effort being put in), and it would seem more sensible to
t One of the principal difficulties has been that of defining "complete ignorance". A far
more thorough discussion will be found in Chapter 13 of Reference 9. See in particular
pp. 284-285, 294-296 and the synopsis of Milnor's work (pp. 297-298).
1 Savage himself uses a purely descriptive approach. The probabilities that a subject
assigns to an event are to be determined by observing his choice in well-defined decision
situations. However, it often happens that a decision-maker wishes to use another's
subjective probabilities in determining his choice. In this case it has been suggested that the
necessary probabilities might be obtained by interrogation, for example by asking the
subject to imagine the numbers 1 to 100 in a hat. He is then to choose a number n such
that he feels the same confidence (i.e. he would be prepared to place equal bets) that a number
in the range 1 to n inclusive would occur in a single draw from the hat as he feels about the
likelihood of the event. The subjective probability can then be said to be n/100. It is still a
point of contention, however, whether this method produces "real" probabilities.
? An excellent elementary account of this is given by Schlaifer."
29
try to take this into account in a decision problem than to ignore it as "vague
opinion".
The school has not attempted to devise means for ascertaining the probability
that any individual should attach to an event-this is still left to "business
acumen" or "flair" or any other means at the individual's disposal. It would,
however, offer the advice that any existing information regardingthe probability
(in the objective sense) of an event should be taken into account in assigning
subjective probability. As an extreme case, it would be expected that a subject
would assign a probability of to a head appearing on the next toss of a coin,
which has already been shown to be "fair" by a large number of tosses. Notice
that if the subject assigns some other value to this event (as he may do if he has
just observed a long run of heads) we may say that he is "irrational", but we
cannot say that he must not do it. If he behaves in an irrational manner in
assigning probabilities, and then acts accordingly, one might be tempted to
expect that he would not be so successful a decision-maker, in the long run, as
one who acts rationally with respect to the available information.
Having obtained an appropriate set of weights for the "states of the world"
we can, as before, apply the "Bayes procedure" of finding the expected value
of each decision, and choosing the one which has the highest expectations
Thus, if in the example one assigns weights 0 49 to S1, 0 01 to S2, 0 to S3,
0 01 to S4, 0 49 to S5, 0 to any other states that might be thought up, the
expected values of the decisions are:
E(D1) = 6480, E(D2) = 10,120, E(D3) = 10,150,
E(D4)= 10,200, E(D5)= 14,800,
from which D5 is the best decision. However, before going ahead with a
30,000-ton plant, it is worth asking whether we are satisfied with the Bayes
approach as it stands.
Consider the following decision problem. There arejust two states of the world,
S1 and S2, which are considered to be equally likely to arise. There are three
decision possibilities, with respective pay-offs (in L's) as illustrated in Table 6.
The expected value of each decision, evaluated as before, gives E(D1) = 300,
E(D2) = 300, E(D3) = 500. Thus, according to the Bayes criterion the correct
choice is D3. If, for some reason, D3 is removed from consideration, we should
be indifferent between D1 and D2. However, the fact that most people who
found themselves in this situation would refuse to abide by this "solution"
indicates that this criterion also leaves something to be desired. In an attempt
to resolve this difficulty, decision theorists have evolved a theory of "utility".
Utility is a hypothetical quantity, related to cash value, and it is postulated that
a decision-maker attempts to maximize his "expected utility", rather than cash,
t Notice that even this is arbitrary; we could, for instance, always take the decision which
has the highest pay-off for the most likely state of the world. This, however, would lead us
into other difficulties.
30
when he takes a decision. This would appear to be a step backwards, since the
decision-maker's utility function is evaluated from the decisions he takes
rather than vice versa. However, the concept is extremely useful in clarifying
TABLE 6. ILLUSTRATION OF THE BAYES CRITERION
State
Decision S1 S2
D, --20 620
D2 --2,000 2,600
D3 -200,000 201,000
the issues, and we shall see how it does suggest a simple means of extending the
Bayes criterion which will make it more acceptable, in many instances, than the
simple form in which it was discussed earlier.
Utility theory
Modern utility theory is a quite different concept from the utility theory of
the classical economists. Whereas the latter attempted to attach a "value" to
the possession of certain goods, the modern theory (generally attributed to von
Neumann and Morgenstern12)is meant to be a portrayal of an individual's
attitude to risk. Consider the simplest gambling situation. A ticket in a certain
lottery, in which there is only one prize, costs (say) ?5. If the prize is ?10, how
large would have to be the probability of your winning before you would buy a
ticket? Suppose the prize were ?50 or ?100, what would the probabilities be
then? Now multiply all the above numbers by 10,000 (or 100,000). Assume the
lottery ticket is the cost of the investment in a plant which will either be a
complete flop or produce the stated returns as a "prize". What would have to
be the probabilities before you would recommend that your firm should go
ahead with the investment? Decision theory does not purport to be of any help
in making these decisions; the answers will always be particular to the individual
making them. However, once the answers to certain questions of this sort have
been given, the individual's "utility function" can be drawn up. When this has
been done decision theory can be used to solve much more complex decision
problems (ones in which there are many possible decisions and many states of
the world) in such a way that the answers obtained to such problems will be
consistent with the answers that the individualgaveto thesimpledecisionquestions.
In order to see how a utility function is derived, imagine that you have got
yourself into a situation where you may win ?1000 (event A) or lose ?1000
t "Consistency" here implies behaviour in accordance with certain axioms, i.e. seemingly
obvious elementary principles of choice. For example, "preferences are transitive"-that
is, if a person is faced with three alternatives A, B and C, and he says he prefers A to B
and B to C, then he should prefer A to C if B is withdrawn. For a complete discussion see
Chapter 2 of Reference 9.
31
(event B), depending on the luck of a draw. If you are unhappy with the
situation, you can buy yourself out at a cost of LX. If you are happy with the
situation, you can consider selling out. Suppose you are told that the chance of
event A is 0-1, and that of event B is 0 9. Would you prefer to accept the situation,
or would you want to buy yourself out? If the latter, what is the most you
would pay? Suppose after weighing the relatively high chance of losing ?1000,
you decide you would be prepared to pay about ?850 for a release. Now
suppose the probability of B is reduced to 0 7, and that of A increased to
0 3 correspondingly, what price would you pay then? For the sake of argument
we will take this to be about ?650. If the chances of events A and B are
50-50, many people to whom a loss of ?1000 would be something of a burden
would still prefer to buy themselves out of the possibility by payment of a sum,
let us say ?200. On the other hand, if the probability of a win rises to, say, 0 8,
one might feel that this was a chance worth taking. However, it would be
expected that if offered, say, ?300 cash, you would be prepared to forgo your
chances of ?1000 gain (or ?1000 loss).
We can now calculate the utilities of these fixed sums, in this gambling
situation, in the following way. The end points of the utility scale are arbitrary.
Let us assign a utility of zero to a loss of ?1000 or (as it is convenient to express
it) a gain of - ?1000. Let us assign a utility of unity to a gain of ?1000. The
utility of the sum which would have the same value to the decision-maker as
a gamble giving 0 9 probability of zero utility and 0-1 probability of unit
utility is calculated as 0 9 x 0+0-1 x 1 = 041. That is, in the example, the utility
of -?850 is 041. Similarly, the utility of -?650 is 0 3. The utility of -?200 is
0 5, the utility of ?300 is 0 8. We can now draw up the implied utility curve
(Figure 2) by passing a smooth curve through the plotted points (in practice
we would attempt to obtain more points, and then check the points against the
curve, when plotted). Notice that this curve reflects a conservative attitude
towards risk taking, in that a loss of ?500 (say) shows a greater fall in utility
than the rise due to a gain of ?500. Another way of looking at this is to note that
the individual concerned would, when faced with a possible risk situation in
which he stood to gain or lose ?500, require odds of better than 50-50 of a win
before he would take the bet. The conservative utility function appears to be
virtually universal for "serious" decision-making situations, although other
forms are possible.t A recent paper'4 which describes an experimental determi-
nation of utility curves in an industrial organization brings out this inherent
conservatism very clearly.
As an example, consider the following: You have to choose between 3
investment opportunities, each costing ?1000 but having different probabilities
for the various pay-offs as shown in Table 7.
t In Chapter 4 of Reference 13 it is demonstrated that utility curves generally tend to be

