Project Selection Mo

Nadeem Kureshi

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.
2.
3.
4.
5.
6.

Realism
Capability
Flexibility
Ease of use
Cost
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

$ 226,000

Salvage Value

$40,000(P/A, 12%, 10)

$20,000(P/F, 12%, 10)

6,440

Annual Disbursements

$22,000(P/A, 12%, 10)

Initial Investment (t=0)

Net Present Value

-$124,000
-$100,000

$ 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

Salvage Value

$ 20,000

$22,000(F/A, 12%, 10) -$386,078

Initial Investment

$20,000(year 10)

Annual Disbursements

$40,000(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:

125

$5,000 per year -$ 5,000

Investment:

$2,000(P/F, 10%, 10)(A/P, 10%,10)

Costs:

$10,000

Salvage

$10,000 per year

$40,000(A/P, 10%, 10)

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
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
Investment

Alternative A
(45,000) 10,500

11,500

10

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)
Pay Back Period
Fraction of First Positive Year
Pay Back Period

Annual Net Cash Flows

4
5
6
7

3,000 16,500 30,000 43,500 57,000 70,500 84,000

b
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
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
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
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
Alternative A
(250)

86

50

77

Annual Net Cash Flows

4
5
6
7

10

41

70

127

24

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

52

0.73
3.73

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

10

41

70

127

24

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

52

0.73
3.73

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

10

41

70

127

24

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

52

0.73
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
Cash Flow

0
(30.0)

1
(1.0)

2
5.0

3
5.5

4
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.

ACTIVITY

Exercise Project Selection

Approximate Time: 30 minutes