In all areas of business, determining how to allocate investment capital to maximize returns is a ubiquitous challenge, where approaches to solutions cover a very wide spectrum. Portfolio optimization for capital investment is often too complex to allow for tractable mathematical formulations. Nonetheless, many analysts force these problems into standard forms that can utilize traditional optimization technologies including linear and quadratic programming. Unfortunately, such formulations omit key aspects of real world settings, thus resulting in flawed solutions. Simulation optimization offers a flexible modeling and solution approach that overcomes these limitations.
This paper begins with a discussion of capital investment decision making using traditional tools and methodologies such as net present value (NPV) analysis. Next follows an overview of the much-improved technique of optimization technology to select the best possible project mix for a given capital budget. The paper concludes with an illustrative project portfolio optimization example in the Petroleum and Energy industry.
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