Nadeem Kureshi

Nadeem KureshiNadeem Kureshi

Project Selection Models

Project SelectionProject 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 ModelsDecision 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 Criteria for Project Selection ModelSelection Model

1. Realism2. Capability3. Flexibility4. Ease of use5. Cost6. Easy computerization

Numeric and Non-Numeric Numeric and Non-Numeric ModelsModels

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 MethodQ-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 MethodThe 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.

ModelsModels

Present & Future ValuePresent & Future Value Benefit / Cost RatioBenefit / Cost Ratio Payback periodPayback period Internal Rate of ReturnInternal Rate of Return Annual ValueAnnual Value Variations of IRRVariations of IRR

Present ValuePresent ValueThe Present value or present worth method of The Present value or present worth method of evaluating projects is a widely used technique. The evaluating projects is a widely used technique. The Present Value represents an amount of money at time Present Value represents an amount of money at time zero representing the discounted cash flows for the zero representing the discounted cash flows for the project.project.

T = 0 +/- Cash Flows

PV

Net Present Value (NPV)Net Present Value (NPV)TThe Net Present Value of an investment it is simply the difference he Net Present Value of an investment it is simply the difference between cash outflows and cash inflows on a present value basis. between cash outflows and cash inflows on a present value basis.

In this context, the discount rate equals the minimum rate of return In this context, the discount rate equals the minimum rate of return for the investmentfor the investment

Where: Where:

NPV = NPV = ∑ Present Value (Cash Benefits) - ∑ Present Value (Cash Costs)∑ Present Value (Cash Benefits) - ∑ Present Value (Cash Costs)

Initial Investment:Initial Investment: $100,000$100,000 Project Life:Project Life: 10 years10 years Salvage Value:Salvage Value: $ 20,000$ 20,000 Annual Receipts:Annual Receipts: $ 40,000$ 40,000 Annual Disbursements:Annual Disbursements: $ 22,000$ 22,000 Annual Discount Rate:Annual Discount Rate: 12%, 18%12%, 18%

What is the net present value for this project?What is the net present value for this project?

Is the project an acceptable investment?Is the project an acceptable investment?

Present Value Present Value ExampleExample

Present Value Example Present Value Example SolutionSolution

Annual ReceiptsAnnual Receipts $40,000(P/A, 12%, 10)$40,000(P/A, 12%, 10) $ 226,000$ 226,000

Salvage ValueSalvage Value $20,000(P/F, 12%, 10)$20,000(P/F, 12%, 10) $ 6,440 $ 6,440

Annual DisbursementsAnnual Disbursements $22,000(P/A, 12%, 10)$22,000(P/A, 12%, 10) -$124,000-$124,000

Initial Investment (t=0)Initial Investment (t=0) -$100,000-$100,000

Net Present ValueNet Present Value $ 8,140$ 8,140 Greater than zero, therefore acceptable projectGreater than zero, therefore acceptable project

Future ValueFuture Value

The future value method evaluates a project The future value method evaluates a project based upon the basis of how much money will be based upon the basis of how much money will be accumulated at some future point in time. This accumulated at some future point in time. This is just the reverse of the present value concept.is just the reverse of the present value concept.

T = 0 +/- Cash Flows

FV

Initial Investment:Initial Investment: $100,000$100,000 Project Life:Project Life: 10 years10 years Salvage Value:Salvage Value: $ 20,000$ 20,000 Annual Receipts:Annual Receipts: $ 40,000$ 40,000 Annual Disbursements:Annual Disbursements: $ 22,000$ 22,000 Annual Discount Rate:Annual Discount Rate: 12%, 18%12%, 18%

What is the net future value for this What is the net future value for this project?project?

Is the project an acceptable investment?Is the project an acceptable investment?