sigmoid in shape, if the range of pay-offs considered is sufficiently great.
32
Utility analysis can now be used to determine which investment should be
chosen in order to be "consistent" with the answers given to the questions from
which the utility curve was drawn up. The procedure is to replace the cash sums
0.8 _ *
06 -
04 -
02 -
oS I ll I
-1000 -500 0 500 1000
Cash /
FIG. 2. A utility curve.
involved by their utilities, as read off from the utility curve. Calculate the
expected utility of each investment and choose that showing the highest. Table 8
illustrates the calculations for this example.
TABLE 7. COMPARISONOF INVESTMENTSPROBLEM
Probability of pay-off
Pay-off
Investment Investment Investment
A B C
Lose ?1000 entirely 0410 0f20 0
Lose only ?500 0-20 0410 0 35
Break even 0 30 0-20 0 25
Make a profit of ?500 0-20 0-20 0 30
Make a profit of ?1000 0-20 0 30 0 10
Investment C is the one which should be chosen. Moreover, the decision-maker

of this example should be "indifferent"(i.e. would be prepared to choose on the
result of a toss of a fair coin) between investments A and B, if C be removed
from consideration. The expected cash value of each investment can also be
calculated. On this basis, investment C is the worst, having an expected cash
3 33
value of ?75. Investment B is best, having an expected cash value of ?150, while
investment A has an expected cash value of ?100. The fact that utility analysis
chooses investment C is simply a reflection of the conservatism shown by the
decision-maker when his utility curve was drawn up, i.e. it is preferred partly
because it is less risky than either of the other two. Similarly, although the
expected cash value of investment B is 50 per cent more than that of investment
TABLE 8. UTILITY ANALYSIS SOLUTION OF PROBLEM IN TABLE 7
Investment A Investment B Investment C

Cash
pay-off Utility Proba- Weighted Proba- Weighted Proba- Weighted
(?) bility utility bility utility bility utility
-1000 0 0 10 0 0 20 0 0 0
- 500 0 36 0-20 0 072 0 10 0 036 0 35 0-126
0 0 64 0-30 0 192 0 20 0-128 0-25 0-160
500 0 86 0-20 0-172 0 20 0-172 0 30 0 258
1000 1-00 0-20 0 200 0 30 0 300 0-10 0.100
Expected utility 0 636 0 636 0 644
A, it is also "more risky", as far as possible losses are concerned, and this makes
their values, considered as entities, equivalent in the eyes of this decision-maker.
It is interesting to note that if the sums involved in this example were much
smaller, the decision-maker might well then act in accordance with expected
cash value. If we rework this problem (Table 7) with all the possible cash values
divided by 10, we obtain Table 9.
TABLE 9. UTILITY ANALYSIS SOLUTION OF MODIFIED PROBLEM
Investment A Investment B Investment C

