Journal of the Operational Research Society (2014), 1–10 © 2014 Operational Research Society Ltd. All rights reserved.

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A mean-risk index model for uncertain capital

budgeting
Qun Zhang, Xiaoxia Huang* and Chao Zhang
University of Science and Technology Beijing, Beijing, China
This paper discusses the capital budgeting problem of projects using annual cash inflows, cash outflows and initial
investment outlays given by experts’ evaluations when no historical data are available. Uncertain variables are used
to describe the projects’ parameters. A profit risk index and a capital risk index are proposed, and a mean-risk index
model is developed for optimal project selection. In addition, the deterministic forms of the model are given and a
solution algorithm is provided. For the sake of illustration, a numerical example is also presented. The results of the
example show that both profit risk index and capital risk index are important in investment risk control. However,
when the profit risk control requirement is strong, the selected project portfolio may be insensitive to the capital risk
constraint; when the profit risk control requirement is moderate, the capital risk constraint plays an important role.
The results also show the tendency that when either the tolerable profit risk level or the tolerable capital risk level
becomes higher, the obtained expected net present value of the project portfolio becomes larger, which is in
agreement with the investment rule that the higher the risk, the higher the return.
Journal of the Operational Research Society advance online publication, 7 May 2014;
doi:10.1057/jors.2014.51

Keywords: capital budgeting; project selection; uncertain programming; risk index

Introduction Since it is usually difficult to predict the exact values of the

project parameters in real life due to the complexity of the
Capital budgeting is concerned with the optimal selection of
economic environment, indeterminacy needs to be taken into
projects such that the investment in the selected projects can
account. Traditionally, people used to assume that project
bring a company maximum profit. The most popular project
parameters were random variables, and a variety of capital
appraisal method is the Net Present Value (NPV) method. For
budgeting methods have been proposed. For example, De et al
most companies, available investment capital is limited; there-
(1982), Keown and Martin (1977), and Keown and Taylor
fore, scholars have discussed the capital budgeting problem
(1980) developed stochastic chance-constrained programming
under budget limitations. A major contribution to the theoretical
models to select optimal capital projects. Brigham and Houston
formulation of the problem was made by Weingartner (1963).
(2002) presented a stochastic Monte Carlo simulation method
He regarded investment parameters such as cash inflows, cash
to evaluate the expected return and the risk of a project.
outflows and available investment capital to be exact numbers.
Medaglia et al (2007) proposed an evolutionary approach for
Employing the NPV method, he suggested a model with the
selecting multi-objective linearly constrained projects, etc.
maximization of the total NPV of the projects as the objective
Though probability theory is a powerful tool for handling
and the investment outlays at every investment period not
capital budgeting problems with indeterminate parameters, its
exceeding the capital resources as the constraints. Later on, the
use is conditional upon there being enough historical data.
basic model was substantially extended to increase its relevance
However, there exist cases in reality where there is a lack of
and applicability to real-world situations. Some prime research
historical data. For example, for an R&D project, there is no
topics include the choice of a suitable objective function
historical data about the initial outlay of the project. Nor is there
(Bernhard, 1969), the integration of contingency relations
the historical data about the net cash flows that will be brought
among the projects (Weingartner, 1966), the integration of
by the project. Then the parameter values have to be given by
decisions regarding the investors’ capital structure (Baumol
experts’ evaluations rather than by historical data. Kahneman
and Quandt, 1965), and the handling of the difference between
and Tversky (1979) have found that in these cases too much
borrowing rates and lending rates (Padberg and Wilczak, 1999).
weight is given to the chance of unlikely events. If in this
situation we still use probabilities to describe the estimates,
*Correspondence: Xiaoxia Huang, Dongling School of Economics and
Management, University of Science and Technology Beijing, Beijing,
counterintuitive results may occur. Let us give one example
100083, China. here. Suppose we have 40 independent projects that have
E-mail: hxiaoxia@manage.ustb.edu.cn identical characteristics. Furthermore, suppose the real initial
2 Journal of the Operational Research Society
outlay of each project is uniformly distributed between 113 and
117 million dollars. Let ξi denote the ith project outlay, i = 1,
2, …, 40, respectively. It can be seen that if we have enough
historical data, we can use random variables to describe the
initial outlays and use probabilities to describe the frequencies.
Since the minimum real outlay of each project is 113 million
dollars, the probability of the total outlay of all 40 projects equal
to or greater than 113 × 40 million dollars will be 1, that is,
Pr{ξ1 + ξ2 + … + ξ40 ⩾ 113 × 40} = 1, which means that the total
outlay of all 40 projects equal to or greater than 4520 million
dollars will surely occur. In this case probability theory plays an
important role. However, suppose now people do not have
any historical data about the initial outlays. For the above-
mentioned reason, the estimated occurrence chances have
greater variance than the real frequencies. Suppose experts
estimate that the initial outlay of each project is uniformly
distributed between 100 and 120 million dollars. If in this
situation we still use probabilities to describe the experts’
estimates, we can obtain by stochastic simulation (6000
simulation times) that the probability of the total outlay of all
40 projects equal to or greater than 113 × 40 million dollars is
less than 0.07%, that is, Pr{ξ1 + ξ2 + … + ξ40 ⩾ 113 × 40} =
0.00067, which means that the total outlay of all 40 projects
equal to or greater than 4520 million dollars will almost surely
not occur. It can be seen that, by inappropriately using
probability theory, an event that will surely happen becomes
an event that will surely not happen. This result is dangerous for
decision making because people will take measures to provide
for an event that may happen at a certain occurrence chance
level but will not take any measures to provide for an event that
will surely not happen. In fact, Tversky and Kahneman (1974)
have already pointed out that heuristic methods applied to
assess probabilities and predict values sometimes lead to
systematic and severe errors.
To handle capital budgeting problems with imprecise human
estimates, scholars have explored using fuzzy set theory. For
example, based on fuzzy set theory, Kuchta (2000) and
Kahraman et al (2002) developed the formulas of fuzzy present
value, fuzzy equivalent uniform annual value, fuzzy future
value, fuzzy benefit-cost ratio and fuzzy payback period.
Avineri et al (2000) proposed a technique in the selection of
transportation projects using a fuzzy weighted average. Karsak
and Kuzgunkaya (2002) presented a fuzzy multiple objective
programming approach to select flexible manufacturing sys-
tems. Iwamura and Liu (1998) and Huang (2007) extended
chance-constrained programming ideas to solve fuzzy capital
budgeting problems, and Huang (2008) extended Markowitz’s
mean-variance idea to handle fuzzy capital budgeting.
This research opened up new ways of handling capital
budgeting problems with imprecise human estimates. However,
subsequent research has found that paradoxes will appear if we
use fuzzy variables to describe the subjective estimates of
project parameters. For example, if we use a fuzzy variable to
describe the annual cash inflow of a project, we should have a
membership function. Suppose a triangular fuzzy variable
ξ = (3, 3.5, 4) million dollars. On the basis of the membership
function and the definition of possibility measure, we have the
following three propositions: (1) The cash inflow is ‘exactly 3.5
million dollars’ with possibility measure 1; (2) The cash inflow
is ‘not exactly 3.5 million dollars’ with possibility measure 1;
(3) Being ‘exactly 3.5 million dollars’ is as possible as ‘not
exactly 3.5 million dollars’. Regarding the first proposition,
what a coincidence it should be that we can have the cash flow
being exactly 3.5 million dollars, not a penny less or more, to let
the proposition hold! The second proposition is quite reason-
able. However, the third proposition is contradictory to our
common sense and unacceptable because ‘being exactly 3.5
million dollars’ is almost impossible compared with ‘not being
exactly 3.5 million dollars’. Recently, Liu (2007) proposed an
uncertain measure and developed uncertainty theory via an
axiomatic system of normality, self-duality, countable sub-
additivity and product uncertain measure. Considerable work
has been done to develop uncertainty theory. For example, Liu
(2007) defined uncertain variables based on uncertain measure
and presented the concept of uncertainty distribution to char-
acterize the uncertain variables. Peng and Iwamura (2010)
proved a sufficient and necessary condition of uncertainty
distribution. Liu presented the concept of independence (Liu,
2009) and further proposed the operational law (Liu, 2010) for
the calculation of the uncertainty distribution of the monotone
function of independent uncertain variables. In order to measure
the size of an uncertain variable, Liu (2007) defined its expected
value and further verified the linearity property of the operator
(Liu, 2010). Other results on inequality have been achieved
(Liu and Xu, 2010; Zhang, 2011) as have developments on
uncertain sequence (Gao, 2009; You, 2009), etc. With uncer-
tainty theory, an uncertain variable is characterized by an
uncertainty distribution instead of a membership function. If
we use an uncertain variable to describe a project parameter, we
can see from the definitions and properties of the uncertain
measure and the uncertainty distribution introduced in the
Appendix that the event that will surely occur will not become
the event that will surely not occur. (The chance of it occurring
gauged by the uncertainty measure is 35% in the above-
mentioned example if we use uncertain variables to describe
the experts’ estimates of initial outlays.) In addition, by using
uncertainty theory the above-mentioned paradox disappears.
Nowadays, uncertainty theory has been adopted as a useful tool
for modelling human uncertainty. As applications of uncer-
tainty theory, Zhu (2010) developed an uncertain optimal
control theory and applied it to portfolio selection. Huang
proposed a mean-risk curve method (Huang, 2011) and a
mean-variance method (Huang, 2012) to deal with portfolio
optimization with returns given by experts’ judgements. Other
portfolio selection methods based on uncertainty theory can be
found in Huang (2010). In addition, Gao (2011) solved a
shortest path problem with arc lengths offered by experts’
evaluations. Gao (2012) offered a single facility location
method, and Zhang et al (2012) proposed a multi-national
project selection method with parameters given by experts’

