January 2020
Capital Budgeting and Portfolio Optimization
The concept of capital budgeting and portfolio optimization has far- reaching consequences beyond the DoD. Private industry can greatly beneft from the concepts and methodologies developed in this research to apply portfolio optimization to its respective capital investment portfolios. These optimized portfolios are, by defnition, the best andmost efcient usage of a frm’s capital to generate the greatest amount of valuewhilemitigating risks for the organization and keeping limited budgetary and human resource constraints in check. More technically savvy individuals can apply the same methodologies in their retirement and investment portfolios, and portfolio managers can also leverage the knowledge and insights from the research to apply efcient frontier analyses for their clients’ invested portfolios. A portfolio, by defnition, is any combination of two or more assets, projects, capabilities, or options. The whole portfolio is usually assumed to be greater than the sumof its parts, based on outcome performancemeasures, expected return on investment (ROI), capabilities, and other metrics (Mun, 2015). This assumption is due to the potential risk reduction, leverage, and synergy in terms of lower cost, interoperability, and fatter learning curve when multiple programs or capabilities are combined into a more cohesive portfolio (Mun, 2015, 2016). In today’s competitive global economy, companies in the private sector are faced with many difficult decisions. These decisions include allocating fnancial resources, building or expanding facilities, managing inventories, anddetermining product-mix strategies. The decisions theU.S.military faces are no diferent. The DoD, as a whole, has often struggled with trying to fnd the best force mix, or optimal programs that maximize military capabilities within set budgetary, scheduling, and human resource constraints. Such decisionsmight involve thousands ormillions of potential alternatives. Considering and evaluating each of them would be impractical or even impossible. An optimization model can provide valuable assistance in incorporating relevant variables when analyzing decisions and finding the best solutions for making decisions. These models capture the most important features of a problem and present them in a form that is easy to interpret. Models often provide insights that intuition alone cannot. An optimization model has three major elements: decision variables, constraints, and an objective. In short, the optimization methodology fnds the best combination or permutation of decision variables (e.g., which
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Defense ARJ, January 2020, Vol. 27No. 1 : 60-107
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