Cash - - .
pay-off Utility Proba- Weighted Proba- Weighted Proba- Weighted
(?) bility utility bility utility bility utility
-100 0 59 0 10 0 059 0 20 0 118 0 0

- 50 0-61 0 20 0-122 0 10 0 061 0 35 0 214
0 0 64 0 30 0 192 0-20 0 128 0-25 0-160
50 0 66 0 20 0 132 0-20 0-132 0 30 0 198
100 0-68 0 20 0 136 0 30 0 204 0 10 0-068
Expected utility 0 641 0-643 0-640
The difference between the investments on the utility scale is small, but this
is only a reflection of the fact that we chose the zero and unit of the scale as
- ?1000 and + ?1000 with certainty, respectively. The analysis definitely ranks
the investments in the order B, A, C, i.e. the same as that of their expected
cash values. This is in keeping with known behaviour that, when the sums
34
involved are relatively small, less importance is attached to the risk involved
when making a decision. It can be explained in terms of utility theory by noting
that over a small range the utility curve can be approximated as a straight line;
if the utility curve is a straight line then a decision-maker will act on the basis
of expected cash value. This also explains "underwriting". To an individual,
investment B is not an acceptable proposition; to a consortium of 10 people,
each sharing the risks and pay-offs equally, it becomes worth while.
For completeness we can apply the utility analysis to the "what size plant"
problem of Table 2. Although, in practice, one should evaluate the utility curve
over the relevant range of pay-offs, we will, for convenience, use the curve of
Figure 2, merely altering the horizontal scale to read between T 50,000. Then
using the symbol U to denote expected utility, we have U(D1) = 0700,
U(D2) = 0 735, U(D3) = 0 730, U(D4) = 0 712, U(D5) = 0 710. Thus D2 (build
a 15,000-ton plant) should be chosen. This is a very different decision from that
obtained by maximizing expected cash value!
SUMMARY
The foregoing has been intended to show that there is no such thing as a
theoretical "absolute" decision-making criterion. All we seem able to produce
is the tautology that a decision is "good" if it is what an intelligent, reasonable
man would do in the circumstances.t As there are so many subjective elements
in the choice of criterion to use, there seem to be no valid grounds for objecting
to subjective elements within the criterion. Certainly, it seems that whenever
a criterion containing subjective elements is proposed there will be cries that it
is not objective. Likewise, however, if a criterion that claims objectivity is
proposed, there are cries that it does not take into account the decision-maker's
subjective valuation of pay-offs involved, nor his subjective beliefs. The Bayes-
Utility-Subjective Probability approach does seem to many people to be the
most satisfactory proposal yet. It allows one to be conservative, but no more
so than one wishes, and it appears to take subjective valuations and beliefs
about the world into account in a rational way.
The question is sometimes asked that since decision making is, fundamentally,
a subjective process, what is the justification for building a complex structure
of decision "theory" for use in involved problems? The only thing that analysis
can do for us is to ensure that the answers we get are always consistent with
one another and with our intuitive premises,: but, as Professor Barnard has
pointed out,15 there is no a priori merit in being consistent; it is better to be
inconsistent than consistently wrong. If we have to trust our intuition in simple
cases, why not do so in complicated ones? The only answer that can be given
to this is itself a subjective judgement. It is simply the belief, widely held by
t It is worth noting that our judicial system relies heavily on this concept.
$ An interesting discussion of this point will be found in Chapter 10 of Reference 17.
35
operational research workers, that although intuition is a reasonably good
guide to the solution of simple problems, it is not a good guide to the solution
of complex ones. Analysis which, in effect, reduces complex problems to
equivalent simple ones will assist us to make good decisions in involved cases.
We can make two comments:
(1) This largely accounts for any contention there might be between
operational research and traditional management methods. Those who
practise the latter do not accept the above view, believing that intuition
is as good in solving complex problems as it is in simple ones.
(2) If, in fact, our intuition is bad at solving even simple decision problems,
then Barnard's aphorism implies that we would be better off without
analysis; we might then be right some of the time, if only by accident.
3. APPLICATION TO CAPITAL INVESTMENT PROBLEMS

The foregoing has been an attempt to examine the foundations of recent
thinking about decision making under uncertainty. One way of applying it is,
as demonstrated in the examples, to replace the cash (or other) values in the
problem by their respective utilities (as obtained from the utility curve) and
find the decision which maximizes expected utility. Although this method is,
in principle, of general applicability, there are, as is often the case, certain
computational short-cuts which can be used. The one which is generally adopted
(very often without consideration as to whether it is appropriate) is to assume
that the utility function is linear, i.e. that one should maximize expected cash
pay-off (discounted if desired). This appears to give satisfactory results for
problems of day-to-day operations, or where the sums at stake are small
compared with the total resources of the firm, since most utility curves can be
approximated by straight lines over a small range. Details of this approach will
be found in References 11 and 16.
Capital investmentproblems
We define a "Capital Investment Problem" to be one which involves resources
of such magnitude that the assumption of linearity of the utility curve is not
satisfactory and must be replaced. Markowitz"7 has developed a powerful
technique for dealing with this case, and has applied it to the problem of share-
portfolio selection. Although it is not permissible to assume linearity of the
utility function, most such functions, of conservative form, can be reasonably
approximated by a quadratic.t This turns out to be a useful thing to do,
for the same sort of reasons that make "variance" a convenient (though arbi-
trary) measure of "spread" of statistical data. Figure 3 shows the utility curve
of Figure 2 with a quadratic approximation. If one can write U = +1C?+ 7C2
t Provided, of course, that the turning point of the quadratic occurs outside the range of
pay-offs considered.
36
where of, /3 and y are constants and C is cash, then E(U) = o + 3E(C)+ yE(C2).
But since E(C2) = variance (C) + [E(C)12,it is clear that we need only calculate
the expected value and variance of the cash pay-offs in any such problem, in
order to solve it. Markowitz suggests that we can, in fact, think of the variance
as the measure of risk appropriate to a quadratic utility function.
A large proportion of Markowitz's book is concerned with a description of
a computational routine (quadratic programming) for obtaining the "efficient
set" of a large number of possible investments. When there are a large number
- Empiricalutility curve
---The curve U=-14xlo C ,-
+X5 lUC+64xlOC
08 /
_ /;~~~~~~
.-
-0.6 /~~~~~
._ /~~~~~
D 04
02 /
-1000 -500 0 500 l000

