A Portfolio Approach to Capital Budgeting: An Application to the Expansion to Additional Product Lines

Abstract

The importance of the covariance of returns between capital assets is one of the basic principles of modern portfolio theory. An investor should seek capital assets which have negative covariance of returns, or if such capital assets are not available, capital assets with low covariance should be sought for a portfolio. From the variance-covariance structure of returns of the capital assets and the expected returns for each capital asset, a risk-reward trade-off or efficient frontier can be generated. The trade-off represents the minimum risk, as measured by portfolio variance, that could be incurred to realize a desired rate of return for the portfolio. This concept applies to a portfolio of capital budgeting projects as well as to a portfolio of securities. This paper demonstrates how this concept of portfolio diversification can be applied to a capital budgeting problem. The problem involves an actual problem faced by a U.S. distributor who must decide whether to expand sales into one of two industries. Quadratic programming is used to generate the risk-reward relationships and it is shown that the entry into one industry clearly provides a superior risk-reward relationship than entry into the other industry and compared to the company's present sales policy.