Chapter Five

Project evaluation and

selection
Evaluation and selection of projects
• There are two approaches to select projects : Non-numeric Project
Selection Models and Numeric project selection methods
• Numerical project selection methods
• A project is selected after a detailed and thorough analysis on the basis
of measurements/numbers
• Non-Numerical project selection methods
• These are used in the absence of detailed feasibility studies
• Projects would not pass through a rigorous numerical analysis.
• Instead, the rule of thumb and the vested interests are much more
applicable.
• Some of the non-numeric approaches are:-
1. Sacred Cow model
Evaluation and selection of projects
2. Operating necessity model
3. Competitive necessity model
4. Product line extension model
5. Comparative Benefit model
1. Sacred Cow model
• In this model, a project is usually suggested by a senior and powerful
individual in an organization and the idea is then passed to the officers
below.
• In many cases, other officers prefer to assist the boss to achieve what
he/she wants.
• Although such projects may not pass through rigorous analysis, the boss
may continue until he/she is convinced that it can no longer work.
Evaluation and selection of projects
• Many projects in the public sector of developing countries have been
initiated using this approach.
• Usually, these projects are initiated by powerful politicians such as
ministers with the aim to give their home areas the so-called
‘accelerated development’.
2. Operating necessity model
• In this project selection model, projects are initiated because they are
required to keep a system in operation.
• These are threatening situations such as floods which will simply call for
projects to be started without much evaluation.
3. Competitive necessity model
• Projects are usually initiated and given a lot of support if they will help
an organization maintain a competitive edge over other organizations.
Evaluation and selection of projects
• Such projects are considered to be of survival importance to an organization
and may not necessarily be required to go through careful numerical analysis.
4. Product line Extension model
• This model is used when a project is intended to develop and distribute a
new product or products.
• Usually, such a project, if intended to fill a gap or to strengthen a weak link or
to take the organization to a new direction, will be judged favorably without
careful calculations of the profitability of the project.
5. Comparative benefit model
• This model is used where a firm has several projects that must be considered
and some ranking is given.
• In actual practice, in this model, the projects are sorted out into three
categories: good, fair and poor.
Numerical methods
• This analysis will become the basis for evaluating the project profitability.
• Project profitability depends on a comparison of costs versus revenues
using realistic market prices of materials, labor and outputs.
• The aspects, which have to be looked into while conducting financial
appraisal are:
• investment outlay and costs of the project;
• means of financing, source of finance, credit terms, interest rates, etc;
• cost of capital ;
• projected profitability;
• break-even point;
• cash flows of the project;
• projected financial position and
• level of financial risk.
Numerical methods
• Financial analysis should also generate future financial statements such
as
income statement,
balance sheet and
uses-and-sources-of-funds statement.
• After these statements are produced, analysts can undertake different
financial ratio analysis so as to ascertain financial feasibility.
• The financial analysis must clearly show fund flows in each period in the
project life.
• It must answer the following basic question
• “are we creating value for the firm”
Numerical methods
• Independent
• The cash flows of one project are unaffected by the acceptance of the
other/cash flows are unrelated.
• If two projects are independent, accepting or rejecting one project
has no bearing on the decision on the other.
• Mutually Exclusive /
• The acceptance of one project precludes/prevents accepting the other
• These are projects typically perform the same function(either -or
project )
• Contingent Projects
o Contingent projects are those in which the acceptance of one project
is dependent on another project
Numerical methods
1. None Discounting Criteria
A. The Payback Period
• It is one of the most widely used tools for evaluating capital projects.
• The payback period represents the number of years it takes for the cash
flows from a project to recover the project’s initial investment.
• A project is accepted if its payback period is below some pre-specified
threshold.
• This technique can serve as a risk indicator—the more quickly you
recover the cash, the less risky is the project.
• Payback is a very poor way of determining a project’s acceptability
(ignores all cash flows after your cutoff date and it does not discount
Cash flows)
Numerical methods
• To compute the payback period, we need to know the project’s cost and
to estimate its future net cash flows.
• Payback period =years before cost recovery + (remaining cost to
recover /cash flow during the year)
• Compute the Payback Period (PB) given the following net cash flows:
Year Net Cash flow
0 (20,000)
1 6,000
2 7,000
3 8,000
4 5,000
5 4,000
Numerical methods
• Solution Year Net Cash flow Cumulative NCFs
0 (20,000)
1 6,000 6,000
2 7,000 13,000
3 8,000
4 5,000
5 4,000