judgements. Other applications of uncertainty theory can be
found in the areas of subjective uncertain logic (Li and Liu,
2009; Chen and Ralescu, 2011), subjective uncertain inference
(Gao et al, 2010), and uncertain renewal process (Yao and Li,
2012), etc. In this paper, we will explore the use of uncertainty
theory to solve a capital budgeting problem in which the project
parameters are given by experts’ evaluations because of a lack
of historical data.
The rest of the paper is organized as follows. First, a profit
risk index and a capital risk index will be proposed. A mean-
risk index model for uncertain capital budgeting will be
developed in the next section. The crisp forms of the model
will be given after that, and a solution algorithm will be
presented in the subsequent section. To illustrate the application
of the model, an example will be provided and discussed in the
penultimate section. Finally, in the last section, some conclud-
ing remarks will be given. In addition, to help better understand
the paper, some properties about uncertain variables that are
used in the paper will be briefly reviewed in the Appendix.
A mean-risk index uncertain capital budgeting model
To understand an uncertain capital budgeting problem, consider
a company that needs to select projects for investment from a
number (k) of independent projects. Each project has no salvage
value at the end of its lifetime. For convenience, we use the
following notations:
UCIjt: the uncertain annual cash inflows of project j at the
end of tth year.
UCOjt: the uncertain annual cash outflows of project j at the
end of tth year.
UIOj: the uncertain initial investment outlays of project j.
Tj: the lifetime of project j.
C: the company’s available capital for investment.
r: the hurdle rate of the capital or the required profit rate.
xj the decision variables defined by:
(
1; if project j is selected
xj ¼
0; otherwise;
j = 1, 2, …,k, respectively.
To consider the time value of the capital, future profits of the
projects are transformed into their equivalent current cash
values. Then the company’s profits can be expressed as follows,
k X
X Tj
UCIjt xj - UCOjt xj
UNPV ¼ - UIOj xj : (1)
j¼1 t¼1 ð1 + rÞt
The company wants to pursue the maximum investment
profit. However, because UNPV now is an uncertain variable, it
is meaningless to maximize a variable. Usually, an expected
value is adopted as the representative of the uncertain return,
so the company can pursue the maximum expected investment
Qun Zhang et al—Mean-risk index model for uncertain capital budgeting 3
return. That is, the company’s objective can be expressed as
follows,
" #
X
k X
Tj
UCIjt xj - UCOjt xj
max E - UIOj xj (2)
j¼1 t¼1 ð1 + rÞt
where E is the expected value operator of uncertain
variables.
In an uncertain environment, investment return is accompa-
nied with investment risk. In the area of investment risk
analysis, variance is the most popular risk measurement and is
usually adopted in probabilistic capital budgeting (Seitz and
Ellison, 2005). Huang used variance to measure the investment
risk and followed Markowitz’s idea to handle fuzzy capital
budgeting problems (Huang, 2008). The idea is that the greater
the deviation from the expected NPV of the selected project
portfolio, the less likely it is that the company can obtain the
objective of expected NPV, and thus the riskier the project
portfolio is. Therefore, when making the capital budgeting
decision, the company should first require that the variance
value of the NPV of the project portfolios be less than or equal
to a predetermined tolerable variance level and then select the
project portfolio with the maximum expected NPV. Though
variance is a popular risk measurement in investment risk
analysis, it is not so convenient to use for some investors
because it is difficult to judge if a variance level is tolerable or
not when the expected value of the project portfolio is
unknown. With different expected values, the investors’ max-
imum tolerable variance values may be different. For example,
suppose we have two project portfolios A and B. The variance
values of the NPVs of the two portfolios are both 1, but the
expected NPV of portfolio A is 0.1 and the expected NPV of
portfolio B is 10. It is easy to see that although the variance
values of A and B are same, portfolio A will be regarded quite
unlikely to realize the NPV 0.1, and so variance 1 is intolerable.
On the contrary, variance value 1 may be tolerable for portfolio
B because portfolio B will probably realize the NPV 10 with the
same variance value 1. This is true not only in probabilistic and
fuzzy cases but also in an uncertain environment. In addition, in
reality, people usually prefer to have direct and intuitive
information about a likely loss event. For these reasons we
propose an alternative risk measurement for capital budgeting
with parameters containing imprecise human judgements. We
know from the traditional NPV method that when NPV value is
greater than 0, the company can earn money at a profit rate
higher than their preset base rate, that is, hurdle rate r.1 When
NPV value is equal to or less than 0, the company is earning
money at a rate equal to or lower than their preset base profit
rate r. We define the event in this case as the loss event because
the preset base profit rate is not exceeded. In an uncertain
environment, a loss event, that is {UNPV ⩽ 0}, may occur. To
1
To be exact, the sentence is valid when the NPV graph is monotonically
decreasing. In general, the rate of return of a project will be a lending rate in
some periods and a borrowing rate in other periods.
4 Journal of the Operational Research Society