Future Value ExampleFuture Value Example

Future Value Example Future Value Example SolutionSolution

Annual ReceiptsAnnual Receipts $40,000(F/A, 12%, 10)$40,000(F/A, 12%, 10) $ 701,960$ 701,960

Salvage ValueSalvage Value $20,000(year 10)$20,000(year 10) $ 20,000$ 20,000

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

Initial Investment Initial Investment $100,000(F/P, 12%, 10)$100,000(F/P, 12%, 10) -$310,600-$310,600

Net Future ValueNet Future Value $ 25,280$ 25,280 Positive value, therefore acceptable projectPositive value, therefore acceptable project Can be used to compare with future value of other projectsCan be used to compare with future value of other projects

PV/FVPV/FV

No theoretical difference if No theoretical difference if project is evaluated in present project is evaluated in present or future valueor future value

PV of $ 25,282PV of $ 25,282

$25,282(P/F, 12%, 10)$25,282(P/F, 12%, 10) $ 8,140$ 8,140

FV of $ 8,140FV of $ 8,140

$8,140(F/P, 12%, 10)$8,140(F/P, 12%, 10) $ 25,280$ 25,280

Annual ValueAnnual Value

Sometimes it is more convenient to Sometimes it is more convenient to evaluate a project in terms of its evaluate a project in terms of its annual value or cost. For example it annual value or cost. For example it may be easier to evaluate specific may be easier to evaluate specific components of an investment or components of an investment or individual pieces of equipment based individual pieces of equipment based upon their annual costs as the data upon their annual costs as the data may be more readily available for may be more readily available for analysis.analysis.

Annual Analysis ExampleAnnual Analysis Example

A new piece of equipment is being A new piece of equipment is being evaluated for purchase which will evaluated for purchase which will generate annual benefits in the amount of generate annual benefits in the amount of $10,000 for a 10 year period, with annual $10,000 for a 10 year period, with annual costs of $5,000. The initial cost of the costs of $5,000. The initial cost of the machine is $40,000 and the expected machine is $40,000 and the expected salvage is $2,000 at the end of 10 years. salvage is $2,000 at the end of 10 years. What is the net annual worth if interest on What is the net annual worth if interest on invested capital is 10%?invested capital is 10%?

Annual Example SolutionAnnual Example Solution

Benefits:Benefits: $10,000 per year$10,000 per year $10,000$10,000

SalvageSalvage $2,000(P/F, 10%, 10)(A/P, 10%,10)$2,000(P/F, 10%, 10)(A/P, 10%,10) $ 125$ 125

Costs:Costs: $5,000 per year$5,000 per year -$ 5,000-$ 5,000

Investment:Investment: $40,000(A/P, 10%, 10)$40,000(A/P, 10%, 10) -$ 6,508-$ 6,508

Net Annual ValueNet Annual Value --$1,383$1,383

Since this is less than zero, the project is expected to earn less than the 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.acceptable rate of 10%, therefore the project should be rejected.

Benefit/Cost RatioBenefit/Cost Ratio

The benefit/cost ratio is also called the The benefit/cost ratio is also called the

profitability indexprofitability index and is defined and is defined as the ratio of the sum of the present as the ratio of the sum of the present value of future benefits to the sum of the value of future benefits to the sum of the present value of the future capital present value of the future capital expenditures and costs.expenditures and costs.

B/C Ratio ExampleB/C Ratio Example

Project AProject A Project BProject B Present value cash inflowsPresent value cash inflows

$500,000$500,000 $100,000 $100,000 Present value cash outflowsPresent value cash outflows

$300,000$300,000 $ 50,000 $ 50,000 Net Present ValueNet Present Value

$200,000$200,000 $ 50,000 $ 50,000 Benefit/Cost RatioBenefit/Cost Ratio

1.671.67 2.0 2.0

Payback PeriodPayback PeriodOne of the most common evaluation criteria used.One of the most common evaluation criteria used.

Simply the number of years required for the cash income Simply the number of years required for the cash income from a project to return the initial cash investment.from a project to return the initial cash investment.

The investment decision criteria for this technique suggests The investment decision criteria for this technique suggests that if the calculated payback period is less than some that if the calculated payback period is less than some maximum value acceptable to the company, the proposal is maximum value acceptable to the company, the proposal is accepted.accepted.

