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Session 1639

Provably Optimal Economic Decision-Making

Bernard Goldberg Department of Industrial Engineering University of Houston Houston, Texas 77204-4812

Abstract

Current methods of economic decision-making use multiple criteria that often result in conflicting indications of the best alternatives, none of which are provably optimal. As a consequence, economic decision-making differs between and within organizations. The proof presented in this paper provides a single criterion for selecting engineering and financial alternatives that maximize the net present-value of an organization subject to a capital constraint1. Major differences from current practice include forecasting costs of borrowing money for discounting cash flows and measuring capital costs. It is assumed each alternative has accurate input and output cash flow forecasts that incorporate engineering and marketing risks. The proof of optimal economic decision-making can then be validated mathematically and verified with financial accounting statements. The single criterion for selecting alternatives that is proposed here promises to be the best practical guide for optimal economic decision-making not only in industrial firms, but also in financial institutions, government agencies and nonprofit organizations.

I. Introduction

It is commonly thought that the best way of doing each project would be to select the alternative whose cash flows have the largest net present-value. But net present-values are not defined until discount rates are specified. If low discount rates are specified, alternatives with the largest net present-values could have output cash flows that are received in the distant future. Specifying high discount rates would reduce the net present-values of distant cash flows. How high the discount rate should be is an open question in both theory and practice. Discount rates in current use often include engineering and marketing risks as well as investor opportunity costs. This results in discount rates such as weighted average -costs-of-capital (WACC)3 and minimum attractive-rates-of-return (MARR)4 which can be much greater than costs of borrowing money.

However, high discount rates distort the decision-making process. All economic decision-making works within capital constraints derived from loans and investments. When available cash and retained earnings of an organization are insufficient for its investments, money may be borrowed to fulfill investment requirements. This suggests that competing uses of capital funds should be compared by discounting their cash flows with the organization’s costs of borrowing money.

If cash flows are discounted instead with WACC or MARR interest rates, the results have very different meanings. For example, suppose a 15% rate-of-return investment opportunity requires an input of $100 that returns an output of $115 one-year later. Assuming a 20% per year WACC

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Goldberg, B. (2000, June), Provably Optimal Economic Decision Making Paper presented at 2000 Annual Conference, St. Louis, Missouri. 10.18260/1-2--8649