Project Selection Model

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
don’t 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 firm’s
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
company’s 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 firm’s 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 poor—according 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) $ 226,000
 Salvage Value
 $20,000(P/F, 12%, 10) $ 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: $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 future value for this

project?
Is the project an acceptable investment?
 Future Value Example
Solution
 Annual Receipts
 $40,000(F/A, 12%, 10) $ 701,960
 Salvage Value
 $20,000(year 10) $ 20,000
 Annual Disbursements
 $22,000(F/A, 12%, 10) -$386,078
 Initial Investment
 $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 $10,000
 Salvage
 $2,000(P/F, 10%, 10)(A/P, 10%,10) $ 125
 Costs:
 $5,000 per year -$ 5,000
 Investment:
 $40,000(A/P, 10%, 10) -$ 6,508
 Net Annual Value -
$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 Project B
 Present value cash inflows
$500,000 $100,000
 Present value cash outflows
$300,000 $ 50,000
 Net Present Value
$200,000 $ 50,000
 Benefit/Cost Ratio
1.67 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 Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 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

a 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
b
Pay Back Period
Fraction of First Positive Year 0.78 c) 0.78 = 10,500/13,500
Pay Back Period 3.78 d) 3 + 0.78
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 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

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 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

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 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

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 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 0.73
Pay Back Period 3.73
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 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 0.73
Pay Back Period 3.73
 Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 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 0.73
Pay Back Period 3.73
IRR & Discount Rates
 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 0 1 2 3 4 5 6 7 8 9

Cash Flow (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 Cash Cash Cash Cash Cash

Flow Yr Flow Yr Flow Yr Flow Yr Flow Yr Flow Yr
0 1 2 3 4 5
-500 -500 +750 +600 +800 +1000
ROR NPV

2% 1,941

6% 1,581

10% 1,283

15% 981

20% 739

IRR 47.82% 0
 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 0–1 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 firm’s 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
n
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: n v
Si  SijWj Cik
j 1 k 1

where Cik 1 if the i th project satisfies the Kth constraint, and 0 if it does
 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 & Gamble’s potential
market share is not at least 50 percent;
 and that does not utilize Procter & Gamble’s
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.
 ACTIVITY

 Exercise – Project Selection

 Approximate Time: 30 minutes