Capital Investment — An Optimal Control Perspective

Abstract

Many managers appear to have a mental model of how investment decisions should be carried out. This paper attempts to identify some of the characteristics of such a mental model by constructing an optimal control model of the process of authorizing an investment project. The key activities in the model are design, support generation and authorization. It is assumed that the effort that can be expended on each is limited. The objective function is the net present value of the cash flows associated with the project. The solution to the model is readily interpreted qualitatively. For viable projects, four different patterns of decision-making are found, each of which is optimum under appropriate circumstances. It is argued that in many actual investment decisions it should be possible for managers to approximate reasonably closely the optimal behaviour, and that therefore the optimal control model may shed light on managers' mental model.

Keywords:

• bang bang control
• capital investment decision-making
• design
• optimal control
• risk
• support generation