Cash (C) Z
FIG. 3. The utility curve of Figure 2, with a quadratic approximation.
of alternative ways of investing money, it is quite possible that a number of these

will have the same expected value, but different risks. If, for each expected value,
we pick out the portfolio which has the lowest risk, then these portfolios are, by
definition, the "efficient set". It is then a relatively simple matter to choose,
from the efficient set, that portfolio which maximizes the expected utility.
Markowitz's analysis is developed in the context of the stock market which is
characterized by there being a very large number of securities between which
to split the investment principal, and the return from a given security is directly
proportional to the amount invested in that security. The details of this aspect
of Markowitz's work are not relevant to this paper. However, there are clearly
some basic similarities between problems of investment of capital in shares,
and those of investment in plant. We have therefore attempted to develop
Markowitz's approach in order to apply it to the latter field. The remainder
37
of this paper indicates the form that this seems to take. The essential differences
from Markowitz's work are that there are relatively few projects under
consideration for the "portfolio", and that the return from any project is not
linearly related to the amount invested in that project.
The choice of criterion

We must first re-examine the question of choice of criterion. Are we to work
basically in terms of "present worth", "internal rate of return" or something
else? As he has indicated earlier, the author does not believe that this question
can be resolved by arguing as to which is more consistent with other arbitrary
concepts such as interest rate. In any organization in which decision making
is decentralizedeach (decision-making) centre must have a criterion for assessing
its performance. Surely the "correct" criterion for each centre to use is that
which, if each acts so as to optimize it, the overall result will be as near optimum
for the whole as possible. This applies whether the whole is an individual firm
or a free-enterpriseeconomy. For example, it has already been mentioned that
if the generally accepted criterion were internal rate of return, the tendency
would be to build small plants (and presumably relatively many of them),
whereas the present worth criterion would tend to give larger and fewer plants.
It seems plausible to suggest that if the appropriate study were performed it
ought to be possible to determine which of these comes closer to the optimum
for the economy as a whole (if this cannot be achieved we are no closer to
resolving this problem). Likewise, other criteria could be evaluated. If one can
be found which seems consistently to give results more near the overall optimum
than the others, this is the "correct" criterion for individual firms to use.
However, the "appropriate study" does not yet seem to have been performed.
Until it is, we shall have to make do with "present worth". This still leaves us
looking for a satisfactory means of determining the discount rate to be used.
Discount rate
Most economists who have considered this question have stated that the
appropriate rate to use is that which the firm has to pay for capital, i.e. the
"cost of capital". The present author, however, regards the "cost of capital"
as one of those quasi-mythological creatures, like the Loch Ness Monster-
everybody has heard of it; a few people claim to have seen it, but nobody has
ever run it to earth. Ashton (loc. cit.) sums up the position well. The cost of
capital depends on how it is raised. This latter is a matter for the company's
treasurer (e.g. himself), who will see to it that some financial ratios are kept
"respectable". The following argument is offered as an alternative.
One of the several economists' theories of profit suggests that profit is the
reward for taking "uninsurable risks". This implies that under no risk all
investments would pay a "bank" rate of return (assuming that the "bank"
38
can be considered a virtually riskless investment). Any investments, therefore,
which show a rate of return higher than this are carrying some risk. Thus, if one
discounts at a rate higher than bank rate, some allowance is presumably being
made for risk. An alternative to this would appear to be to discount at bank
rate which in theory measures the pure (i.e. riskless) time-preference of money,
and then allow for risk through the present worth function obtained, in the
manner to be described. Discounting at bank rate offers a convenient datum,
i.e. investment in the bank then has zero present worth and zero risk. The
advantages of this procedure are that it is not necessary to assume that all
potential investments have the same risk (i.e. should be discounted at the same
rate) or to determine a specific discount rate for each. In the "what size plant
for an expanding market" problem, the higher the discount rate used (i.e. the
higher the risk) the less the future is anticipated, and hence the smaller the
plant built. We shall see that the same qualitative result is true of the proposed
alternative.
Capital investmentunderrisk
The problem we are taking as an example is that of deciding what size plant
to build for a market whose size, etc., is uncertain. It seems reasonable to ask
that a method of solution should have the following characteristics. It should
take into account
(a) the Directors' judgements of the ability of the firm to take risks;
(b) any relevant information that is available, even if this is subjective;
(c) the interactions of investment decisions within a firm on one another;
(d) the interaction of investment decisions with the environment (e.g.
competitors' behaviour).
The following approach seems to be one whereby these requirements might be
achievable.
Method of analysis
Partition the variables of the problem into a vector X, whose elements
represent variables under the decision-maker's control, and a vector x, whose
elements are uncontrolled. Let the scalar function f(x, X) be the discounted
present worth of the income stream which will arise from the project if decision
X is taken and conditions x occur. Assume a probability distribution 4(x) for
the unknowns. This will generally be a mixture of subjective and objective
information, culled from the sources that the decision-makerfeels most confident
in. Let g(X) be the present worth of the cost incurred by taking decision X.
Let W(x, X) be the conditional present worth of the project:
W=f(x, X)-g(X). (1)

