Project Selection Mo
Project Selection
Project selection is the process of evaluating
individual projects or groups of projects,
and then choosing to implement some set of them
so that the objectives of the parent organization
will be achieved.
The proper choice of investment projects is crucial
to the long-run survival of every firm.
Daily we witness the results of both good and bad
investment choices.
Decision Models
Models abstract the relevant issues about a problem from the
plethora of detail in which the problem is embedded.
Reality is far too complex to deal with in its entirety.
This process of carving away the unwanted reality from the
bones of a problem is called modeling the problem.
The idealized version of the problem that results is called a
model.
Models may be quite simple to understand, or they may be
extremely complex. In general, introducing more reality into a
model tends to make the model more difficult to manipulate.
Criteria for Project Selection
Model
1.
Realism
2. Capability
3. Flexibility
4. Ease of use
5. Cost
6. Easy computerization
Numeric and Non-Numeric
Models
Both widely used, Many organizations use both at
the same time, or they use models that are
combinations of the two.
Nonnumeric models, as the name implies, do not
use numbers as inputs. Numeric models do, but the
criteria being measured may be either objective or
subjective.
It is important to remember that:
the qualities of a project may be represented by
numbers, and
that subjective measures are not necessarily less
useful or reliable than objective measures.
Nonnumeric Models
Nonnumeric models are older and
simpler and have only a few subtypes to
consider.
The Sacred Cow
Suggested by a senior and powerful official in the organization. Often initiated
with a simple comment such as, If you have a chance, why dont you look
into . . ., and there follows an undeveloped idea for a new product, for the
development of a new market, for the design and adoption of a global data
base and information system, or for some other project requiring an investment
of the firms resources. Sacred in the sense that it will be maintained until
successfully concluded, or until the boss, personally, recognizes the idea as a
failure and terminates it.
The Operating Necessity
If a flood is threatening the plant, a
project to build a protective dike does
not require much formal evaluation,
which is an example of this scenario. If
the project is required in order to keep
the system operating, the primary
question becomes: Is the system worth
saving at the estimated cost of the
project?
The Competitive
Necessity
The decision to undertake the project
based on a desire to maintain the
companys competitive position in that
market.
Investment in an operating necessity project
takes precedence over a competitive
necessity project
Both types of projects may bypass the more
careful numeric analysis used for projects
deemed to be less urgent or less important
to the survival of the firm.
The Product Line
Extension
A project to develop and distribute new
products judged on the degree to which it
fits the firms existing product line, fills a
gap, strengthens a weak link, or extends
the line in a new, desirable direction.
Sometimes
careful
calculations
of
profitability are not required. Decision
makers can act on their beliefs about what
will be the likely impact on the total system
performance if the new product is added to
the line.
Comparative Benefit
Model
Organization has many projects to consider
but the projects do not seem to be easily
comparable. For example, some projects
concern potential new products, some concern
changes in production methods, others
concern computerization of certain records,
and still others cover a variety of subjects not
easily categorized (e.g., a proposal to create a
daycare center for employees with small
children).
No precise way to define or measure benefit.
Q-Sort Method
Of the several techniques for ordering
projects, the Q-Sort is one of the most
straightforward.
First, the projects are divided into three groups
good, fair, and pooraccording to their
relative merits. If any group has more than
eight members, it is subdivided into two
categories, such as fair-plus and fair-minus.
When all categories have eight or fewer
members, the projects within each category
are ordered from best to worst. Again, the
order is determined on the basis of relative
merit. The rater may use specific criteria to
rank each project, or may simply use general
overall judgment.
The Q-Sort Method
Numeric Models:
Profit/Profitability
A large majority of all firms using project
evaluation and selection models use
profitability as the sole measure of
acceptability.
Models
Present & Future Value
Benefit / Cost Ratio
Payback period
Internal Rate of Return
Annual Value
Variations of IRR
Present Value
The Present value or present worth method of evaluating
projects is a widely used technique. The Present Value
represents an amount of money at time zero representing
the discounted cash flows for the project.
PV
T=0
+/- Cash Flows
Net Present Value (NPV)
The Net Present Value of an investment it is simply the difference
between cash outflows and cash inflows on a present value basis.