measure the chance of the loss event, we define a profit risk Deterministic form
index as follows:
To solve the model (7), we need to convert it into its
Definition 1 The profit risk index of the investment is deterministic form.
defined as
Theorem 1 Suppose uncertain annual cash inflows, uncer-
PRI ¼ MfUNPV ⩽ 0g (3) tain annual cash outflows and uncertain initial outlays are
all non-negative uncertain variables. Let Φjt, Φ′jt and Ψjt
where M is the uncertain measure of the uncertain variable. denote the continuous uncertainty distributions of uncer-
Since {UNPV ⩽ 0} is a perceptible loss event, it is easy for tain annual cash inflows, uncertain annual cash outflows
the company to provide their tolerance of the chance of this loss and uncertain initial outlays, where j = 1, 2, …, k, t = 1, 2,-
event. Then, the company can require that the profit risk index …, Tj, respectively. Let ejt, eejt and e′j denote the expected
of the investment should not be greater than a preset tolerable values of uncertain cash inflows, uncertain cash outflows
level α. That is, the profit risk control constraint can be and uncertain initial outlays, where j = 1, 2, …, k, t = 1, 2,-
expressed as follows: …, Tj, respectively. Then the model (7) can be converted
( ) into the following model:
Xk X Tj
UCIjt xj - UCOjt xj X k
8
M - UIOj xj ⩽ 0 ⩽ α: (4) > P k PTj P
ð1 + rÞt >
> ejt xj - eejt xj
-
k 0
j¼1 t¼1 j¼1 > max
> ej xj
>
t
ð1 + rÞ
>
> j¼1 t¼1 j¼1
>
>
The company has a limited budget. When the initial invest- >
> subject to :
>
>
ment outlay is an uncertain variable, there exists the risk that the < P k P Tj 0
Φjt- 1 ðαÞxj - Φjt- 1 ð1 - αÞxj Pk
outlay will exceed the available capital C. Following the profit - Ψj- 1 ð1 - αÞxj ⩾ 0
>
t
ð1 + rÞ
>
> j¼1 t¼1 j¼1
risk index idea, we define a capital risk index as follows: >
>
>
> P k
>
> Ψj- 1 ð1 - βÞxj ⩽ C
Definition 2 The capital risk index of the initial outlay >
>
> j¼1
>
exceeding the budget is defined as >
:
xj 2 f0; 1g; j ¼ 1; 2; ¼ ; k:
( )
Xk
(8)
CRI ¼ M UIOj xj > C : (5)
j¼1