39
Then:
E(W) = ,ff(x X) -g(X)] b(x)dx (2)
V(W) = fLf(X,X)-g(X)]2 i(x) dx- [E(W)]2 (3)
= {[f(x, X)]2+(x) dx- [f(x, X) +(x) dx] (4)
Both E(W) and V(W) are functions of X. The "efficient set" consists of those
values of the decision variables X that minimize V for any given value of E.
Consider first the case where X consists of a single element X, the size of plant
to be built. Then the functions E and V will generally behave as follows
(Figures 4 and 5). For small values of X, E(W) will be negative, since fixed
"Efficient set"
0
CLl
Size of plant built (X)
FIG. 4. Form of E(W).
costs will be incurred, but output will be small. As X increases, E(W) will
become positive, reach a peak and then turn down again, since the capital cost
of building a very large plant will tend to outweigh the expected value of the
additional sales which it may catch. V(W) will generally be small for small
values of X, since the profitability of a small plant, though small, is known.
As the plant size increases, this variance does also.
The concept of "efficient set" enables us to state immediately that we would
never build a plant on the downward sloping portion of the curve on Figure 4,
40
since for any point on this there is a point on the upward sloping portion which
has the same expected present worth and a smaller variance. If we also exclude
50/
,0/
0
gL
Size of plant built (X)

FIG. 5. Form of V(W).
plants for which E(W) is negative then it can be seen that the efficient set for
this project is given by the thickened region of the curve in Figure 4.
We can now plot V(W) against E( W) for the efficient set, Figure 6, and thence
find the plant size which maximizes expected utility by maximizing U = U(E, V)
subject to the functional relationship between V and E shown in Figure 6.
-3
0
C
0O
B1 /~~~~4
Expected present worth [E(W)]
FIG. 6. The relationshipbetweenvarianceand expected valuefor a "risky"project.
Example
The following simple example should make the procedure clear. We will
assume that x consists of a single component x, the size of the market initially,
41
and we wish to determine the optimum size, X, of a plant (which we will call
"Plant A", in the sequel) for which:
f(x,X)=x, OA XX
(5X
- X, X>X
g(X) = 2 98X? 5 (6)

and +(x) is a Normal distribution of mean 20 and standard deviation 5. Using
equations (2) and (4) we can determine the "efficient set" of plant sizes (the
range 9-22), and the relationship between X, E(W) and V(W). This is given
in columns 1, 2 and 3 of Table 10. In order to choose the best size of plant it
is now necessary to specify a utility function. We will take for this example the
quadratic:
U= -0-015W2+025W. (7)
Taking expectations gives:
E(U) = -0 0l5E(W2)+0 25E(W). (8)
E(W2) is tabulated in column 4 of Table 10, and E(U) in column 5. We see
that a plant of size 19 gives maximum E(U).
TABLE 10
(1) (2) (3) (4) (5)

Plant Expected Variance of E(W2) Expected
size present worth present worth = (3) + (2)2 utility
X E(W) V(W) E(U)
9 0-021 0 078 0 078 0 004

10 0-519 0-142 0-411 0-124
11 1-029 0-251 1-310 0 238
12 1-544 0 427 2-811 0 344
13 2 055 0 702 4-925 0 440
14 2-551 1.115 7-623 0 523
15 3 023 1-710 10-849 0-593
16 3-460 2 531 14-503 0 647
17 3 850 3-615 18-438 0 686
18 4-184 4 983 22-489 0 709
19 4-455 6-629 26-476 0-717
20 4-657 8-523 30-211 0-711
21 4-787 10-592 33 509 0694
22 4-848 12-754 36-257 0 668
It is worth noting that as the coefficient of W2 (which measures the

conservativeness) in the utility function increases through negative values, the
larger the plant that will be built, until, when this coefficient reaches zero
(i.e. the utility function becomes a straight line) the plant of size corresponding
42
to the peak of Figure 4 is built. Thus the less conservative a firm can afford to be,
the greater the present worth it will obtain, on average,t from its projects-
"To him that hath shall be given."
Several decision variables

We turn now to the case where X is a vector of several components,
X1, X2,..., X. We will again assume that the "external" variables x have been
integrated out, and we have obtained:
E(W) =F(X1, X2,9 .., X>) (9)

and
V( W) =G(X1, X2, ..*. Xn). (10)
In order to minimize V for a given value of E, we use the usual Lagrangian

argument.I Consider:
G(X19X29 .... , X>) -AF(X1, *X-9(11)

X2, .............
X>)
Differentiating and setting the results equal to zero, we have:
=A- i= 1,2, ... ,n. (12)