• Payback period =years before cost recovery + (remaining cost to recover /cash flow
during the year)
• = 2 years + (20,000-13,000/8000)
• = 2 years + (7,000/8,000)
• = 2 years +0.875= 2.875 years
Numerical methods
• The PB period when the cash flows are in the form of an annuity is calculated as: PB
= NCF0/NCFn Year Net Cash flow
• Example 0 (5,000)
1 2,000
2 2,000
3 2,000
4 2,000

• PB = NCF0/NCFn = 5,000/2,000= 2.5 years

• There is no economic rationale that links the payback method to
shareholder wealth maximization.
• If a firm has a number of projects that are mutually exclusive, the
projects are selected in order of their payback rank: projects with the
lowest payback period are selected first.
Numerical methods
Cash Flows
• Project: Yr0 Yr1 Yr2 Yr3
• A -2,000 +1,000 +1,000 +10,000
• B -2,000 +1,000 +1,000 -
• C -2,000 - +2,000 -

Project: Payback (years) NPV @ 10%

A 2 7,248.69
B 2 - 264.46
C 2 - 347.11

• Under NPV, only project A is acceptable. B and C have negative NPV’s and
are thus both unacceptable.
• But if your payback period is 2 years, then all the projects are acceptable
Numerical methods
• The payback period analysis can lead to erroneous decisions because the rule
does not consider cash flows after the payback period.
• Decision Rule: Payback period ≤ Payback cutoff point  Accept the project.
• Payback period > Payback cutoff point  Reject the project.
• Key advantages
• Easy to understand
• Biased towards liquidity/simple measure of a liquidity.
• Disadvantages
• Ignores the time value of money
• Requires an arbitrary cutoff point
• Ignores cash flows beyond the cutoff date
• Bias against long-term projects such as R & D and new product launches.
• Fail to consider the riskiness of the project
Numerical methods
• Accounting Rate of Return(ARR) - sometimes called the book rate of return.
• This method computes the return on a capital project using accounting numbers—the
project’s net income (NI) and book value (BV) rather than cash flow data.
• ARR = Average net income /average book value
• Example- a project has the following NI:
Year 1 2 3
NI 13,620 3,300 29,100

• average book value 72,000.

• require an average accounting return of 25%
• Average Net Income:
• (13,620 + 3,300 + 29,100) / 3 = 15,340
• ARR = 15,340 / 72,000 = .213 = 21.3%
• Do we accept or reject the project?
Numerical methods
Numerical methods
• Average net income = [100,000 + 150,000 + 50,000 + 0 + (−50,000)]/5=
50,000
• AAR= 50,000/250,000 = 0.20= 20%
• It has a number of major flaws as a tool for evaluating capital
expenditure decisions.
• ARR is not a true rate of return. ARR simply gives us a number
based on average figures from the income statement and balance
sheet. Since it involves accounting figures rather than cash flows, it
is not comparable to returns in capital markets.
• It ignores the time value of money.
• There is no economic rationale that links a particular acceptance
criterion to the goal of maximizing shareholders’ wealth.
Numerical methods
2. Discounted Methods
A. Discounted pay back period
• One weakness of the ordinary payback period is that it does not take into
account the time value of money.
• The discounted payback period calculation calls for the future cash flows
to be discounted by the firm’s (opportunity) cost of capital/rate of
return/discount rate
• The major advantage of the discounted payback is that it tells
management how long it takes a project to reach a positive NPV.
• It indicates the difference between the current value of the cash inflows
for the project and current value of the cash outflow
• However, this method still ignores all cash flows after the payback period.
Numerical methods
• Example - Compute the Discounted Payback Period (DPB) given a
required return of 12% and the following net cash flows:
Year NCF Discounted CF Cumulative
(12%)
0 (20,000)
1 6,000 5,357.14 5,357.14
2 7,000 5,580.36 10,937.50
3 8,000 5,694.24 16,631.74
4 5,000 3,177.59 19,809.33
5 4,000 2,269.71 22,079.04