Then, the capital risk control constraint can be expressed as Proof: The deterministic form of the objective can be directly
follows: obtained according to Theorem 3 in the Appendix. □
( ) Since UCIjt, UCOjt, UIOj are all non-negative uncertain
Xk
M UIOj xj > C ⩽ β (6) variables, according to Equation (A.2) of Theorem 2 in the
j¼1 Appendix, the inverse uncertainty distribution function value of

where β is a preset tolerable level.

k X
X Tj
UCIjt xj - UCOjt xj X
k

t - UIOj xj
j¼1 t¼1 ð1 + rÞ j¼1
Thus, to maximize the mean portfolio return in the sense of
at α is
present value under the risk control constraints that the profit
0
risk index should not exceed the tolerable value α, and that the k X
X Tj
Φjt- 1 ðαÞxj - Φjt- 1 ð1 - αÞxj X
k

capital risk index should not exceed the preset value β, the t - Ψj- 1 ð1 - αÞxj :
j¼1 t¼1 ð1 + rÞ j¼1
project should be selected according to the following mean-risk
index model: Since any uncertain measure M is increasing, the determi-
8 " # nistic form of the profit risk control constraint is obtained.
>
> max E P k PTj
UCIjt xj - UCOjt xj P k
>
> - UIOj xj According to the self-duality property of uncertain measure,
>
> ð1 + rÞt
>
> j¼1 t¼1 j¼1 we have
>
> ( ) ( )
>
> subject to :
>
> Xk X k
>
> ( ) M UIOj xj > C ¼ 1 - M UIOj xj ⩽ C :
>
< Pk P Tj
UCIjt xj - UCOjt xj Pk
j¼1 j¼1
M ð1 + rÞt
- UIOj xj ⩽ 0 ⩽ α (7)
>
>
>
>
j¼1 t¼1 j¼1
Thus, the capital risk control constraint can be transformed
>
> ( )
>
> P into
>
>
k
>
> M UIOj xj > C ⩽ β ( )
>
> X k
>
>
j¼1
>
: M UIOj xj ⩽ C ⩾ 1 - β:
xj 2 f0; 1g; j ¼ 1; 2;    ; k: j¼1
 Qun Zhang et al—Mean-risk index model for uncertain capital budgeting 5

Since UIOj are all non-negative uncertain variables, accord- normal uncertain variable is here denoted by ξ ∼ N(e, σ). It can
ing to Equation (A.1) of Theorem 2 in the Appendix, the be calculated that the expected value of the normal uncertain
inverse uncertainty distribution function value of variable is E[ξ] = e and the variance V[ξ] = σ2. It has been
X
k proven (Chen and Dai, 2011) that a normal uncertain variable
UIOj xj has a maximum entropy among all types of uncertain variables
j¼1 whose expected value is e and whose variance value is σ2.
at 1 − β is A parameter with maximum entropy distributes most disper-
sively, and it will be most difficult to predict whether a specific
X
k
xj Ψj- 1 ð1 - βÞ: value of the parameter will occur. Thus, for safety of decision
j¼1 making, if investors can only predict the expected and variance
values of the project parameters, they can use normal uncertain
Since any uncertain measure M is increasing, the determi-
variables to describe the project parameters.
nistic form of the capital risk control constraint is obtained.
Thus, the theorem is proved. Example 2. Suppose that the annual cash inflows, annual
We call an uncertain variable a linear uncertain variable if it cash outflows and the initial investment outlays are
has the following linear uncertainty distribution independent normal uncertain variables UCIjt ∼ N(ejt, σjt),
8 UCOjt ∼ N(e′jt, σ j′t) and UIOj ∼ N(e″j , σ″j ), j = 1, 2, …, k,
>
> 0; if t < a
< t = 1, 2…, Tj, respectively. According to Model (8), the
ΦðtÞ ¼ ðt - aÞ=ðb - aÞ; if a ⩽ t ⩽ b capital budgeting model is
>
>
: 8
1; if t > b: > Pk P Tj
ejt xj - e0jt xj P k
>
> - e00j xj
>
> max ð1 + rÞt
For convenience, it is here denoted by L(a, b). It can be >
> j¼1 t¼1 j¼1
>
>
>
>
calculated according to Equation (A.3) in the Appendix that the >
> subject to :
>
> !
expected value of the linear uncertain variable E[ξ] = (a + b)/2. >
>
>
> Pk P Tj
ejt - e0jt
If investors can only give the lowest and highest bounds of the >
> - e 00
>
< j¼1 t¼1 ð1 + rÞ
t j xj
parameter values and have no other preferences, they can use !
pffiffiffi (10)
linear uncertain variables to describe these parameters because >
> 3 α X k X
Tj
σ jt + σ 0jt
>
> + 00
+ σ j xj ⩾ 0
linear uncertain variables can provide the same information. >
> π
ln
1 - α j¼1 t¼1 ð1 + rÞt
>
>
>
>
>
>
Example 1 Suppose that the uncertain annual cash inflows, > P pffiffi
> 1 - β P 00
k k
>
> 00
> j¼1 ej xj + π ln β j¼1 σ j xj ⩽ C
3
uncertain annual cash outflows and the initial investment >
>
>
outlays are independent linear uncertain variables UCIjt ∼ >
>
:
L(ajt, bjt), UCOjt ∼ L(aajt, bbjt), and UIOj ∼ L(cj, dj), j = xj 2 f0; 1g; j ¼ 1; 2; ¼ ; k:
1, 2, …, k, t = 1, 2…, Tj, respectively. According to Model
(8), the capital budgeting model is

