Project Valuation & Selection

Project Financial Management

Ata ul Musawir
Poor Project Results
The rapid adoption of project management means:

• There are many projects that fall outside the organization’s

stated mission

• There are many projects being conducted that are completely

unrelated to the strategy and goals of the organization

• There are many projects with funding levels that are excessive
relative to their expected benefits

2
How To Improve

• The best firms:

• Have top management involvement

• Have robust and detailed project selection processes

• Ensure projects are aligned to strategy

• Adopt a holistic view of projects ‘from concept to cash’

3
Project Selection Management Overview

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Project Selection Management Overview

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Project Selection Models
• Effective project selection is critical for project
success

• Project selection is also critical to long-term org.

survival

• Various numeric and non-numeric models can be

used to analyze projects and make an effective
selection decision

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What is a Model?
• A model is an abstraction of reality, a simplified
representation of something. It is used as a decision-making
aid for simplifying more complex real-life phenomena.

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Why do we use models?

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Types of Project Selection Models

1. Nonnumeric models

2. Numeric models

• Multiple models may be used simultaneously

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Nonnumeric Models

• Models that do not return a numeric value for a

project to be compared with other projects

• Not ‘models’ in the strict sense but rather

justifications for projects

• Just because they are not true models does not

make them ‘bad’

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Types of Nonnumeric Models (Slide 1 of 2)
Necessity Models

• Managerial Necessity (‘Sacred Cow’)

• Often suggested by top management
• Maintained until completion or boss terminates it
• 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

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Types of Nonnumeric Models (Slide 2 of 2)
Organizational ‘Fit’ Models

• Product Line Extension

• Project evaluated on fit with existing product line, fills a
gap, strengthens a weak link, or extends a line
• Comparative Benefit
• Projects are subjectively rank ordered based on their
perceived benefit to the company
• Sustainability
• Focusing on long-term profitability rather than short-run
payoff

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Numeric Models

• Models that return a numeric value for a project

that can be easily compared with other projects

• First, we need to understand:

A. Estimation of Project Cash Flows
B. Time Value of Money

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Time Value of Money

• Which would you prefer: Rs. 100,000 today or Rs.

100,000 ten years from today?

• Why?

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Time Value of Money
• Obviously, Rs. 100,000 now is worth more than Rs. 100,000 in
10 years even if there is no inflation.

• It can earn money during the interval. One could deposit the
money in the bank and earn interest on it.

• The earning power of money over time and is called time

value of money.

• The interest rate is generally accepted as the measure of the

earning power of money over time.

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Time Value of Money
• Simple vs. Compounded Interest

• Simple interest pays a

fixed amount over time

• Compound interest means

your interest earns interest

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Time Value of Money
• Simple vs. Compounded Interest

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Time Value of Money
• Simple vs. Compounded Interest

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Time Value of Money
• Simple vs. Compounded Interest

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Time Value of Money
• Simple vs. Compounded Interest

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Time Value of Money
• Simple vs. Compounded Interest

• Compound interest grows exponentially over time

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 Exercises
• Would you prefer simple or compounding interest on
your savings account? Why?

• Would you prefer simple or compounding interest on

a loan you took from the bank? Why?

• What kinds of personal financial decisions have you

made that involve compound interest?

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Time Value of Money
• Calculating the Future Value of an investment under
Compound Interest

where
• FVn = Future value at time period n
• P0 = principal, or original amount borrowed (or lent) at time period 0
• i = interest rate per time period (also referred to as the discount rate)
• n = number of time periods
• FVIFi,n = (1 + i)n the future value interest factor at i% for n periods

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 Activity
Calculate the Future Values of the following:

1. The value after 10 years of Rs. 100,000 deposited in a bank

today at 10% interest rate per annum
2. The value after 10 years of Rs. 100,000 deposited in a bank
today at 15% interest rate per annum
3. The value after 6 years of Rs. 425,000 deposited in a bank
today at 9% interest rate per annum
4. The value after 8 years of Rs. 865,000 deposited in a bank
today at 8% interest rate per annum
5. The value after 5 years of Rs. 100,000 deposited in a bank
today and then another 100,000 deposited 2 years from
now in the same account at 5% interest rate per
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Time Value of Money
• Calculating the Present Value of an investment under
Compound Interest

where
• PV0 = P0 = principal, or original amount borrowed (or lent) at time period 0
• i = interest rate per time period (also referred to as the discount rate)
• n = number of time periods
• PVIFi,n = [1/(1 + i)n] the present value interest factor at i% for n periods