Example illustrates five investment proposals having Example illustrates five investment proposals having identical capital investment requirements but differing identical capital investment requirements but differing expected annual cash flows and lives.expected annual cash flows and lives.

Payback PeriodPayback Period

ExampleExampleCalculation of the payback period for a given investment proposal.Calculation of the payback period for a given investment proposal.

a)a) Prepare Prepare End of YearEnd of Year Cumulative Net Cash Flows Cumulative Net Cash Flowsb)b)Find the Find the First Non-Negative YearFirst Non-Negative Yearc)c) Calculate Calculate How MuchHow Much of that year is required to cover the of that year is required to cover the

previous period negative balanceprevious period negative balanced)d)Add up Add up Previous Negative Cash Flow YearsPrevious Negative Cash Flow Years

Initial Annual Net Cash FlowsInvestment 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

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 PeriodFraction of First Positive Year 0.78Pay Back Period 3.78

a

b

c) 0.78 = 10,500/13,500

d) 3 + 0.78

Example: Example: Calculate the payback period for the following investment proposalCalculate the payback period for the following investment proposal


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


Example:Example: Calculate the payback period for the following investment proposalCalculate the payback period for the following investment proposal


Alternative A(120) 10 10 50 50 50 50 50 50 50 50



Example:Example:Calculate the payback period for the following investment proposalCalculate the payback period for the following investment proposal


Alternative A(120) 10 10 50 50 50 50 50 50 50 50





Alternative A(250) 86 50 77 52 41 70 127 24 6 40





Alternative A(250) 86 50 77 52 41 70 127 24 6 40





Alternative A(250) 86 50 77 52 41 70 127 24 6 40



IRR & Discount RatesIRR & Discount Rates

Internal Rate of ReturnInternal Rate of Return

Internal Rate of Return refers to the Internal Rate of Return refers to the interest rateinterest rate that the investor will receive on the investment that the investor will receive on the investment principalprincipal

IRR is defined as that IRR is defined as that interest rate (interest rate (rr) ) which which equates the sum of the present value of cash inflows equates the sum of the present value of cash inflows with the sum of the present value of cash outflows for with the sum of the present value of cash outflows for a project. This is the same as defining the IRR as that a project. This is the same as defining the IRR as that rate which satisfies each of the following expressions:rate which satisfies each of the following expressions:

∑ ∑ PV cash inflows - ∑ PV cash outflows = 0PV cash inflows - ∑ PV cash outflows = 0

NPV = 0 for NPV = 0 for rr

∑ ∑ PV cash inflows = ∑ PV cash outflowsPV cash inflows = ∑ PV cash outflows

In general, the calculation procedure involves a trial-and-error In general, the calculation procedure involves a trial-and-error solution. The following examples illustrate the calculation procedures for solution. The following examples illustrate the calculation procedures for determining the internal rate of return.determining the internal rate of return.

ExampleExampleGiven an investment project having the following annual cash flows; find the Given an investment project having the following annual cash flows; find the

IRR.IRR.

Solution:Solution:

Step 1.Step 1. Pick an interest rate and solve for the NPV. Try Pick an interest rate and solve for the NPV. Try r r =15%=15%

NPV 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)= -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) + + 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)10(P/F,9,15)

= + $5.62= + $5.62

Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a 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.higher interest rate in order to reduce the NPV value.

Step 2.Step 2. If If r r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.=20% is used, the NPV = - $ 1.66 and therefore this rate is too high.

Step 3.Step 3. By interpolation the correct value for the IRR is determined to be By interpolation the correct value for the IRR is determined to be r r =18.7%=18.7%

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

IRR using ExcelIRR using Excel

Using Excel you should insert the following Using Excel you should insert the following function in the targeted cell C6:function in the targeted cell C6:

AnalysisAnalysisThe acceptance or rejection of a project based on the IRR The acceptance or rejection of a project based on the IRR criterion is made by comparing the calculated rate with criterion is made by comparing the calculated rate with the required rate of return, or the required rate of return, or cutoff ratecutoff rate established by established by the firm. If the IRR exceeds the required rate the project the firm. If the IRR exceeds the required rate the project should be accepted; if not, it should be rejected.should be accepted; if not, it should be rejected.