8
> Pk
aj xj + bj xj
>
> max Solution algorithm
>
> 2
>
> j¼1
>
> Huang (2008) presented a fuzzy simulation-based genetic
>
> subject to :
>
> algorithm to solve the mean-variance capital budgeting pro-
>
>
< P k Pk blem. Here, the algorithm is revised to provide a solution to the
ð1 - αÞ aj xj + α bj xj ⩾ 0 (9)
>
>
above model. In the algorithm, we use the deterministic form of
>
>
j¼1 j¼1
>
> Model (8) to calculate the objective and the constraint values. In
>
> Pk P k
>
> β c x + ð1 - βÞ d j xj ⩽ C particular, when annual cash inflows, annual cash outflows and
>
> j j
>
> j¼1 j¼1 the initial investment outlays are linear uncertain variables, we
>
:
xj 2 f0; 1g; j ¼ 1; 2; ¼ ; k; use the deterministic form of Model (9) to calculate the
objective and the constraint values; and when they are normal
uncertain variables, we use the deterministic form of Model
where aj = ∑Tj t = 1(ajt − bbjt)/((1 + r) ) − dj and bj = ∑t = 1(bjt −
t Tj (10). Then we use the genetic algorithm to find the optimal
aajt)/((1 + r) ) − cj.
t solution. Below we give the solution representation and then
We call an uncertain variable a normal uncertain variable if it summarize the algorithm.
has the following normal uncertainty distribution
   - 1
πðe - tÞ Solution representation
ΦðtÞ ¼ 1 + exp pffiffiffi ; t 2 <;
3σ Since the solution of xj should be 0 or 1, an integer
where e and σ are real numbers and σ > 0. For convenience, this vector x = (x1, x2, …, xk) is used to represent a solution
6 Journal of the Operational Research Society

to the optimization problem, where xj ∈ {0, 1}, j = 1, 2, …, k. An Example

Then the solution x = (x1, x2, …, xk) can be coded by
For the sake of illustration, a numerical example is presented
the chromosome C = (c1, c2, …, ck), where cj ∈ {0, 1}, j = 1,
here. The example is performed on a personal computer with
2, …, k. The mapping between a solution and a chromosome
the following parameters in the GA: the population size is 30,
is x≡C.
the probability of crossover Pc = 0.5, the probability of mutation
Pm = 0.6, and the parameter ν in the rank-based evaluation
Step 1: Determine the size of population pop_size.
function is 0.05.
Step 2: Randomly generate an integer vector C(c1, c2, …, ck)
from the integer set {0, 1}. Example 3 Assume a company is considering its investment
Step 3: Calculate the constraints according to the determinis- plan in 11 independent R&D projects whose investment
tic forms of the constraints in Model (8). In particular, periods are all 1 year. There is no salvage value for each
when annual cash inflows, annual cash inflows and project when the project dies. The initial investment outlay
the initial investment outlays are linear uncertain of each project at the beginning of the investment year and
variables, calculate the constraint values according the annual cash inflows and outflows for each project at
to the deterministic forms of the constraints in Model the end of every year are given by experts and are listed in
(9); or when they are normal uncertain variables, use Tables 1 and 2, respectively. The lifetime (LT) is given in
the deterministic form of Model (10). Then check the Table 2. The available investment budget of the company is
feasibility of the chromosome as follows: 120 million dollars, and the hurdle rate of the capital is 6%
Pk PTj -1 0-1 t
t¼1 Φjt ðαÞxj - Φjt ð1 - αÞxj =ð1 + rÞ
If j¼1
per year.
Pk
- j¼1 Ψj- 1 ð1 - αÞxj < 0; or Suppose the investors require that neither the profit risk index
Pk -1 nor the capital risk index should be greater than 5%. Then,
j¼1 Ψj ð1 - βÞxj > C; return 0;
return 1; according to Model (8), we have the model as follows:
8
in which 1 means feasible, and 0 non-feasible. > P11 P 9
ejt xj - eejt xj P11
>
> max - e0j xj
Step 4: Take the chromosome as a feasible initial chromo- >
> 1:06t
>
> j¼1 t¼1 j¼1
>
>
some if it is checked to be feasible. Otherwise, repeat >
> subject to :
>
>
steps 2 and 3 until a feasible chromosome is obtained. >
>
Step 5: Repeat the above steps 2, 3 and 4 pop_size times. < P 11 P 9 Φ - 1 ð0:05Þx - Φ0 - 1ð0:95Þx P11
- Ψj- 1 ð0:95Þxj ⩾ 0 (11)
jt j jt j
1:06t
Then pop_size feasible initial chromosomes are >
>
>
>
j¼1 t¼1 j¼1
generated. >
>
>
> P11
Step 6: Calculate the objective values for all chromosomes >
> Ψj- 1 ð0:95Þxj ⩽ 120
>
>
according to the deterministic form of the objective in >
> j¼1
>
:
Model (8). In particular, when annual cash inflows, xj 2 f0; 1g; j ¼ 1; 2; ¼ ; 11:
annual cash outflows and the initial investment out-
lays are linear uncertain variables, calculate the A run of the computer with 1000 generations within 6 s
objective values according to the deterministic form shows that the maximum expected NPV is 160.48 million
of the objective in Model (9); and when they are dollars and the optimal plan is x* = (1, 0, 0, 1, 1, 0, 0, 0, 0, 0, 0).
normal uncertain variables, use the deterministic To test the effect of requirement for profit risk index on the
form of Model (10). decision result of the projects’ investment, we keep β = 0.05
Step 7: Give the rank order of the chromosomes according to and adjust the maximum tolerable profit risk index value and
the objective values, and compute the rank-based redo the experiment. The results are shown in Table 3. It can be
evaluation function for all the chromosomes. seen that when the tolerable profit risk level changes, there is a
Step 8: Calculate the fitness of each chromosome accord- clear tendency that the greater the tolerable profit risk level, the
ing to the values of the rank-based evaluation greater the obtained maximum expected NPV; and the smaller
function. the tolerable profit risk level, the lower the obtained maxi-
Step 9: Select the chromosomes by spinning the roulette wheel. mum expected NPV. It can also be seen that since the project
Step 10: Update the chromosomes by crossover and mutation
operators, in which the values of the constraints are
calculated according to the deterministic forms of the Table 1 Uncertain initial outlays (million $)
constraints in Models (8), (9) or (10) according to the Project 1 2 3 4 5 6
different situations.
Initial outlay L(30, 36) L(20, 25) L(25, 35) L(30, 42) L(22, 30) N(20, 3)
Step 11: Repeat the sixth to tenth steps for a given number of
cycles. Project 7 8 9 10 11 —
Step 12: Report the best chromosome as the final plan for
Initial outlay N(20, 4) N(14, 3) N(24, 3) N(18, 3) N(25, 5) —
capital budgeting.
 Qun Zhang et al—Mean-risk index model for uncertain capital budgeting 7

