Professional Documents
Culture Documents
Project Selection
Project Selection
Project Selection
Project Selection
Decision Models
Realism
2. Capability
3. Flexibility
4. Ease of use
5. Cost
6. Easy computerization
Nonnumeric Models
The Competitive
Necessity
Comparative Benefit
Model
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.
Numeric Models:
Profit/Profitability
Models
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
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%
Annual Receipts
$40,000(P/A, 12%, 10)
Salvage Value
$20,000(P/F, 12%, 10)
$ 226,000
$
6,440
Annual Disbursements
$22,000(P/A, 12%, 10)
-$124,000
-$100,000
$ 8,140
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
Initial Investment:
Project Life:
Salvage Value:
Annual Receipts:
Annual Disbursements:
Annual Discount Rate:
$100,000
10 years
$ 20,000
$ 40,000
$ 22,000
12%, 18%
Annual Receipts
$40,000(F/A, 12%, 10)
Salvage Value
$20,000(year 10)
-$386,078
Initial Investment
$ 20,000
Annual Disbursements
$22,000(F/A, 12%, 10)
$ 701,960
-$310,600
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
Benefits:
$10,000 per year
Salvage
$2,000(P/F, 10%, 10)(A/P, 10%,10)
125
-$ 5,000
Investment:
$40,000(A/P, 10%, 10)
Costs:
$5,000 per year
$10,000
-$ 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
Project A
Present value cash inflows
$500,000
Present value cash outflows
$300,000
Net Present Value
$200,000
Benefit/Cost Ratio
1.67
Project B
$100,000
$ 50,000
$ 50,000
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
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
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 1
9 10
Alternative A
(120) 10 10 50 50 50 50 50 50 50 50
End of Year Cummulative Net Cash Flow
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120) 10
10
10
50
50
50
50
50
50
50
50
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120)
10
10
50
10
50
50
50
50
50
50
100
150
200
250
300
50
1.00
4.00
Example:
Calculate the payback period for the following investment proposal
Initial
Investment 1
9 10
Alternative A
(250) 86 50 77 52 41 70 127 24
6 40
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250) 86
50
77
52
41
70 127
24
10
40
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250)
86
50
77
52
41
70 127
24
10
40
0.73
3.73
Example
Given an investment project having the following annual cash flows; find the IRR.
Year
Cash Flow
0
(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
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%
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
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.
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%
process.
If the value increases, the investor gets a higher payoff.
Unweighted 01 Factor
Model
X marks in 0-1
scoring model are
replaced by
numbers, from a 5
point scale.
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.
j 1
k 1
Si SijWj Cik
Final Thought