Thus:
aG 3F aG aF aG/ 3F (13)
aX1/aX1 aX2a Xn aX1
is the condition for the minimum.
These equations, together with those for E(W) and V(W), are, in principle,
sufficient to enable X to be eliminated, and a relationship between V(W) and
E(W) (as in Figure 6) to be obtained. This is the efficient set, each point on
which corresponds to particular values of the components of X.
Several independentprojects
Suppose several projects are being considered at the same time. Let the ith
project have decision variables Xi and external variables xi. Let fi, gi and fi
be the appropriate functions, as defined above. If for each project these are
functions only of the variables of that project, then the projects can be said to
be independent. In this case, we can obtain the efficient set for the "portfolio"
of projects from the efficient sets of the individual projects. Let E(W) and
V(Wi) be the expected value and variance of the present worth, on the efficient
set for the ith project. Let E(W) and V(W) be the respective quantities for the
t Provided that its estimates of present worth, etc., are unbiased.
I Where there are constraints which make the functions non-differentiable, more general
"hill climbing" techniques must be used.
43
"portfolio" of projects. Then, under the assumption of independence, we have,
using well-known properties of expectation and variance:
E(W) = EE(Wi), (14)

i
V(W) = V(Wi). (15)

i
The Lagrangian method can again be used to show that, on the efficient set:
dV(W41)_dV(W2)
ec.(6
dE(W1) dE(W2) = etc., (16)
that is, if points on the various V-E curves representing the individual efficient
sets are chosen such that the slopes of these V-E curves are all equal at these
points, then this combination of points will lead to a point on the portfolio
efficient set.
A graphical solution
In the independent case, the portfolio efficient set can be obtained from the
individual efficient sets, graphically, as follows. Calculate dV/dE as a function
of E for each project, and plot the functions against E, on one sheet of paper,
as shown in Figure 7 for three projects. Any horizontal line such as H-H will
Project Project Project

no.3 no. I no.2
I I
> H -- -- -- - - - ------- -- -H
BI
AI
Expected present worth [E (W)]
FIG. 7. Graphical method for portfolio problem.
cut the curves at points at which the values of d V/dE are equal. If perpendiculars
are dropped from these points to the E axis, and values of Ei read off, these
values give a combination of projects that is on the portfolio efficient set. The
44
value of E at that point on the set is the sum of these Ei. The portfolio variance
at that point can be obtained by summing the individual variances, obtained
from the individual efficient sets, for those values of the Ei. By sliding H-H
up and down, the whole course of the portfolio efficient set is generated. Notice
that when H-H is below B, project No. 2 is not to be entered into, since
investment in the bank will give a higher expected value with no greater risk.
Similarly, when H-H is below A, only project No. 3 is taken up.
We conclude this section by showing that it will not be necessary to calculate
dV/dE along each efficient set as an additional exercise; this function will
normally be calculated as part of the exercise of calculating the individual
efficient sets. For, on an efficient set, we have:
E(W) = F(X1, X2, ..........

Xn) . (9) ,
V(W) = G(X1,X2, ***, Xn) (10)
aG IaF aG IaF aG IaF
X aX
aDG/ aDG/ EaX2 aGXnaXD (13)
Now:
SE = ~a aXF?A SX2+ .. a SXXn (17)
G D aG
DX X +G GX2+X 6X. (18)
Substituting (13) into (18) gives:
avJ AF
V DE DF (9
X1 +D xX2+ * =DX A- E (19)
by (17).
Therefore:
dV D)G IDEF
dE . etc.
... (20)
DXE1 aDXi1
Thus in calculating the values of (DG/DX1)/(DF/DX1), etc., in order to determine
the efficient set, the slope of the efficient set is determined also. Similarly, it can
be shown that the slope of the portfolio efficient set at any point is equal to the
common slope at the points on the individual efficient sets which contribute to it.
We conclude with two further examples.
Examples
The first example is a particularly simple one which can be solved without
recourse to the above analysis, by the application of symmetry considerations.
It is included to demonstrate the importance of the "portfolio" approach to
capital investment.
45
Two independent plants (i.e. making different products) are being considered,
both of which have functional and numerical data identical to that of Plant A
considered earlier. If the projects are considered independently, each will be
built of size 19, as shown earlier. However, if the projects are taken together,
TABLE 11
(1) (2) (3) (4) (5)

Two Expected Variance Expected
plants, present of present E(W2) utility
each of worth worth (3)+(2)2 E(U)
size X E(W) V(W) =()+22 EU
9 0 042 0 156 0 158 0-008

10 1 038 0 285 1-362 0 239
11 2 058 0-505 4 740 0 443
12 3-088 0853 10-389 0-616
13 4-110 1-404 18-296 0 753
14 5-102 2-230 28 260 0-852
15 6 046 3 420 39-974 0-912
16 6 920 5-062 52-948 0 936
17 7 700 7 230 66 520 0-927
18 8-368 9-965 79 988 0 892
19 8-910 13-258 92-646 0-838
20 9-314 17-046 103-797 0 772
21 9-574 21-184 112 845 0*701
22 9-696 25-509 119-521 0 631
as a portfolio, the solution is somewhat different. Symmetry considerations

applied to equation (16) are sufficient to show that, if both projects are to be
entered into, the two plants will be built of equal sizes. We can thus draw up
Table 11, the second and third columns of which will have entries exactly
double those of the corresponding columns of Table 10. Columns 4 and 5 of
Table 11 can then be completed, as before.
We can make the following observations from Table 11.
(1) If we build two plants each of size 19 (the optimum size for a single plant)
we shall obtain a higher expected utility than that obtained from building
one plant only.
(2) We can do even better by building two plants each of size 16.
(3) If we build two plants each of size 22, we obtain a lower expected utility
than if we build just one plant of this size. This clearly illustrates the effect
of curvature in the utility function.
The second example involves two dissimilar plants, each of which again has
one decision variable and one "unknown" variable to illustrate the use of the
graphical method described above.
46
The parameters of one of these plants are taken to be the same as Plant A
considered above. The other plant (Plant B) is described by the equations:
f(x,X)=-10+ 15x Ox< X) (21)
=-10+15X-0-5(x-X), x>X (
g(X) = 2 9X? 6 (22)

