Project Selection

EEE 399 -01-MW

Spring 2024

Prepared by: Masud Karim

05 February 2024
 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
 Nature of Project Selection Models

2 Basic Types of Models

 Numeric

 Nonnumeric

Two Critical Facts:

 Models do not make decisions - People do!

 All models, however sophisticated, are only partial

representations of the reality they are meant to
reflect
 Nonnumeric Models
 The Sacred Cow In this case the project is suggested by a senior and
powerful official in the organization. Often the project is initiated with a
simple comment such as, “If you have a chance, why don’t you look into…,”

 The Operating Necessity -the project is required in order to keep the

system operating. If a flood is threatening the plant, a project to build a
protective wall does not require much formal evaluation.

 The Competitive Necessity – project is necessary to sustain a competitive

position. Many business schools are restructuring their undergraduate and
MBA programs to stay competitive with the more forward-looking schools.

 The Product Line Extension –projects are judged on how they fit with
current product line, fill a gap, strengthen a weak link, or extend the line in
a new desirable way.
 Comparative Benefit Model – Several projects are considered and one with
the most benefit to the firm is selected
 Numeric Models: Profit/Profitability

 Payback period - initial fixed investment/estimated

annual cash inflows from the project
 Average Rate of Return - average annual profit/average
investment
 Discounted Cash Flow - Present Value Method
 Internal Rate of Return - Finds rate of return that
equates present value of inflows and outflows
 Profitability Index - NPV of all future expected cash
flows/initial cash investment
 Numeric Project Selection Model
Payback period
 The payback method is the simplest way of looking at one or more
major project ideas. It tells you how long it will take to earn back the
money you'll spend on the project.

Payback period =
initial fixed investment in the project / estimated annual net cash
inflows
 The ratio of these quantities is the number of years required for the
project to repay its initial fixed investment.
 For example, assume a project costs $100,000 to implement and has
annual net cash inflows of $25,000. Then
 Payback period $100,000/$25,000 = 4 years
 Example 1: Payback Period
 Seagull plc has identified that it could make operating cost savings in
production by buying an automatic press. There are two suitable such
presses on the market, the Zenith and the Super. The relevant data relating
to each of these are as follows:
Zenith Super
$ $
Cost (payable immediately) 20,000 23,000
Annual Savings:
Year 1 4000 8000
2 6000 6000
3 6000 5000
4 7000 6000
5 6000 8000
Find out the anticipated payback period of the two machine and which you
will select?
Solution: Example 1-Payback Period
 Payback Period Calculation: Zenith
 Year Initial Invest Cash Inflow Accumulated Inflow Balance
0 -$20,000 0 0 -$20,000
1 $4,000 $4,000 -16,000
2 $6,000 $10000 -10,000
3 $6,000 $16,000 -4,000
4 $7,000 $23,000 +3,000

The final year can be estimated by dividing the remaining balance by the next
year cash inflows.
$4,000/$7,000 = 0.5714 × 12 = 6.857 months = 6 months 26 days
It will take Zenith Press about 3 years and 6 months and 26 days to recover its
initial investment if the cash flow estimates are correct
 Solution: Example 1-Payback Period……..continue
 Payback Period Calculation: Super
 Year Initial Invest Cash Inflow Accumulated Inflow Balance
0 -$23,000 0 0
-$23,000
1 $8,000 $8,000 -15,000
2 $6,000 $14,000 -9,000
3 $5,000 $19,000 -4,000
4 $6,000 $25,000 +2,000
The final year can be estimated by dividing the remaining balance by the next
year cash inflows.
$4,000/$6,000 = 0.6667 × 12 = 8 months
It will take Super Press about 3 years and 8 months to recover its initial
investment.
Based on Payback Period Model we will select ZENITH.
Advantages of PB
Principal Advantages of Payback Method is its simplicity. It
also provides information about how long funds will be tied
up in a project. The shorter the payback is, the greater the
project’s liquidity.

Disadvantages of PB
No clearly defined accept/reject criteria
No risk assessment
Ignores cash flows beyond the payback period
Ignores time value of money
 MCQ- Payback Period
 The cash inflows and (outflows) associated with a project are as
follows: At Start(120,000), 1st Year revenue 40,000, 2nd year 60,000,
3rd year 30,000, residual value after 3 years 20000. The payback
period of the project is,

 A) 2 years and 6 months.