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 Activity
Calculate the Present Values of the following:

1. Rs. 100,000 to be received 10 years from now at 10%

discount rate per annum
2. Rs. 100,000 to be paid 10 years from now at 10% discount
rate per annum
3. Rs. 650,000 to be received 6 years from now at 14%
discount rate per annum
4. Rs. 90,000 to be paid 1 year from now at 8% discount rate
per annum
5. Rs. 255,000 to be paid 2 years from now then another Rs.
255,000 to be paid 5 years from now, both at 12% discount
rate per annum
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Time Value of Money
• Working with a series of cash flows

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Time Value of Money
• Compounding a series of cash flows (i = 8%, terminal year = 3):

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Time Value of Money
• Discounting a series of cash flows (i = 8%):

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Activity

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Numeric Models

• Back to selection models

• Major types
• Profit/profitability (payback, NPV, IRR, profitability
index)
• Scoring
• Window-of-opportunity analysis
• Discovery-driven planning

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Numeric Models: Profit/Profitability

• Profit/profitability models look at costs and revenues:

1. Payback period and discounted payback period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Profitability Index

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Discounted Cash Flow (DCF)
Analysis
• Discounted cash flow (DCF) Analysis: Any method of
investment project evaluation and selection that
adjusts cash flows over time for the time value of
money.

• Calculates the present value of future cash flows

based on a discount rate defined by the organization.

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1. Discounted Payback Period
• Time value of money is taken into consideration

1. Identify the last year in which cumulative cash

flows are negative, suppose this year is n
2. Take the absolute value of the cumulative cash
flow value in this year then divide it by the cash
flow value (not cumulative) in the following year
3. Add the result to n, the answer is the discounted
payback period
1. Discounted Payback Period
• For uneven and discounted annual cash flows
(example):
n

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Activity
Company A has a project requiring an initial cash investment of
Rs. 150,000. The project is expected to return Rs. 50,000 each
year for the next five years.

(a) Calculate the undiscounted payback period.

(b) Calculate the discounted payback period. The appropriate

discount rate is 8%.

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1. Payback Period

Benefits:
• Quick method to check the number of years until the
investment ‘breaks even’

Drawbacks:
• Difficult to use when there are cash outflows in
multiple years
• Does not consider cash flows after the payback
period date

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2. Net Present Value (NPV)

• The value of a stream of cash inflows and outflows in

today’s currency
• Also known as net discounted cash flow
• Includes the time value of money
• Includes all inflows and outflows, not just the ones
through payback point
• Most popular profitability model

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2. Net Present Value (NPV)

• 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

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2. NPV Formula

n
Ft
NPV (project) = A0 + 
((11++ k +) pt)t
t
t =1

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2. NPV Formula Terms

A0 Initial cash investment

Ft Cash flow in time period t (negative for
outflows)
k The discount rate
pt Predicted rate of inflation during period t
t The number of years of life

• A higher NPV is better

• As discount rate increases, NPV decreases
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2. NPV Example
• E.g. A project with initial cash outflow of $100,000 and net cash flows of
$34,432 in year 1, $39,530 in year 2, $39,359 in year 3, $32,219 in year 4,
discount rate of 12%

• Hence, NPV is $10,768

• If discount rate was 13%, would NPV be higher or lower?