Table 2 Uncertain annual cash inflows and outflows (million $)

Year 1 2 3 4 5 6 7 8 9 LT

P1-UCI L(20, 30) L(20, 30) L(32, 38) L(32, 38) L(32, 38) L(32, 38) L(32, 38) L(30, 34) L(30, 34) 9
P1-UCO L(12, 20) L(12, 20) L(20, 25) L(20, 25) L(20, 25) L(20, 25) L(20, 25) L(20, 25) L(20, 25)
P2-UCI L(16, 20) L(16, 20) L(25, 33) L(25, 33) L(25, 33) L(25, 33) L(15, 20) — —- 7
P2-UCO L(12, 18) L(12, 18) L(16, 20) L(16, 20) L(16, 20) L(16, 20) L(10, 13) — —
P3-UCI L(20, 24) L(28, 34) L(28, 34) L(28, 34) L(28, 34) — — — — 5
P3-UCO L(12, 18) L(15, 25) L(15, 25) L(15, 25) L(15, 25) — — — —
P4-UCI L(21, 23) L(21, 23) L(21, 23) L(30, 36) L(30, 36) L(30, 36) L(30, 36) L(30, 36) — 8
P4-UCO L(14, 22) L(14, 22) L(14, 22) L(14, 18) L(14, 18) L(14, 18) L(14, 16) L(14, 16) —
P5-UCI L(28, 34) L(30, 38) L(30, 38) L(40, 45) L(40, 45) L(40, 45) L(40, 45) — — 7
P5-UCO L(20, 30) L(20, 30) L(20, 30) L(25, 30) L(25, 30) L(25, 30) L(25, 30) — —
P6-UCI N(32, 5) N(32, 5) N(32, 5) N(35, 3) N(35, 3) N(35, 3) N(35, 3) — — 7
P6-UCO N(22, 2) N(22, 2) N(22, 2) N(26, 1) N(26, 1) N(26, 1) N(26, 1) — —
P7-UCI N(23, 3) N(23, 3) N(23, 3) N(26, 3) N(26, 3) N(26, 3) N(26, 3) N(25, 2) N(25, 2) 9
P7-UCO N(14, 1) N(14, 1) N(14, 1) N(16, 2) N(16, 2) N(16, 2) N(16, 2) N(16, 1) N(16, 1)
P8-UCI N(24, 2) N(24, 2) N(24, 2) N(26, 2) N(26, 2) N(26, 2) — — — 6
P8-UCO N(13, 1) N(13, 1) N(13, 1) N(11, 1) N(11, 1) N(11, 1) — — —
P9-UCI N(28, 2) N(28, 2) N(28, 3) N(28, 3) N(28, 3) N(28, 3) — — — 6
P9-UCO N(15, 1) N(15, 1) N(17, 2) N(17, 2) N(17, 2) N(17, 2) — — —
P10-UCI N(26, 2) N(26, 2) N(30, 3) N(30, 3) N(30, 3) N(30, 3) N(24, 1) N(24, 1) — 8
P10-UCO N(15, 1) N(15, 1) N(16, 1) N(16, 1) N(16, 1) N(16, 1) L(16, 2) N(16, 2) —
P11-UCI N(25, 1.5) N(25, 1.5) N(25, 1.5) N(28, 2) N(28, 2) N(28, 2) N(28, 2) N(28, 2) — 8
P11-UCO N(16, 3) N(16, 3) N(16, 3) N(17, 2) N(17, 2) N(17, 2) N(17, 2) N(17, 2) —

Table 3 Optimal project portfolios under different tolerable profit Table 4 Optimal project portfolios at α = 0.05 with different
risk requirements β levels