 B) 2 years and 8 months.
 C) 3 years
 D) More than 3 years
 E) None

Answer : B
 MCQ- Payback Period
 The cash inflows and (outflows) associated with a project are as
follows: At Start(120,000), 1st Year revenue 40,000, 2nd year 60,000,
3rd year 30,000, additional income after 2 years 20000. The payback
period of the project is,

 A) 2 years
 B) 2 years and 8 months.
 C) 3 years
 D) More than 3 years
 E) None

Answer : A
 MCQ- Payback Period
Which of the following will not be a relevant factor when using
the payback method of capital investment appraisal?

A. The timing of the first cash inflow

B. The total cash flows generated by the asset
C. The cash flows generated by the asset up to the payback
period
D. The cost of the asset

Answer : B
 MCQ- Payback Period
Why is the payback method often considered inferior to
discounted cash flow in capital investment appraisal?

A. It does not take account of the time value of money

B. It is more difficult to calculate
C. It only takes into account the future income of a project
D. It does not calculate how long it will take to recoup the
money invested

Answer : A
 MCQ- Payback Period
If the Payback Period is 4 years and the uniform increase in cash
flows per year is $275,000, and the project will last for 6 years, then
the net Initial Investment can be?

A. 1,100,000
B. 11,000,000
C. 1,650,000
D. It is not possible to calculate.

Answer : A
 MCQ- Payback Period
An asset costs $210,000 with a $30,000 salvage value at the end of its
ten-year life. If annual cash inflows are $30,000, the cash payback
period is

A. 8 years.
B. 7 years.
C. 6 years.
D. 5 years

Answer : B
 MCQ- Payback Period
An asset costs $210,000 with an extra ordinary income $30,000 value
at the end of its five-year life. If annual cash inflows are $30,000, the
cash payback period is

A. 8 years.
B. 7 years.
C. 6 years.
D. 5 years

Answer : C
 Example 2- Payback Period
 Due to increased demand, the management of Rani Beverage
Company is considering to purchase a new equipment to increase the
production and revenues. The useful life of the equipment is 10 years
and the company’s maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given
below:
 Initial cost of equipment: $37,500
 Annual cash inflows: Sales: $75,000
 Annual cash Outflows:
 Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
 Non cash expenses: Depreciation expense: $7,000
 Required: Should Rani Beverage Company purchase the new
equipment? Use payback method for your answer.
 Solution: Example 2- Payback Period

 Step 1: In order to compute the payback period of the equipment, we

need to workout the net annual cash inflow by deducting the total of
cash outflow from the total of cash inflow associated with the
equipment.
 Computation of net annual cash inflow:
 $75,000 – ($45,000 + $13,500 + $1,500) = $15,000
 Step 2: Now, the amount of investment required to purchase the
equipment would be divided by the amount of net annual cash inflow
(computed in step 1) to find the payback period of the equipment.
 = $37,500/$15,000 =2.5 years
 Depreciation is a non-cash expense and therefore has been ignored
while calculating the payback period of the project.
 According to payback method, the equipment should be purchased
because the payback period of the equipment is 2.5 years which is
shorter than the maximum desired payback period of 4 years
Project Selection Model: Net Present Value - NPV
 The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used to analyze the profitability
of an investment or project.
n
CF
PV =

t 1 (1  i ) t

 PV = Present Value
 CF = Future Cash Flow =FV
 i = Discount Rate
 t = Number of Years

 Equation for NPV is

NPV = PV (Cash inflows) – PV (cash outflows)
 NPV at various situations
If... It means... Then….

NPV > 0 the investment would add value to the firm

the project should be accepted

NPV < 0 the investment would subtract value from the firm
the project should be rejected

NPV = 0 the investment would neither gain nor lose value

for the firm.
the project could be accepted as
shareholders obtain required rate of
return. This project adds
no monetary value. Decision should
be based on other criteria, e.g. strategic
positioning.
 MCQ-Net Present Value
 A project is expected to result in $2 million in five years. The
current interest rate is 5%. What is the PV of the project?
 A. $1,359,252
B. $1,567,398
C. $1,784,972
D. $2 million

 B. - $1,567,398 – Get those PV & FV formulas on your brain dump.

Again, this is one of those problems that may or may not surface on
your exam. It did for me! (But depreciation didn’t.)
 Present Value = FV / [(1 + r)^n], where r is the rate of return and n is the
number of years = $2 million / [(1 + .05)^5].
 MCQ - NPV
 You must select one and only one project to take on for
your company. The net present value (NPV) for each project
is as follows: Project A’s NPV is $10K, Project B’s NPV is
$20K, and Project C’s NPV is $30K.
 A. Project A
B. Project B
C. Project C
D. This problem cannot be solved without knowing the
interest rate for each project.

