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The Discount Rate Problem in Capital Rationing Situations: Comment

Published online by Cambridge University Press:  19 October 2009

A. Geoffrey Lockett  and
Cyril Tomkins
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Extract

Recently, Lusztig and Schwab [5] drew attention to a problem which occurs when applying linear programming methods to portfolio selection where capital is rationed over several investment periods. The problem is to determine the relevant discount rate with which to calculate the net present values of the objective function when this same rate is dependent upon the optimal solution to the linear program. Lusztig and Schwab suggested a neat procedure by which it was claimed that one could overcome this difficulty and which also does not rely upon the measurement of subjective utility as did the Baumol and Quandt approach [2]. It was decided to test the Lusztig and Schwab model (afterwards called the L-S procedure for brevity) on a hypothetical problem, and doing so resulted in two conclusions:

(a) The L–S procedure, as described, is incomplete but with small modification may be useful; however,

(b) concentration upon the discount rate problem in isolation from other capital budgeting problems may well be a pointless exercise.

Type
Communications
Information
Journal of Financial and Quantitative Analysis , Volume 5 , Issue 2 , June 1970 , pp. 245 - 260
Copyright
Copyright © School of Business Administration, University of Washington 1970

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References

1.Bailey, A. D., and Gray, J., “A Study of the Importance of the Planning Horizon on Reports Utilizing Discounted Future Cash Flows,” Journal of Accounting Research, Spring 1968.CrossRefGoogle Scholar
2.Baumol, W. J., and Quandt, R., “Investment and Discount Rates Under Capital Rationing — A Programming Approach,” Economic Journal, Vol. LXXV (June 1965), pp. 317–329.CrossRefGoogle Scholar
3.Glover, F., “Management Decision and Integer Programming,” Accounting Review, April 1969.Google Scholar
4.Lerner, E. M., and Rappaport, A., “Limited D.C.F. in Capital Budgeting,” Harvard Business Review (September–October 1968).Google Scholar
5.Lusztig, P., and Schwab, B., “A Note on the Application of Linear Programming to Capital Budgeting,” Journal of Financial and Quantitative Analysis, December 1968.CrossRefGoogle Scholar
6.Quirin, G. D.The Capital Expenditure Decision, Homewood, Illinois: R. D. Irwin, 1967.Google Scholar