(i.e. there is a "penalty cost" attached to having a plant smaller than the eventual
market size).
TABLE 12. EFFICIENT SET, PLANT B
Size of E(W) V(W) dV

plant (X) E(W) V(W
21 1-11 2 20 0-023
22 230 240 0365
23 3-35 3-11 1-092
24 4 20 4 55 2-478
25 4.83 6-82 5 116
26 5-24 9-79 11-088
27 5-42 13 14 41-007
+(x) is a Normal distribution of mean and standard deviation equal to

25 and 31 respectively.
Performing the calculations indicated by equations (2) and (4) enables us to
draw up Table 12, for the efficient set of Plant B.
Curves of dV/dE vs. E for Plants A and B are shown in Figure 8. Figure 9
shows curves of the individual efficient sets (on the inner scales), together with
the "portfolio" efficient set (on the outer scales). The points marked "*" and
the arrows on Figures 8 and 9 show how each point on this latter curve was
obtained. The optimum portfolio and its components, when referred to the
utility function of equation (7), are also shown in Figure 9. Thus Plant A should
be built of size 15-5 for which E(W) = 3 2, V(W) = 2-0. Plant B should be
built of size 23 6 for which E(W) = 3 9, V(W) = 3 9, giving for the portfolio
an expected present worth of 7 1, with a standard deviation of 2-4.
Comments
The above examples have illustrated the value and importance of considering
investments as a whole, rather than piecemeal. This approach can be used to
solve budgeting problems-if all outlets for a company's investment capital
both within and outside the firm (and this can include hypothetical future
projects, research and development, etc.) are analysed as a portfolio, the
47
OperationalResearch Quarterly Vol. 16 No. 1
50 _
40 - 27
30
20 Figures along curves indicate 21

values of the respective variables
X (plant size)
20 22
19-
8-
_19
6 - 24
5 - 7 -~ ~ ~ ~~~~~1 18/ 2
2 Plant A- Ad - Plant B
I- 14 23
019 _
0-7 - 13
0-6 _
0-5 -
0-4 - 122
0-2 - 1
0.1
0 I 2 3 4 5 6
Expected present worth E

8 9
Inner scales refer to the individual efficient sets
Outer scales refer to the portfolio efficient set
16 8 -
14 7 -
Plant A / / / Plant B
efficient set efficient set
2
61 Portfolio
oE //)7 efficient set
105 5
Optimum Portfolio
08
D 63
4 2
21
o s I ! I , L! I I
0 1 2 3 4 5 6
0 2 4 6 8 10 12
Expected present worth E
FIGS. 8 and 9. Graphical solution of example.
48
solution obtained will automatically allocate capital in the correct quantities to
each project. Any excess capital available should be invested in the bank; any
shortage of capital raised. This might help to solve Davies' problem.18
If (and at present this seems to be a big if) a Board can produce the utility
function which is appropriateto its firm at that time, capital investment decisions
could be delegated. That is, the true embodiment of a "capital investment
policy" is a utility function. The Board's job, in this respect, is to make sure
this function is kept up to date.
CONCLUSIONS
In Part 1 of this paper an attempt has been made to show that capital investment
decision problems are very much more complex than most of the writers on
this subject would have us believe. The criteria that such writers advocate are
nothing more than completely arbitrary interpretations of what themselves are
arbitrary, and rather vague, notions of how capital should be managed in a
free-enterprise economy. To claim, as is often done, that the road to good
capital investment is paved with discounted present worths (or what you will)
is not far short of irresponsible, since nobody has yet demonstrated this to be
true. All that can truly be said of these criteria is that they seem to make sense
to their respective authors. The arguments used to justify these approaches are
at best metaphysical; at worst illogical-"acceptance only of these proposals
which will cause no decline in the value of existing shareholders' equity"
(Lawson, loc. cit.). How can one ever ensure this whilst projects have some risks
attached to them? In any case, surely equity shareholders are prepared to risk
their money. If they were not, they should have bought "gilt-edged".
Part 2 of this paper is a brief survey of part of the field of decision making
under uncertainty, which leads to the method of analysis given in Part 3. All
that is claimed for this is "that it seems to make sense to its author", and to be
an improvement on other approaches in that it enables a measure of risk to be
obtained for a project. Thus less is left to intuition.
The decisions made by applying this approach will only be "right" in the
sense that the utility function, etc., used is "right". This in turn will depend on
the structure and rules of the "economic game". No doubt an investigation
into the "correctness" of these would be an even more valuable and rewarding
study in the long run.
ACKNOWLEDGEMENT
I should like to express my sincere gratitude to Mr. P. G. Smith, of The Distillers Company
Limited, for his considerable help and patience during the preparation of this paper.
4 49
REFERENCES
1I. McDOWELL (1960) The economical planning period for engineering works. Operat. Res.
8, 533.
2 F. S. HILLIER (1963) The derivation of probabilistic information for the evaluation of
risky investments. Mgmt. Science, 9, 443.
3 G. H. LAWSON (1963) Capital investment criteria in business. The Accountant, 148, 448.
4 A. S. ASHTON (1962) Investment planning by private enterprise. Lloyds Bank Rev. 66, 23.
5 G. TERBORGH (1958) Business Investments Policy. Machinery and Allied Products
Institute, Washington.
6 J. HIRSHLEIFER (1959) On the theory of optimal investment decision. In: E. SOLOMON (Ed.)
The Management of Corporate Capital. Free Press of Glencoe.
7 D. J. WHITE (1964) Dynamic Programming and the Value of an Investment Opportunity.
Working Papers Nos. 14 and 21, Centre for Business Research, Manchester.
8 B. R. WILLIAMS (1957) The impact of uncertainty on economic theory. In: CARTER,
MEREDITH and SHACKLE (Eds.), Uncertainty and Business Decisions. Liverpool University
Press, Liverpool.
9 R. D. LUCE and H. RAIFFA (1957) Games and Decisions. Wiley, New York.
10 L. J. SAVAGE (1954) The Foundations of Statistics. Wiley, New York.
1 R. SCHLAIFER (1959) Probability and Statistics for Business Decisions. McGraw-Hill,
New York.
12 J. VON NEUMANN and 0. MORGENSTERN (1944) The Theory of Games and Economic
Behaviour. Princeton University Press, Princeton.
13
H. CHERNOFF and L. E. MOSES (1959) Elementary Decision Theory. Wiley, New York.
14
p. E. GREEN (1963) Risk attitudes and chemical investment decisions. Chem. Eng. Progr.
59, 35.
15 G. A. BARNARD (1963) The advantages and limitations of the Bayesian approach to
decision making. Paper delivered at the meeting of the Operational Research Society
on 4 November, 1963.
16 H. RAIFFA and R. SCHLAIFER (1961) Applied Statistical Decision Theory. Harvard
University Press, Boston.
17 H. M. MARKOWITZ (1959) Portfolio Selection. Wiley, New York.
18 O. L. DAVIES (1962) Some statistical considerations of research projects in the pharma-
ceutical industry. Applied Statistics, 11, 170.
50