• DPB= 4 years + (20,000- 19,809.04)/2,269.71

• =4 years + 190.67/ 2,269.71 = 4.084 years
Numerical methods
B. Net Present value (NPV)
• The present value of a project is the difference between the present
value of the expected future cash flows and the initial cost of the project.
• It is a technique that is consistent with the goal of maximizing
shareholder wealth.
• The NPV of a project is the difference between the present value of the
expected future cash flows and the initial cost of the project.
• Net Cash flow (NCF) for each time period t, where NCFt =
• (Cash inflows – Cash outflows) for the period t.
• NPV = sum of PV of NCFt– Required Investment (Cost or outflow at t0)
• It indicates the difference between the current value of the cash inflows for the
project and current value of the cash outflow. Thus, NPV= +ve---inflows>outflows
NPV= -ve---inflows<outflows NPV=0----inflows=outflows
Numerical methods

n
NCFt
NPV =∑
(1 + R)t
t=0 NOTE: t=0

Initial cost often is CF0 and is an outflow.

n NCFt
NPV = ∑ (1 + R)-t CF0
t=1
Numerical methods
• If NPV is positive, accept the project
• NPV > 0 means:
• Project is expected to add value to the firm
• Will increase the wealth of the owners
• NPV is a direct measure of how well this project will meet the goal of
increasing shareholder wealth.
• While accepting a negative NPV project leads to a decline in shareholder
wealth.
• Projects that have an NPV equal to zero imply that management will be
indifferent between accepting and rejecting the project.
Numerical methods

• Example
• A new project have the following estimated cash flows:

• Year 0: CF = -165,000
• Year 1: NCF = 63,120
• Year 2: NCF = 70,800
• Year 3: NCF = 91,080

• The required return for assets is 12%(cost of capital)

• Compute NPV for the Project
Numerical methods
n
• Using the formula: CFt
NPV  
t 0 (1  R ) t

NPV = -165,000/(1.12)0 + 63,120/(1.12)1 + 70,800/(1.12)2 + 91,080/(1.12)3 =

12,627.41
NPV
Required Return = 12%
Year CF Formula Disc CFs
0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00)
1 63,120.00 =(63120)/(1.12)^1 = 56,357.14
2 70,800.00 =(70800)/(1.12)^2 = 56,441.33
3 91,080.00 =(91080)/(1.12)^3 = 64,828.94
12,627.41
Numerical methods
• Example - Compute the Net Present Value (NPV) given a required return
of 12% and the following net cash flows:
Year Net Cash flow (NCTt)
0 (20,000)
1 6,000
2 7,000
3 8,000
4 5,000
5 4,000

• NPV = -20,000/(1.12)0 + 6000/(1.12)1 + 7000/(1.12)2 + 8000/(1.12)3 +5000/(1.124)

+4000/(1.125)= 2,079.04
• What is NPV if required return is 17%
• NPV = -20,000/(1.17)0 + 6000/(1.17)1 + 7000/(1.17)2 + 8000/(1.17)3 +5000/(1.174)
+4000/(1.175)= -270.55
Numerical methods

• Example - Compute the Net Present Value (NPV) given a required return of 11%
discounted annually and the following net cash flows:

Year Net Cash flow (NCTt)