In this context, the discount rate equals the minimum rate of return for
the investment
Where:
NPV = Present Value (Cash Benefits) - Present Value (Cash Costs)
Present Value
Example
Initial Investment:
$100,000
Project Life:
10 years
Salvage Value:
$ 20,000
Annual Receipts:
$ 40,000
Annual Disbursements: $ 22,000
Annual Discount Rate: 12%, 18%
What is the net present value for this project?
Is the project an acceptable investment?
Present Value Example
Solution
Annual Receipts
$40,000(P/A, 12%, 10)
Salvage Value
$20,000(P/F, 12%, 10)
$ 226,000
$
6,440
Annual Disbursements
$22,000(P/A, 12%, 10)
-$124,000
Initial Investment (t=0)
-$100,000
Net Present Value
$ 8,140
Greater than zero, therefore acceptable project
Future Value
The future value method evaluates a project based
upon the basis of how much money will be
accumulated at some future point in time. This is
just the reverse of the present value concept.
FV
T=0
+/- Cash Flows
Future Value Example
Initial Investment:
Project Life:
Salvage Value:
Annual Receipts:
Annual Disbursements:
Annual Discount Rate:
$100,000
10 years
$ 20,000
$ 40,000
$ 22,000
12%, 18%
What is the net future value for this project?
Is the project an acceptable investment?
Future Value Example
Solution
Annual Receipts
$40,000(F/A, 12%, 10)
Salvage Value
$20,000(year 10)
-$386,078
Initial Investment
$ 20,000
Annual Disbursements
$22,000(F/A, 12%, 10)
$ 701,960
$100,000(F/P, 12%, 10)
-$310,600
Net Future Value
25,280
Positive value, therefore acceptable project
Can be used to compare with future value of other projects
PV/FV
No theoretical difference if project is
evaluated in present or future value
PV of $ 25,282
$25,282(P/F, 12%, 10)
$ 8,140
FV of $ 8,140
$8,140(F/P, 12%, 10)
$ 25,280
Annual Value
Sometimes it is more convenient to
evaluate a project in terms of its annual
value or cost. For example it may be
easier to evaluate specific components
of an investment or individual pieces of
equipment based upon their annual
costs as the data may be more readily
available for analysis.
Annual Analysis Example
A new piece of equipment is being
evaluated for purchase which will generate
annual benefits in the amount of $10,000
for a 10 year period, with annual costs of
$5,000. The initial cost of the machine is
$40,000 and the expected salvage is
$2,000 at the end of 10 years. What is the
net annual worth if interest on invested
capital is 10%?
Annual Example Solution
Benefits:
$10,000 per year
Salvage
$2,000(P/F, 10%, 10)(A/P, 10%,10)
125
-$ 5,000
Investment:
$40,000(A/P, 10%, 10)
Costs:
$5,000 per year
$10,000
Net Annual Value
-$ 6,508
-$1,383
Since this is less than zero, the project is expected to earn less than the acceptable
rate of 10%, therefore the project should be rejected.
Benefit/Cost Ratio
The benefit/cost ratio is also called the
profitability index and is defined as
the ratio of the sum of the present value of
future benefits to the sum of the present
value of the future capital expenditures and
costs.
B/C Ratio Example
Project A
Present value cash inflows
$500,000
Present value cash outflows
$300,000
Net Present Value
$200,000
Benefit/Cost Ratio
1.67
Project B
$100,000
$ 50,000
$ 50,000
2.0
Payback Period
One of the most common evaluation criteria used.
Simply the number of years required for the cash income
from a project to return the initial cash investment.
The investment decision criteria for this technique suggests
that if the calculated payback period is less than some
maximum value acceptable to the company, the proposal is
accepted.
Example illustrates five investment proposals having
identical capital investment requirements but differing
expected annual cash flows and lives.
