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Project Selection Models Overview

The document outlines various project selection models, categorizing them into nonnumeric and numeric models. Nonnumeric models include justifications like Sacred Cow and Competitive Necessity, while numeric models focus on financial metrics such as Payback Period, NPV, and IRR. Each model has its advantages and disadvantages, highlighting the importance of considering both quantitative and qualitative factors in project selection.

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12 views20 pages

Project Selection Models Overview

The document outlines various project selection models, categorizing them into nonnumeric and numeric models. Nonnumeric models include justifications like Sacred Cow and Competitive Necessity, while numeric models focus on financial metrics such as Payback Period, NPV, and IRR. Each model has its advantages and disadvantages, highlighting the importance of considering both quantitative and qualitative factors in project selection.

Uploaded by

priya
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd

Project Selection

Models

2-1
Types of Project Selection Models

 Nonnumericmodels
 Numeric models

2-2
Nonnumeric Models

 Models that do not return a numeric value


for a project to be compared with other
projects
 These are really not “models” but rather
justifications for projects
 Just because they are not true models
does not make them all “bad”

2-3
Types of Nonnumeric Models

 Sacred Cow
– A project, often suggested by the top management,
that has taken on a life of its own
 Operating Necessity
– A project that is required in order to protect lives or
property or to keep the company in operation
 Competitive Necessity
– A project that is required in order to maintain the
company’s position in the marketplace

2-4
Types of Nonnumeric Models Continued

 Product Line Extension


– Often, projects to expand a product line are
evaluated on how well the new product
meshes with the existing product line rather
than on overall benefits
 Comparative Benefit
– Projects are subjectively rank ordered based
on their perceived benefit to the company

2-5
Numeric Models

 Models that return a numeric value for a


project that can be easily compared with
other projects

2-6
Profit/Profitability Models

 Models that look at costs and revenues


– Payback period
– Discounted cash flow/Net Present Value (NPV)
– Internal rate of return (IRR)
– Profitability index
 NPVand IRR are the more common
methods

2-7
Payback Period

 The length of time until the original


investment has been recouped by the
project
 A shorter payback period is better

2-8
Payback Period Example

Project Cost
Payback Period 
Annual Cash Flow

$100,000
Payback Period  4
$25,000

2-9
Payback Period Drawbacks

 Does not consider time value of money


 More difficult to use when cash flows
change over time
 Less meaningful for longer periods of
time (due to time value of money)

2-10
Discounted Cash Flow

 The value of a stream of cash inflows and


outflows in today’s dollars
 Also know as discounted cash flow or just
discounting
 Widely used to evaluate projects
 Includes the time value of money
 Includes all inflows and outflows, not just
the ones through payback point
2-11
Discounted Cash Flow Continued

 Requires a percentage to use to reduce


future cash flows
– This is known as the discount rate
 The discount rate may also be known as
a hurdle rate or cutoff rate
 There will usually be one overall discount
rate for the company

2-12
NPV Formula

n
Ft
NPV (project)  A0  
1 k 
t
t 1

2-13
NPV Formula Terms

A0 Initial cash investment (negative as


this is an outflow)
Ft Cash flow in time period t (negative for
outflows, positive for inflows)
k The discount /hurdle/cutoff ate
t The number of years of life
 A higher NPV is better
 Higher the discount rate lower the NPV

2-14
NPV Formula with inflation or
deflation

2-15
NPV Example

Using our $100,000 investment with a net cash inflow of


$25,000 per year for a period of eight years, a required rate of
return of 15 percent, and an inflation rate of 3 percent per year,
we have:
8
$25,000
NPV (project)  $100,000  
t 1 1  0.15  0.03
t

$1,939

Because the present value of the inflows is greater than the


present value of the outflow— that is, the net present value is
positive—the project is deemed acceptable.
2-16
Internal Rate of Return [IRR]
 If we have a set of expected cash inflows and cash outflows, the internal rate
of return is the discount rate that equates the present values of the two sets
of flows.
If At is an expected cash outflow in the period t and Rt is the expected
inflow for the period t, the internal rate of return is the value of k that satisfies
the following equation:

 The value of k is found by trial and error.

2-17
Profitability Index

 Also known as the benefit–cost ratio, the


profitability index is the net present value
of all future expected cash flows divided
by the initial cash investment.
 If this ratio is greater than 1.0, the project
may be accepted.

2-18
Advantages of Profitability Models

 Easy to use and understand


 Based on accounting data and forecasts
 Familiar and well understood
 Gives a go/no-go indication
 Can be modified to include risk

2-19
Disadvantages of Profitability
Models

 Ignore nonmonetary factors


 Some ignore time-value of money
 Biased toward the short-term
 Payback ignores cash flow after payback
 IRR can have multiple solutions
 All are sensitive to errors
 Nonlinear
 Dependent on determination of cash flows

2-20

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