0 (2,000)
1 800
2 800
3 800
4 800

• Sum of PV of cash inflows is determined by an annuity formula

• PV =
1
PMT 1 - (1 + i)n
i
Numerical methods

• Where i=r/m and n=t*m (m is no. of discounting per year)---i=11%/1=11%) and

n=1*4yrs=4
1
• PV = PMT 1- (1 + i)n
i
• 1
• PV = 800 1- (1 + 0.11)4
0.11
• PV =800(3.10245) = 2.481.96
• NPV= PV – initial investment
• = 2.481.96 -2,000
• = 481.96
• Do we accept or reject the project?
Numerical methods
• What if the discounting for the above example is semiannually?
• Where ---i=11%/2=5.5%)(0.055) and n=2*4yrs=8

1
• PV = PMT 1 - (1 + i)n
i
• 1
800 1- (1 + 0.055)8
• PV =
0.055
• PV =800(6.33456) = 5,067.65
• NPV= PV – initial investment
• = 5,067.65-2,000
• = 3,067.65
• Do we accept or reject the project?
Numerical methods

• The good and the bad

• The good
• Uses the discounted cash flow valuation technique(TVM, risk adjusted
cash flows)
• Provides a direct measure of how much a capital project will increase
the value of the firm.
• Consistent with the goal of maximizing shareholder wealth.
• The bad
• Difficult to understand without an accounting and finance background.
• May be difficult to calculate
• Does not account for liquidity needs
Numerical methods

C. The Internal Rate of Return (IRR)

• IRR is the discounted rate that makes the NPV of an investment zero.
• It is the rate of return associated with a project so we can determine
whether this rate is higher or lower than the firm’s cost of capital.
• An investment is accepted (rejected), if the IRR > the required rate of
return or rejected if IRR < the required rate of return
• The NPV and IRR techniques are similar in that both depend on
discounting the cash flows from a project
Numerical methods

IRR: NPV = 0, solve for IRR.

n
NCFt
NPV    0
t  0 (1  IRR )
t
Numerical methods

70,000
60,000 NPV Profile for a Project
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate
Numerical methods

• Example - Compute the Internal Rate of Return (IRR) given a required

return of 12% and the following cash flows:
Year NCFt
0 (20,000)
1 6,000
2 7,000
3 8,000
4 5,000
5 4,000

• Set the NPV equation equal to zero and solve for the IRR:
• NPV = -20,000/(1+IRR)0 + 6000/(1+IRR))1 + 7000/(1+IRR))2 +
8000/(1+IRR))3 +5000/(1+IRR)4) +4000/(1+IRR)5)= 0
Numerical methods

• At this point, unless you are using a financial calculator or

spreadsheet, solving for the IRR is a trial and error process.
• That is, we would “plug” in different estimates for the IRR, work
through the calculations, and determine if we have found the rate
that causes NPV to equal 0.
• We have already computed the NPV of this project at a 12%
discount rate and found the NPV to be positive.
• In addition, we computed the NPV of the project at a discount rate
of 17% and found NPV to be negative.
• Therefore, we know that the IRR lies somewhere between 12% and
17% (in fact, we can see that the IRR is much closer to 17%).
Numerical methods

• Let IRR=16%
• NPV = -20,000/(1+0.16)0 + 6000/(1+0.16)1 + 7000/(1+0.162 + 8000/(1+0.16)3
+5000/(1+0.164) +4000/(1+0.16)5)
• = -20,000+5,172.41+5,202.14+5,125.26+
2,761.46+1,904.45
• = 165.72
• NPV is very close to zero.
 Continuing the process, we find the IRR = 16.3757%.

