Rules of Thumb and the Impact of Debt in Capital Budgeting Models

Abstract

For financial planning problems involving the simultaneous selection of investment and financing decisions, linear programming models are superior from the standpoint of financial theory to simple rules of thumb such as conventional discounting. Nevertheless, from the practical point of view and as the acceptance of programming models by the financial management community is rather sluggish, it is still relevant to ask the question how do the results of the two approaches differ?. The answer to this depends on the complexity of the modelling found necessary. For very simple situations the answer is none at all, but for other situations the difference can be substantial. This paper investigates part of the middle ground of complexity, where the principal extension to the simplest model is the inclusion of debt and debt capacity and proposes that simple rules of thumb can give results sufficiently close to optimal for most purposes.