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Activity

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3. Internal Rate of Return (IRR)
• The discount rate that equates the present value of
the expected net cash flows with the initial cash
outflow

• In other words, the rate at which NPV = 0

• This IRR is used to evaluate the attractiveness of a

project or investment

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3. Internal Rate of Return (IRR)

Net Present Value (NPV)

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3. IRR Example
• E.g. A project with initial cash outflow of $100,000 and net cash flows of
$34,432 in year 1, $39,530 in year 2, $39,359 in year 3, $32,219 in year 4.
Trial and error approach using i = 15% and i = 20%:

• Hence, IRR is between 15% and 20%

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3. IRR Example
• Solving using the Interpolation method:

• NPV at lower rate = 104,168.01 – 100,000 = 4,168.01

• NPV at higher rate = 94,434.10 – 100,000 = -5,569.90

• IRR = 0.15 + [4,168.01/(4,168.01 - (-5,569.90))]*(0.20 - 0.15)

• IRR = 0.15 + (4,168.01/9,737.91)(0.05)
• IRR = 0.15 + 0.0214
• IRR = 0.1714 = 17.14%

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 3. IRR Example

Original discount rate (12%) and NPV ($10,768)

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3. Internal Rate of Return (IRR)
Advantages
• The IRR makes it easy to measure the profitability of your project and to
compare it’s profitability with other projects
• Allows managers to rank projects by their overall rates of return rather
than their net present values, and the investment with the highest IRR is
usually preferred

Disadvantages
• IRR works only for investments that have an initial cash outflow followed
by one or more cash inflows
• IRR does not measure the absolute size of the investment or the return
• For example, a $1 investment returning $3 will have a higher IRR than a $1
million investment returning $2 million

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Activity: NPV vs. IRR
• Which investment would you choose?

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Activity: NPV vs. IRR
• The convention is to use the NPV rule when the two methods
are inconsistent (i.e. choose the investment with the higher
NPV). NPV better reflects our primary goal: to grow the
financial wealth of the company. Hence, Project A is selected.

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4. Profitability Index

• Also known as the benefit–cost ratio

• 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

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4. Profitability Index Example
• E.g. A project with initial cash outflow of $100,000 and net cash flows of
$34,432 in year 1, $39,530 in year 2, $39,359 in year 3, $32,219 in year 4,
discount rate of 12%

• Hence, the Profitability Index is 1.11

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Activity
A four-year financial project has net cash flows of $20,000; $25,000;
$30,000; and $50,000 in the next four years. It will cost $75,000 to
implement the project. The required rate of return is 0.20.

Determine the:
1. Discounted payback period
2. NPV
3. IRR
4. Profitability Index

Based on the above profitability analyses, do you think the project is

worth conducting?

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Advantages of Profitability Models
1. All use readily available accounting data to determine the cash
flows.

2. Model output is in terms familiar to business decision makers.

3. With a few exceptions, model output is on an ‘absolute’

profit/profitability scale and allows ‘absolute’ go/no-go
decisions.

4. Some profit models can be amended to account for project risk.

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Disadvantages of Profitability Models
1. These models ignore all nonmonetary factors except financial risk.

2. Models that reduce cash flows to their present value are strongly
biased toward the short run.

3. Payback-type models ignore cash flows beyond the payback period.

4. Results are highly sensitive to errors in the input data for the early
years of the project.

5. All these models depend for input on a determination of cash flows,

but it is not clear exactly how the concept of cash flow is properly
defined for the purpose of evaluating projects.

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Numeric Models: Scoring

• Similar to how managers actually evaluate

investments
• Uses multiple criteria
• Can utilize both monetary and qualitative factors
• Weighted factor scoring model

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Numeric Models: Scoring

• Step 1: Determine important selection criteria for

selecting a project. E.g. when developing a new car
model, important criteria can include:
• Appearance
• Braking
• Comfort
• Operating costs
• Manufacturing costs
• Handling
• Reliability

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Numeric Models: Scoring

• Step 2: Assign weights to each criterion in relation to

its importance based on management experience
and market research. Sum of weights must equal to
1.00. E.g.:
• Appearance 0.10
• Braking 0.07
• Comfort 0.17
• Operating costs 0.12
• Manufacturing costs 0.24
• Handling 0.17
• Reliability 0.12
1.00
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Numeric Models: Scoring
• Step 3: Score each project alternative on each of the
criteria selected previously (e.g. Model A may be
assigned a score between 1 to 5 for the criterion
‘appearance’).

• Multiply each score under each criterion with the

weight of the said criterion.

• Find the sum of all products of scores and weights.