P1 P2 P3 P4 P5 P6 P7 P8 P9 P10 P11 α (%) Obj. β Optimal plan with constraint α = 0.05 Obj. (million $)
(million $)
0.05 (1, 0, 0, 1, 1, 0, 0, 0, 0, 0, 0) 160.48
0 0 0 1 1 0 0 0 0 0 0 2 102.49 0.10 (1, 0, 0, 1, 1, 0, 0, 0, 0, 0, 0) 160.48
1 0 0 1 1 0 0 0 0 0 0 5 160.48 0.15 (1, 0, 0, 1, 1, 0, 0, 0, 0, 0, 0) 160.48
1 0 0 1 1 0 0 0 0 0 0 8 160.48
1 0 0 1 0 0 0 1 0 0 0 10 160.54
0 1 0 1 1 0 0 1 0 0 0 12 197.01
1 0 0 1 0 0 0 1 0 1 0 15 216.22 to meet the capital risk control requirement at a wide range.
Therefore the optimal portfolio seems insensitive to the capital
constraint. However, when the profit risk control requirement
selection is not a continuous but a zero-one programming becomes weaker, the portfolios that satisfy the profit risk
problem, the selection results are the same within certain control requirement can contain more projects. Since the
tolerable profit risk levels. For example, when tolerable profit number of the projects in these portfolios is big, the capital risk
risk level is set between 5% and 8%, the investors should make index of some of the portfolios may not be able to meet the
the same decision to select the 1st, 4th and the 5th projects. capital risk control requirement. In this case, the capital
To further understand the relationship between and the effect constraint will play an important role. To test our judgement,
of the profit risk control requirement and the capital risk control we loosened the profit risk control requirement to set α = 0.2
requirement, we keep the tolerable profit risk level at α = 5%, and conducted the experiments at tolerable capital risk index
and change the tolerable capital risk index levels to β = 15%, levels the same as those in Table 4. Furthermore, we conducted
10%, 5%, respectively. The results are unchanged (see Table 4), the experiment without the capital constraint. The results are
which seems to show that the result is insensitive to different given in Table 5. It can be seen from Table 5 that the optimal
capital risk control requirements. We guess that the reason for portfolio changes with different tolerable capital risk control
this insensitivity is that the profit risk control requirement is requirements, which implies that the capital constraint plays an
strong. When the profit risk control requirement is strong to ask important role. In addition, from Table 5 it can be seen that
the profit risk index of the selected portfolios be no greater than without the capital budget constraint, the optimal portfolio
0.05, only a few projects can be included in the portfolios. Since satisfying the profit risk control requirement contains many
the number of the projects in these portfolios is small, the projects (projects 1, 2, 4, 5, 7, 8, 9 and 10). When the tolerable
capital risk index of the portfolios is already very low to be able risk index level decreases to 0.30, 0.15 and 0.05, the number of
8 Journal of the Operational Research Society
Table 5 Optimal project portfolios at α = 0.20 with different
β levels
β Optimal plan with Obj. (million $)
constraint α = 0.20
0.05 (1, 0, 0, 1, 0, 0, 0, 1, 0, 1, 0)
0.15 (0, 1, 0, 0, 1, 0, 0, 1, 1, 1, 0)
0.30 (1, 0, 0, 0, 1,0, 1, 1, 0, 1, 0)
No β constraint (1, 1, 0, 1, 1, 0, 1, 1, 1, , 1, 0)
Table 6 Optimal project portfolios without α constraint
β Optimal plan without α constraint Obj. (million $)
0.05 (0, 1, 0, 0, 0, 1, 1, 1, 0, 1, 0)
0.10 (0, 1, 0, 0, 1, 0, 1, 1, 0, 1, 0)
0.15 (0, 1, 0, , 0, 1, 0, 1, 1, 0, 1, 0)
0.20 (1, 1, 0, 0, 0, 0, 1, 1, 0, 1, 0)
Table 7 Optimal project portfolios without β constraint
α Optimal plan without β constraint Obj. (million $)
0.05 (1, 0, 0, 1, 1, 0, 0, 0, 0, 0, 0)
0.10 (1, 0, 0, 1, 1, 0, 0, 1, 0, 0, 0)
0.15 (1, 1, 0, 1, 1, 0, 0, 1, 0, 1, 0)
projects in each optimal portfolio becomes less than that
without the capital constraint, which more directly verifies that
the capital constraint in these cases plays an important role. We
further conducted experiments without α and β constraints and
provide the results in Tables 6 and 7, respectively. The model
without α constraint can be regarded as having infinite loosen-
ing of α constraint and the model without β constraint can be
regarded as having infinite loosening of β constraint. It can be
seen from Tables 6 and 7 that both the profit risk constraint and
the capital risk constraint play an important role in project
selection. When the profit risk control requirement or the capital
risk control requirement changes, the selected project portfolio
changes. It can also be seen from both Tables 5 and 6 that the
greater the tolerable capital risk level, the greater the obtained
maximum expected NPV; and the smaller the tolerable capital
risk level, the lower the obtained maximum expected NPV,
which is again in agreement with the rule that the greater the
risk, the greater the return.
Conclusions
This paper has discussed a capital budgeting problem when
annual cash inflows, annual cash outflows and initial investment
outlays are given mainly by experts’ evaluations rather than by
historical statistical data. Uncertain variables are used to
describe the project parameters. A profit risk index is introduced
to show the chance level of the project portfolio not being able
to exceed the preset base profit rate, and a capital risk index is
offered to show the chance level of the project portfolio
exceeding the available capital amount. On the basis of the
proposed risk indexes, a mean-risk index capital budgeting
model has been developed. In order to solve the optimization
216.22 problem, the deterministic form of the model has been given