If the required rate of return is the return investors If the required rate of return is the return investors expect the organization to earn on new projects, then expect the organization to earn on new projects, then accepting a project with an IRR greater than the accepting a project with an IRR greater than the required rate should result in an increase of the firms required rate should result in an increase of the firms value.value.

AnalysisAnalysis

There are several reasons for the widespread popularity There are several reasons for the widespread popularity of the IRR as an evaluation criterion:of the IRR as an evaluation criterion:

Perhaps the primary advantage offered by the Perhaps the primary advantage offered by the technique is that it provides a single figure which technique is that it provides a single figure which can be used as a measure of project value. can be used as a measure of project value.

Furthermore, IRR is expressed as a percentage Furthermore, IRR is expressed as a percentage value. Most managers and engineers prefer to value. Most managers and engineers prefer to think of economic decisions in terms of think of economic decisions in terms of percentages as compared with absolute values percentages as compared with absolute values provided by present, future, and annual value provided by present, future, and annual value calculations.calculations.

AnalysisAnalysisAnother advantage offered by the IRR method is related to Another advantage offered by the IRR method is related to the calculation procedure itself:the calculation procedure itself:

As its name suggests, the IRR is determined As its name suggests, the IRR is determined internally for internally for each project and is a function of the magnitude and timing each project and is a function of the magnitude and timing of the cash flows.of the cash flows.

Some evaluators find this superior to selecting a rate prior Some evaluators find this superior to selecting a rate prior to calculation of the criterion, such as in the profitability to calculation of the criterion, such as in the profitability index and the present, future, and annual value index and the present, future, and annual value determinations. In other words, the IRR eliminates the determinations. In other words, the IRR eliminates the need to have an external interest rate supplied for need to have an external interest rate supplied for calculation purposes.calculation purposes.

Selecting a Discount Selecting a Discount RateRate

““There is nothing so disastrous as a rational There is nothing so disastrous as a rational investment policy in an irrational world”investment policy in an irrational world” John John Maynard KeynesMaynard Keynes

We have discussed the time value of money and We have discussed the time value of money and illustrated several examples of its use. In all cases an illustrated several examples of its use. In all cases an interest rate or “discount rate” is used to bring the interest rate or “discount rate” is used to bring the future cash flows to the present (NPV - Net Present future cash flows to the present (NPV - Net Present Value)Value)

The selection of the appropriate discount rate has The selection of the appropriate discount rate has been the source of considerable debate and much been the source of considerable debate and much disagreement. In most companies, the selection of disagreement. In most companies, the selection of the discount rate is determined by the accounting the discount rate is determined by the accounting department or the board of directors and the department or the board of directors and the engineer just uses the number provided to him, but engineer just uses the number provided to him, but short of just being provided with a rate, what is the short of just being provided with a rate, what is the correct or appropriate rate to use?correct or appropriate rate to use?

ExampleExampleWhat is the impact of the discount rate on the investment?What is the impact of the discount rate on the investment?

Cash Cash Flow Yr Flow Yr 00






-500-500 -500-500 +750+750 +600+600 +800+800 +1000+1000RORROR NPVNPV

2%2% 1,941 1,941

6%6% 1,581 1,581

10%10% 1,283 1,283

15%15% 981 981

20%20% 739 739

IRRIRR 47.82%47.82% 00

Real Option ModelReal 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: ScoringNumeric 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 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 X marks in 0-1 scoring model are scoring model are replaced by replaced by numbers, from a 5 numbers, from a 5 point scale. 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

1

n

i ij j

j

S S W

whereSi the total score of the ith project,Sij the score of the ith project on the jth criterion, andWj 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:

1 1

vn

i ij j ik

j k

S S W C

where Cik 1 if the i th project satisfies the Kth constraint, and 0 if it does not.

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 ThoughtFinal 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.

ACTIVITYACTIVITY

Exercise – Project SelectionExercise – Project Selection Approximate Time: 30 minutesApproximate Time: 30 minutes

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