PROBLEMS CHAPTER 2- PM COURSE
Problem 1. Consider the following information in choosing among the four project alternatives
below (labeled A,B,C and D).
Project A is rated:
Payoff potential: high Safety: high
Lack of risk: low Competitive advantage: medium
Project B is rated:
Payoff potential: low Safety: medium
Lack of risk: medium Competitive advantage: medium
Project C is rated:
Payoff potential: medium Safety: low
Lack of risk: medium Competitive advantage: low
Project D is rated:
Payoff potential: high Safety: medium
Lack of risk: high Competitive advantage: medium
Construct a project checklist model for screening these four alternatives. Based on your model,
which project is the best choice for selection? Why? Which is the worst? Why?
B1:
- Define evaluation criteria
+ Payoff potential
+ Safety
+ Lack of risk
+ Competitve advantage
- Assumptions:
+ High = favorable
+ Medium = acceptable
+ Low = unfavorable
B2:
- Construct the checklist
Checklist criteria Project A Project B Project C Project D
High payoff v x v v
potential
Acceptable v v x v
safety level
Low level of risk x v v v
Competitive v v x v
advantage
Total 3 3 2 4
=> Best project: Project D
Worst project: Project C
Problem 2. Suppose the information in Problem 1 was supplemented by importance weights for
each of the four assessment criteria that follow, where 1= low importance and 4= high
importance
Assessment criteria Important weights
Payoff potential 4
Lack of risk 3
Safety 1
Competitive advantage 3
Assume, too that evaluations of high receive a score of 3, medium 2, and low 1. Recreate your
project scoring model and reassess the four project choices (A, B, C and D). Now which project
alternatives is the best? Why?
Criteria Payoff Lack of risk Safety Competitive Total Score
advantage
Weight 4 3 1 3
Project A 3 3 1 2 24
Project B 1 2 2 2 18
Project C 3 2 3 2 18
Project D 3 2 3 2 29
=> Best project: Project D
Worst project: Project B & C
Problem 3. Your vice president for MIS informs you that she has researched the possibility of
automating your organization’s order- entry system. She has projected that the new system will
reduce labor costs by $25,000 each year over the next five years. The purchase price (including
installation and testing ) of new system is $105,250. The system is expected to have a useful life
of five years, after which time it can be sold in the secondary computer systems market for
$10,250. What is the net present value of this investment if the discount rate is 8.5% per year?
Net Present Value (NPV) Calculation
Given data
Initial investment (Year 0): –$105,250
Annual labor cost savings: $25,000 per year for 5 years
Salvage value at end of Year 5: $10,250
Discount rate: 8.5%
Step 1: Present Value of annual savings
Use the present value of an annuity factor:
PVAF=1−(1+r)−nrPVAF = \frac{1 - (1+r)^{-n}}{r}PVAF=r1−(1+r)−n
PVAF=1−(1.085)−50.085PVAF = \frac{1 - (1.085)^{-5}}
{0.085}PVAF=0.0851−(1.085)−5
(1.085)5≈1.5037⇒(1.085)−5≈0.665(1.085)^5 \approx 1.5037 \Rightarrow
(1.085)^{-5} \approx 0.665(1.085)5≈1.5037⇒(1.085)−5≈0.665
PVAF=1−0.6650.085≈3.941PVAF = \frac{1 - 0.665}{0.085} \approx
3.941PVAF=0.0851−0.665≈3.941 PVsavings=25,000×3.941≈98,525PV_{\
text{savings}} = 25,000 \times 3.941 \approx 98,525PVsavings
=25,000×3.941≈98,525
Step 2: Present Value of salvage value
PVsalvage=10,250(1.085)5=10,250×0.665≈6,816PV_{\text{salvage}} = \
frac{10,250}{(1.085)^5} = 10,250 \times 0.665 \approx 6,816PVsalvage
=(1.085)510,250=10,250×0.665≈6,816
Step 3: Net Present Value
NPV=−105,250+98,525+6,816NPV = -105,250 + 98,525 +
6,816NPV=−105,250+98,525+6,816 NPV≈+91NPV \approx +91NPV≈+91
Final Answer
NPV≈+$90 (approximately zero, slightly positive)\boxed{NPV \approx +\
$90 \text{ (approximately zero, slightly positive)}}NPV≈+
$90 (approximately zero, slightly positive)
Problem 4. A heavy manufacturing company wants to decide whether to initiate a new project.
The success of the project depends heavily on the state of the economy, which has a 50/50
chance of being strong enough to support the venture. The project will require an initial
investment of $1 million, and the company expects to earn $500,000 in annual revenues from the
project- unless the economy goes into recession, in which case the project will return only
$100,000 per year. The company requires a 12% return on its investments. Should it undertake
the project?
If the company decides to wait a year, the economy has a 75% chance of improving sufficiently
to ensure $500,000 in annual returns. Does it make sense to wait for a year before making the
investment? Use the options model approach to project evaluation to answer these two questions.
Problem 5. Massivesoft Corporation is trying to decide whether or not to invest in a new
software project. The initial investment will be $5 million. The project has a 40% chance of
returning $1 million per year into the future and a 60% chance of generating only $100,000 in
revenues. Assuming that Massivesoft requires a 15% return on capital investments, determine
whether or not this is a viable project.
If Massivesoft decides to wait one year before investing in the project, it odds of returning $1
million per year improve to 70%. Should Massivesoft wait one year to initiative the project?
Problem 6: Discounted Payback
Your company is seriously considering investing in a new project opportunity but cash flow is
tight these days. Top management is concerned about how long it will take for this new project
to pay back the initial investment of $50,000. You have determined that the project should
generate inflows of $30,000; $30,000; $40,000; $25,000 and $15,000 for the next five years.
Your firm’s required rate of return is 15%. How long will it take to pay back the initial
investment.
Problem 7: Scoring model
Assume that the following information is relative to the process of screening various
opportunities. Our relevant criteria (including importance weighting) include the following:
Quality (5); Cost (3); Speed the market (7); Visibility (4); Reliability (1)
Our company has four project alternatives, which satisfy the key features listed above as follows:
Alpha Beta Gamma Delta
Quality 1 3 3 5
Cost 7 7 5 3
Speed 5 5 3 1
Visibility 3 1 5 3
Reliability 5 5 7 7
Construct a project screening to identify among these four projects the most likely candidate to
be implemented.