232.96 and a solution algorithm has been presented. We have further
255.87
388.56 presented a capital budgeting example when annual cash
inflows, annual cash outflows and initial investment outlays of
some projects are linear uncertain variables while the others are
normal uncertain variables. The results of numerical experi-
ments show that both the profit risk control and the capital risk
control are important in investment risk control. However,
when the profit risk control requirement is strong, the selected
227.24 project portfolio may be insensitive to the capital risk constraint;
243.33
243.33 when the profit risk control requirement is moderate, the capital
252.31 risk constraint plays an important role. The results also show
the tendency that when either the tolerable profit risk level or
the tolerable capital risk level becomes higher, the obtained
expected NPV of the project portfolio becomes greater, which
is in agreement with the investment rule that the higher the risk,
the higher the return.
160.48 In the real world there are cases when the parameters such as
209.55 project cash inflows, cash outflows and initial investment
310.68 outlays have to be given by experts’ judgements, either because
the underlying projects are totally new or because the economic
environment has changed greatly such that there is no suitable
historical statistical data. Therefore, our approach is a useful
exploratory approach to handling capital budgeting problems
with parameters containing imprecise human judgements. In
addition, the proposed profit risk index offers investors direct
information about the chance level of their unwelcome loss
event, and so is an easy-to-use risk measurement. Further
research may involve finding suitable ways to determine the
uncertainty distributions of project parameters besides linear
and normal uncertainty distributions as well as applying the
proposed method to real capital budgeting problems.
Acknowledgements —This work has been supported by National Natural
Science Foundation of China Grants No. 70871011 and No. 71171018, the
Program for New Century Excellent Talents in Universities, and the
Fundamental Research Funds for Central Universities. The authors thank
anonymous reviewers and the editor-in-chief for their valuable comments
and Dr Mark Buck for his help in the revision of the manuscript.
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Appendix
Uncertain variables
To describe a general uncertainty which is subject to imprecise
estimates, Liu (2007) proposed an uncertain measure and an
uncertain variable based on an axiomatic system of normality,
self-duality and countable sub-additivity.
Definition 3 Let Γ be a non-empty set, and L an σ-algebra
over Γ. Each element Λ 2 L is called an event. A set
function MfΛg is called an uncertain measure if it satisfies
the following three axioms (Liu, 2007):
(i) (Normality) MfΓg ¼ 1:
(ii) (Self-duality) MfΛg + MfΛc g ¼ 1:
(iii) (Countable sub-additivity) For every countable sequence
of events{Λi}, we have
( )
[1 X1
M Λi ⩽ MfΛi g:
i¼1 i¼1
The triplet ðΓ; L; MÞ is called an uncertainty space.
It can be proven (Liu, 2010) that any uncertain measure M is
increasing. That is, for any events Λ1 ∈ Λ2, we have
MfΛ1 g ⩽ MfΛ2 g:
In order to define product uncertain measure, Liu (2007)
proposed the fourth axiom as follows:
(i) (Product measure) Let ðΓk ; Lk ; MÞ be uncertainty spaces
for k = 1, 2, …, n. The product uncertain measure is
M ¼ M1 ^ M2 ^ ¼ ^ Mn :
10 Journal of the Operational Research Society
Definition 4 (Liu, 2007) An uncertain variable is a measur-
able function ξ from an uncertainty space ðΓ; L; MÞ to
the set of real numbers, that is, for any Borel set of B of real
numbers, the set
fξ 2 Bg ¼ fγ 2 Γ j ξðγÞ 2 Bg
is an event.
An uncertainty distribution function is used to characterize an
uncertain variable and is defined as follows.
Definition 5 (Liu, 2007) The uncertainty distribution Φ:
ℜ → [0, 1] of an uncertain variable ξ is defined by
ΦðtÞ ¼ Mfξ ⩽ tg:
When the uncertain variables are represented by uncertainty
distributions, the operational law is given by Liu (2010) as
follows:
Theorem 2 (Liu, 2010) Let ξ1, ξ2, …, ξn, ξn + 1, …, ξn + m be
independent uncertain variables with uncertainty distribu-
tions Φ1, Φ2, …, Φn, Φn + 1, …, Φn + m, respectively. Let f
(t1, t2, …, tn) be strictly increasing with respect to t1, t2, …,
tn, and g(t1, t2, …, tn, tn + 1, …, tn + m) be strictly increasing
with respect to t1, t2, …, tn and strictly decreasing with
respect to tn + 1, tn + 2, …, tn + m.
Then
ξ ¼ f ðξ1 ; ξ2 ; ¼ ; ξn Þ
is an uncertain variable with inverse uncertainty distribution
function
Ψ - 1 ðαÞ ¼ f ðΦ1- 1 ðαÞ; Φ2- 1 ðαÞ; ¼ ; Φn- 1 ðαÞÞ;
(A.1)
0 < α < 1;
and
η ¼ gðξ1 ; ξ2 ; ¼ ; ξn ; ξn + 1 ; ¼ ; ξn + m Þ
is an uncertain variable with inverse uncertainty distribution
function
Ψ - 1 ðαÞ ¼ f ðΦ1- 1 ðαÞ; ¼ ; Φn- 1 ðαÞ;
Φn-+11 ð1 - αÞ; ¼ ; Φn-+1m ð1 - αÞÞ;
0<α<1 ðA:2Þ
if Φ1− 1(α), Φ2− 1(α), …, Φn− 1(α), Φn−+11(α), …, Φn−+1m(α) are
unique for each α ∈ (0, 1).
To measure the size of an uncertain variable, Liu defined the
expected value of uncertain variables.
Definition 6 (Liu, 2007) Let ξ be an uncertain variable. Then
the expected value of ξ is defined by
Z 1 Z 0
E½ξ ¼ Mfξ ⩾ rgdr - Mfξ ⩽ rgdr (A.3)
0 -1
provided that at least one of the two integrals is finite.
Theorem 3 (Liu, 2010) Let ξ1 and ξ2 be independent
uncertain variables with finite expected values. Then for
any real numbers a1 and a2, we have
E½a1 ξ1 + a2 ξ2  ¼ a1 E½ξ1  + a2 E½ξ2 : (A.4)
Received 16 May 2011;
accepted 31 March 2014 after four revisions