Payback Period
Example
Calculation of the payback period for a given investment proposal.
a) Prepare End of Year Cumulative Net Cash Flows
b) Find the First Non-Negative Year
c) Calculate How Much of that year is required to cover the previous
period negative balance
d) Add up Previous Negative Cash Flow Years
Initial
Investment
Annual Net Cash Flows
4
5
6
7
10
Alternative A
(45,000) 10,500 11,500 12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500
End of Year Cummulative Net Cash Flow
(45,000) (34,500) (23,000) (10,500) 3,000 16,500 30,000 43,500 57,000 70,500 84,000
Pay Back Period
Fraction of First Positive Year
Pay Back Period
0.78
3.78
c)
0.78 = 10,500/13,500
d)
3 + 0.78
Example:
Calculate the payback period for the following investment proposal
Initial
Investment 1
Annual Net Cash Flows
3 4 5 6 7 8
9 10
Alternative A
(120) 10 10 50 50 50 50 50 50 50 50
End of Year Cummulative Net Cash Flow
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120) 10
Annual Net Cash Flows
3 4 5 6 7 8
10
10
50
50
50
50
50
50
50
50
End of Year Cummulative Net Cash Flow
(120) (110) (100) (50) 0 50 100 150 200 250 300
Pay Back Period
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120)
10
10
50
Annual Net Cash Flows
4
5
6
7
10
50
50
50
50
50
50
End of Year Cummulative Net Cash Flow
(120) (110) (100) (50)
0
50
100
150
200
250
300
Pay Back Period
Fraction of First Positive Year
Pay Back Period
50
1.00
4.00
Example:
Calculate the payback period for the following investment proposal
Initial
Investment 1
Annual Net Cash Flows
3 4 5 6 7 8
9 10
Alternative A
(250) 86 50 77 52 41 70 127 24
6 40
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250) 86
Annual Net Cash Flows
3 4 5 6 7 8
50
77
52
41
70 127
24
10
40
End of Year Cummulative Net Cash Flow
(250) (164) (115) (38) 14 55 124 252 276 282 322
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250)
86
50
77
Annual Net Cash Flows
4
5
6
7
52
41
70 127
24
10
40
End of Year Cummulative Net Cash Flow
(250) (164) (115) (38) 14 55 124 252 276 282 322
Pay Back Period
Fraction of First Positive Year
Pay Back Period
0.73
3.73
Internal Rate of Return
Internal Rate of Return refers to the interest rate that the
investor will receive on the investment principal
IRR is defined as that interest rate (r) which equates the
sum of the present value of cash inflows with the sum of the
present value of cash outflows for a project. This is the
same as defining the IRR as that rate which satisfies each
of the following expressions:
PV cash inflows - PV cash outflows = 0
NPV = 0 for r
PV cash inflows = PV cash outflows
In general, the calculation procedure involves a trial-and-error solution. The
following examples illustrate the calculation procedures for determining the internal
rate of return.
Example
Given an investment project having the following annual cash flows; find the IRR.
Year
Cash Flow
0
(30.0)
(1.0)
5.0
5.5
4.0
17.0
20.0
20.0
(2.0)
10.0
Solution:
Step 1. Pick an interest rate and solve for the NPV. Try r =15%
NPV
= -30(1.0) -1(P/F,1,15%) + 5(P/F,2,15) + 5.5(P/F,3,15) + 4(P/F,4,15)
+ 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15)
= + $5.62
Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a
higher interest rate in order to reduce the NPV value.
Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.
Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%
IRR using Excel
Using Excel you should insert the following function in the
targeted cell C6:
Analysis
The acceptance or rejection of a project based on the IRR
criterion is made by comparing the calculated rate with the
required rate of return, or cutoff rate established by the
firm. If the IRR exceeds the required rate the project should
be accepted; if not, it should be rejected.
If the required rate of return is the return investors expect
the organization to earn on new projects, then accepting a
project with an IRR greater than the required rate should
result in an increase of the firms value.
Analysis
There are several reasons for the widespread popularity
of the IRR as an evaluation criterion:
Perhaps the primary advantage offered by the
technique is that it provides a single figure which
can be used as a measure of project value.
Furthermore, IRR is expressed as a percentage
value. Most managers and engineers prefer to
think of economic decisions in terms of
percentages as compared with absolute values
provided by present, future, and annual value
calculations.
Analysis
Another advantage offered by the IRR method is related to
the calculation procedure itself:
As its name suggests, the IRR is determined internally
for each project and is a function of the magnitude and
timing of the cash flows.
Some evaluators find this superior to selecting a rate prior
to calculation of the criterion, such as in the profitability
index and the present, future, and annual value
determinations. In other words, the IRR eliminates the
need to have an external interest rate supplied for
calculation purposes.