The project with the highest total score may be
selected.
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 Weighted Factor Model Example
• Example: choosing between developing different
models of cars. Scores in each criterion from 1 to 5.
Wj: weights of the jth criterion

Sij * Wj ∑SijWj : project with highest

Sij: scores of ith project on the jth criterion total score may be selected

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Weighted Factor Scoring Model

• Each factor is weighted relative to its importance

• Weighting allows important factors to stand out
• A good way to include nonnumeric data in the
analysis
• Weights must add up to 1.00
• All weights must be set up, so higher values mean
more desirable
• Small differences in totals are not meaningful
(because weights are subjective)

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Advantages of Scoring Models

1. Allow multiple criteria

2. Structurally simple

3. Intuitive and reflects actual thinking process

4. Direct reflection of managerial policy

5. Easy to change, allows easy sensitivity analysis

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Disadvantages of Scoring Models

1. Relative measures

2. Results involving excessively large number of

criteria can be hard to interpret

3. Financial aspects of projects not directly

considered

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Numeric Models:
Window-of-Opportunity Analysis
• Often used in product development projects

• A process where the cost, time, and performance

requirements are defined first that must be met
before any R&D work

• If a project meets these requirements, it is selected

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Numeric Models:
Window-of-Opportunity Analysis
• E.g. There is a need to implement an innovation project to
improve the manufacturing process

• First, baseline data of current manufacturing process is

collected (costs, cycle time, staff required)

• Second, desired improvements in the process are defined by

the management

• Third, if any potential project can meet or exceed these

desired improvements, it is selected
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Numeric Models:
Discovery-Driven Planning
• Organization funds enough of the project to determine if the
initial assumptions were accurate

• Used to learn more about the project, rather than necessarily

implement it

• If project remains feasible, planning for the next stage is

revised in light of new data and it is continued

• Otherwise, the project is terminated

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Numeric Models:
Discovery-Driven Planning
• E.g. A project to develop a new technology involving a high degree
of uncertainty.

• An initial project proposal and business case is developed based on

current information
• A pilot phase is undertaken (e.g. designing a physical model or
developing a prototype) to gain further understanding about the
technology
• Based on the new data, project is re-analyzed to check its feasibility
• If the project remains feasible, it moves to the next stage
• If at any stage, data suggest that the project is no longer feasible, it
maybe terminated
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Choosing a Project Selection Model
• Weighted scoring models tend to be favored by managers:
• Allow multiple objectives to be considered
• Easily adapted
• Not biased toward short-run like the profitability models

But remember:
• Usually, multiple models are used

• Models do not make decision – people do: the manager, not

the model, bears responsibility for the decision

• All models, however sophisticated, are only partial

representations of the reality they are meant to reflect

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Some Issues when Selecting Projects
• A dependent (or contingent) project, i.e. one whose acceptance depends
on the acceptance of one or more other projects, deserves special
attention.

• Mutually exclusive projects are those where the selection of a project

may mean that one or more other projects can no longer be selected.

Other issues when comparing projects:

1. Scale of Investment: Costs of projects differ.
2. Cash flow pattern: Timing of cash flows differs. For example, the cash
flows of one project may increase over time whereas those of another
may decrease.
3. Project duration: Projects have unequal durations.

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Some Issues when Selecting Projects
1. Scale of Investment Differences

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Some Issues when Selecting Projects
2. Cash Flow Pattern Differences

• IRR for projects D and I are 23 percent and 17 percent, respectively.

• For every discount rate >10 percent, project D’s NPV and PI will be greater
than those for project I.
• On the other hand, for every discount rate <10 percent, project I’s NPV
and PI will be greater than those for project D.
• If we assume a required rate of return (k) of 10 percent, each project will
have identical net present values of $198 and profitability indexes of 1.17.
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Some Issues when Selecting Projects
3. Differences in Project Durations

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 Some Issues when Selecting Projects
3. Differences in Project Durations: Replacement Chain
Analysis

Assuming the projects can be repeated, in this case we can conduct project A
two times during 10 years whereas project B can only be conducted once.

Therefore, we need to take into account the repetition when comparing NPVs.
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 Some Issues when Selecting Projects
3. Differences in Project Durations: Replacement Chain
Analysis

Hence, we see that the NPVchain of project A is higher than the NPVchain of
project B. Therefore, project A is selected.

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Capital Rationing Constraints: Single
Period Limit

Assume the company can only invest up to $65,000 during this current year.