• IRR> the required rate of return(12%), accept the project

Numerical methods

• Advantages of IRR
• Preferred by executives/ practitioners
• Intuitively appealing (gives practitioners a good idea about at what rate they are able to earn)
• Easy to communicate the value of a project
• Considers all cash flows
• Considers time value of money
• Disadvantages
• Can produce multiple answers especially in the case of non-conventional cash
flows
• Cannot rank mutually exclusive projects
Cash Flows in thousands of Dollars
Project: C0 C1 C2 C3 IRR NPV @ 7%
H -350 400 - - 14.29% $24,000
I -350 16 16 466 12.96% $59,000

• Obviously, project I must be accepted

Numerical methods

 IRR and NPV compared

 The two methods will always agree when the projects are independent and the
projects’ cash flows are conventional(After the initial investment is made (cash
outflow), all the cash flows in each future year are positive (inflows))

Discou 0% 5% 10% 13% 14% 15% 20%

nt rate
NPV 20 11.56 4.13 0.09 -1.20 -2.46 -8.33
Numerical methods

• Consider the following mutually exclusive projects

Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74

• The required return for both projects is 10%.

• Which project should you accept and why?
• Whenever there is a conflict between NPV and another decision rule, always use
NPV
Numerical methods

D. Profitability index (PI)

• Measures the benefit per unit cost, based on the time value of money
• This measure can be very useful in situations where we have limited
capital/capital rationing
• If there is no capital constraint, one should choose the project with the
highest NPV from the mutually exclusive pool
• PI = NPV / Initial Investment
 Decision Rule: pick the projects that give the highest PI (NPV per
dollar of investment)
Numerical methods

which projects the firm must select ?

◦ For example: Suppose your firm had the following

projects and only $20 million to spend:
NPV @
Project C0 C1 C2 10%
L -3.00 2.20 2.42 1.00
M -5.00 2.20 4.84 1.00
N -7.00 6.60 4.84 3.00
O -6.00 3.30 6.05 2.00
P -4.00 1.10 4.84 1.00
Budget -25.00
Numerical methods

NPV @
Project C0 10% PI
L 3.00 1.00 1/3 = 0.33 ACCEPT

M 5.00 1.00 1/5 = 0.20

N 7.00 3.00 3/7 = 0.43 ACCEPT

O 6.00 2.00 2/6 = 0.33 ACCEPT

P 4.00 1.00 1/4 = 0.25 ACCEPT

Numerical methods

• Example of Conflict of PI with NPV

A B
CF(0) $ (10,000) $ (100,000)
PV(CF) $ 15,000 $ 125,000
PI $ 0.50 $ 0.40
NPV $ 5,000 $ 25,000

• Which project must be selected?

• NPV is preferred over PI often if especially there is no capital rationing
Reporting of the feasibility study
1. General Information
• analysis of industry or sector to which the project belongs;
• the gap between supply and demand in the industry/sector
• past performance of proposal owners
• 2. Preliminary Description:
• Alternatives which were considered with the proposed project
• All the relevant options analysis should be explained
• The rationale for the project/how it addresses the existing gap
• 3. Project Description:
• location of the project;
• technology to be used;
• machinery and equipments needed; and
• requirements, utilities, labor, products
Reporting of the feasibility study
• 4. Market plan:
• demand of projects
• prices and prices sensitivity
• distribution arrangements; and
• warehouse and storage arrangements
• 5. Capital Requirements:
• preliminary expenditure;
• land acquisition and development
• plant and equipment
• construction; and
• engineering and project management
• 6. Operating Requirements and Costs:
• raw materials, fuel, utilities
• labor
• repair and maintenance costs
• selling expenses; and
• other expenses depending on the project
Reporting of the feasibility study
• 7. Financial Analysis:
• Initial investment cost
• costs of production
• Working requirements
• cash flows during the economic life of the project; and
• financial performance may be done using tools like:
• Pay back periods
• Net Present Value,
• Internal Rate of Return
• Return on capital employed.
• 8. Economic and Social Analysis:
• impacts on income distribution;
• assured prices to farmers and supplier of inputs;
• saving in foreign exchange; and
• increased production
Reporting of the feasibility study
• 9. Environmental Impact Assessment
• impact or damage on the environment;
• measures required to prevent damage;
• costs involved in restoration of acceptable measures; and
• Mechanisms for monitoring the efficiency and effectiveness of the measures.