Criteria For Capital Investments

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Criteria for Capital Investment: An Approach Through Decision Theory

The arbitrary character of such' concepts as "Discounted Present Worth", which

1. CRITIQUE OF CONVENTIONAL METHODS

FIG. 1. Comparison of cash flows.

present worth calculations. If it is possible to find a reason for preferring one

Risk and uncertainty

2. DECISION MAKING UNDER UNCERTAINTY

TABLE 1. A DECISION MATRIX

D, al,, a,,, al,3 .. a,, n-l a,, I

Dm-1 am-1i1 am-1,2 a,,-1,3 ... am-,.1 -, am-,. ,

TABLE 2. AN EXAMPLE OF A DECISION PROBLEM

Size of Size of market

10,000 13,000 8,000 6,000 3,000 0

TABLE 3. A DECISION PROBLEM ILLUSTRATING ULTRA CONSERVATISM OF MAXIMIN RULE

DI 106 103 103 103 103

TABLE 4. THE "RISK" MATRIX

D1 0 12,000 24,000 37,000 50,000

TABLE 5. NEW "RISK" MATRIX

D1 0 12,000 24,000 37,000 30,000

t In Chapter 4 of Reference 13 it is demonstrated that utility curves generally tend to be

FIG. 2. A utility curve.

TABLE 7. COMPARISONOF INVESTMENTSPROBLEM

Investment C is the one which should be chosen. Moreover, the decision-maker

TABLE 8. UTILITY ANALYSIS SOLUTION OF PROBLEM IN TABLE 7

Investment A Investment B Investment C

Expected utility 0 636 0 636 0 644

TABLE 9. UTILITY ANALYSIS SOLUTION OF MODIFIED PROBLEM

Investment A Investment B Investment C

-100 0 59 0 10 0 059 0 20 0 118 0 0

Expected utility 0 641 0-643 0-640

3. APPLICATION TO CAPITAL INVESTMENT PROBLEMS

-1000 -500 0 500 l000

of alternative ways of investing money, it is quite possible that a number of these

The choice of criterion

W=f(x, X)-g(X). (1)

V(W) = fLf(X,X)-g(X)]2 i(x) dx- [E(W)]2 (3)

= {[f(x, X)]2+(x) dx- [f(x, X) +(x) dx] (4)

Size of plant built (X)

FIG. 4. Form of E(W).

Size of plant built (X)

g(X) = 2 98X? 5 (6)

(1) (2) (3) (4) (5)

9 0-021 0 078 0 078 0 004

It is worth noting that as the coefficient of W2 (which measures the

Several decision variables

E(W) =F(X1, X2,9 .., X>) (9)

In order to minimize V for a given value of E, we use the usual Lagrangian

G(X19X29 .... , X>) -AF(X1, *X-9(11)

Differentiating and setting the results equal to zero, we have:

=A- i= 1,2, ... ,n. (12)

E(W) = EE(Wi), (14)

V(W) = V(Wi). (15)

Project Project Project

Expected present worth [E (W)]

FIG. 7. Graphical method for portfolio problem.

E(W) = F(X1, X2, ..........

Substituting (13) into (18) gives:

(1) (2) (3) (4) (5)

9 0 042 0 156 0 158 0-008

as a portfolio, the solution is somewhat different. Symmetry considerations

g(X) = 2 9X? 6 (22)

TABLE 12. EFFICIENT SET, PLANT B

Size of E(W) V(W) dV