Selecting a Discount Rate
There is nothing so disastrous as a rational investment
policy in an irrational world John Maynard Keynes
We have discussed the time value of money and illustrated
several examples of its use. In all cases an interest rate or
discount rate is used to bring the future cash flows to the
present (NPV - Net Present Value)
The selection of the appropriate discount rate has been the
source of considerable debate and much disagreement. In
most companies, the selection of the discount rate is
determined by the accounting department or the board of
directors and the engineer just uses the number provided to
him, but short of just being provided with a rate, what is the
correct or appropriate rate to use?
Example
What is the impact of the discount rate on the investment?
Cash
Flow Yr
0
Cash
Flow Yr
1
Cash
Flow Yr
2
Cash
Flow Yr
3
Cash
Flow Yr
4
Cash
Flow Yr
5
-500
-500
+750
+600
+800
+1000
IRR
ROR
NPV
2%
1,941
6%
1,581
10%
1,283
15%
981
20%
739
47.82%
Real Option Model
Recently, a project selection model was developed
based on a notion well known in financial markets.
When one invests, one foregoes the value of alternative
future investments. Economists refer to the value of an
opportunity foregone as the opportunity cost of the
investment made.
The argument is that a project may have greater net
present value if delayed to the future. If the investment
can be delayed, its cost is discounted compared to a
present investment of the same amount. Further, if the
investment in a project is delayed, its value may
increase (or decrease) with the passage of time
because some of the uncertainties will be reduced.
If the value of the project drops, it may fail the selection
process.
If the value increases, the investor gets a higher payoff.
The real options approach acts to reduce both
technological and commercial risk.
Numeric Models: Scoring
In an attempt to overcome some of the
disadvantages of profitability models,
particularly their focus on a single
decision criterion, a number of
evaluation/selection models hat use
multiple criteria to evaluate a project
have been developed. Such models
vary widely in their complexity and
information requirements. The examples
discussed illustrate some of the different
types of numeric scoring models.
Some factors to consider
Unweighted 01 Factor
Model
A set of relevant factors is selected by management
and then usually listed in a preprinted form. One or
more raters score the project on each factor, depending
on whether or not it qualifies for an individual criterion.
The raters are chosen by senior managers, for the most
part from the rolls of senior management.
The criteria for choice are:
(1) a clear understanding of organizational goals
(2) a good knowledge of the firms potential project portfolio.
Next slide: The columns are summed, projects with a
sufficient number of qualifying factors may be selected.
Advantage: It uses several criteria in the decision
process.
Disadvantage: It assumes all criteria are of equal
importance and it allows for no gradation of the degree
to which a specific project meets the various criteria.
Unweighted Factor Scoring
Model
X marks in 0-1
scoring model are
replaced by
numbers, from a 5
point scale.
Weighted Factor Scoring Model
When numeric weights reflecting the relative importance
of each individual factor are added, we have a weighted
factor scoring model. In general, it takes the form
Si SijWj
j 1
where
Si the total score of the ith project,
Sij the score of the ith project on the jth criterion, and
Wj the weight of the jth criterion.
Constrained Weighted Factor
Scoring Model
Additional criteria enter the model as constraints rather than
weighted factors. These constraints represent project
characteristics that must be present or absent in order for the
project to be acceptable.
We might have specified that we would not undertake any
project that would significantly lower the quality of the final
product (visible to the buyer or not).
We would amend the weighted scoring model to take the form:
j 1
k 1
Si SijWj Cik
where Cik 1 if the i th project satisfies the Kth constraint, and 0
Example: P & G practice
Would not consider a project to add a new
consumer product or product line:
that cannot be marketed nationally;
that cannot be distributed through mass outlets
(grocery stores, drugstores);
that will not generate gross revenues in excess
of $million; for which Procter & Gambles
potential market share is not at least 50 percent;
and that does not utilize Procter & Gambles
scientific expertise, manufacturing expertise,
advertising expertise, or packaging and
distribution expertise.
Final Thought
Selecting the type of model to aid the
evaluation/selection process depends on
the philosophy and wishes of management.
Weighted scoring models preferred for three
fundamental reasons.
they
allow the multiple objectives of all
organizations to be reflected in the important
decision about which projects will be supported
and which will be rejected.
scoring models are easily adapted to changes in
managerial philosophy or changes in the
environment.
they do not suffer from the bias toward the short
run that is inherent in profitability models that
discount future cash flows.