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Capital Rationing Constraints: Single
Period Limit

Projects are ranked based on IRR, NPV, and PI and top alternatives totaling
$65,000 in initial outflows are identified. With capital rationing, you would
accept projects C, E, F, and G as this set of alternatives has the highest NPV.
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 Risk Considerations in Project Selection
• Both costs and benefits are uncertain
• Costs tend to be under-estimated while benefits tend to be over-
estimated

• Uncertainty about:
• Timing (will project cashflows be generated at the forecasted times?)
• Outcomes (will the project achieve its intended outcomes?)
• Unforeseen consequences of the project (+ve or –ve)

• Can use sensitivity analysis to identify any sensitive

parameters that affect project NPV

• Can make estimates about the probability of outcomes

• Simulation analysis may be used to estimate NPV, IRR, and PI

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 Dealing with Risk: Sensitivity Analysis
• Traditional capital budgeting analysis, as we have seen, places
an emphasis on a series of single-point estimates for inputs
such as yearly cash inflows, installation costs, and final
salvage value etc.

• Sensitivity analysis allows us to challenge those single-point

estimates and ask a series of ‘what if’ questions, e.g. What if
a particular input estimate actually turns out to be higher or
lower than we originally thought?

• As input variable estimates are changed from an original set

of estimates (called the base case), their impact on a project’s
measured results, such as net present value (NPV), can be
determined.

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Dealing with Risk: Sensitivity Analysis

In this example, the effects of changes in three parameters on a project’s

NPV are being examined.

We can see here and from the graph on the next slide that changes in yearly
net operating revenue cash flows has the highest effect on NPV. We can say
that this is a sensitive parameter in our calculation.

Therefore, we need to be very careful in estimating the yearly net operating

revenue cash flows.

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Dealing with Risk: Sensitivity Analysis

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Dealing with Risk: Probabilistic Cashflows
Single Year Estimates

*Note: the above cashflow predictions are only for a single year, in this case first of each project

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Dealing with Risk: Probabilistic Cashflows
Single Year Estimates

In this case, both

project A and
project B have the
same expected
cashflow for Year 1.

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Dealing with Risk: Probabilistic Cashflows
Multi-year NPV Estimates

In this case, all the cashflows for a single project are being estimated and their
NPV is calculated for 9 years. Then each possible NPV is multiplied with it’s
probability of occurrence. Their sum is the expected NPV. This value can then be
compared with the expected NPV of other projects.

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MCQs
What is the Sacred Cow model?

a. A project favored by upper management

b. Secret of the company
c. Most focused on organization goals
d. Expected to be “profitably milked” for a long time

Answer: A

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MCQs
Which of the following project selection models focuses
strongly on the long-term success of the firm?

a. The US military model

b. Product line extension
c. Competitive necessity
d. Sustainability model

Answer: D

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MCQs
Numeric project selection models generally focus on:

a. keeping the workforce numbers stable.

b. profits and profitability.
c. management salary stability.
d. maintaining stock price and ROI.

Answer: B

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MCQs
The Weighted Factor Scoring Model has main the advantage of:

a. Simplicity.
b. Increased attention to relative importance of each selection
criterion.
c. Greater worldwide acceptance.
d. Ease of calculation.

Answer: B

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MCQs
There are two basic types of project selection models,
____________________.

a. numeric and nonnumeric

b. numeric and random
c. binary and continuous
d. quantitative and criteria-based

Answer: A

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MCQs
In this type of project selection, a proposed project would be
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.

a. Comparative benefit model

b. Product line extension
c. Competitive necessity
d. Operating necessity

Answer: B

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MCQs
With the ______ approach model, enough funds are allocated
to the project to determine if the initial assumptions
concerning costs, benefits, etc. were accurate. When the funds
are gone, the assumptions are reevaluated to determine what
to do next.

a. scoring
b. window-of-opportunity
c. discovery-driven planning
d. criteria-based

Answer: C

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MCQs
Effectively executing the PM’s primary role of managing trade-
offs requires that the PM make trade-offs in a way that best
supports the _______.

a. organization’s overall budget

b. change management system
c. PM’s career interests
d. organization’s overall strategy

Answer: D

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