 Simply pick the greatest value. Easy! –Choice is C.

 MCQ - NPV
 What does it mean that NPV = 0?

 A. Project should be accepted

B. Project should be rejected
C. Project could be accepted
D. Depends on the project owner.

 Easy! –Choice is C.
 Profitability Index (PI)
 An index that attempts to identify the relationship between
the costs and benefits of a proposed project through the use
of a ratio calculated as:
PI = PV of Future Cash flow / Initial Investment
 A ratio of 1.0 is logically the lowest acceptable measure on
the index. Any value lower than 1.0 would indicate that the
project's PV is less than the initial investment. As values on
the profitability index increase, so does the financial
attractiveness of the proposed project.

 So, if the profitability index yields a 1.5, an investor can

expect to get a return of $1.50 US Dollar (USD) for each
dollar invested. Alternatively, a profitability index is 0.9, an
investor can expect to get $0.90 USD back for each dollar
spent, which results in negative returns.
 Example : PI
 Seagull plc has identified that it could make operating cost savings in
production by buying an automatic press. There are two suitable such
presses on the market, the Zenith and the Super. The relevant data relating
to each of these are as follows:
Zenith Super
$ $
Cost (payable immediately) 20,000 23,000
Annual Savings:
Year 1 4000 8000
2 6000 6000
3 6000 5000
4 7000 6000
5 6000 8000
Find out the anticipated payback period of the two machine and which you
will select?
Find the NPV of both the machine. Which of these machine be bought if the
borrowing/lending rate cost is 12% p.a.?
Calculate PI of both the machine?
Solution – Example PI
 MCQ- PI
A profitability index of .85 for a project means that:
A. the present value of benefits is 85% greater than the project's costs.
B. the project's NPV is greater than zero.
C. the project returns 85 cents in present value for each current dollar
invested.
D. the payback period is less than one year.

Answer : C
 IRR – Internal Rate of Return
 What discount rate would cause the net present value
(NPV) of a project to be $0.
 NPV = PV ( Inflow) – PV (Outflow)
 If NPV = 0, then
 PV(inflow) =PV(outflow)
 Example : IRR
Calculate IRR
Initial Investment: USD 25,000
1st Year Revenue: USD 15000
2nd Year Revenue: USD 13500
Solution Example -IRR
 MCQ- IRR
 A project has an NPV of £12,632 when a discount rate of 12% is used
and the same project has an NPV of (£6,935) when a discount rate of
22% is used, the actual internal rate of return of the project is:
A. 18.5%
B. 16.5%
C. 6.5%
D. 28.5%

Answer : A
When interpolating to find the IRR it is necessary to look at a rate of return
that produces a positive NPV and a rate of return that produces a
negative NPV. The proportion of the distance form the positive to a zero
NPV is taken and multiplied by the difference in the discount rates used
i.e.
IRR = 12% + (22% - 12%)*(12,632/(12,632+6,935))
IRR = 12% + (10%)*(0.646)
IRR = 18.5%
 MCQ- IRR
 MAX Ltd is about to undertake a project and has computed the NPV of
the project using a variety of discount rates:
Discount Rate Used NPV
10% + TK 130K
15% + TK 50K
20% - TK 50K

What is the approximate IRR of this project?

A. 20%
B. 17.5%
C. 15%
D. 10%

Answer : B
 MCQ- NPV
The discount rate at which two projects have identical is referred to
as Fisher's rate of intersection.
A. present values
B. net present values
C. IRRs
D. profitability indexes

Answer : B
Fisher's rate means the interest rate where the net present values of two
mutually exclusive projects become equal.

Mutually exclusive projects are capital projects which compete directly with
each other. For example, if a manager has a choice to make between
undertaking projects X and Y, and must choose either of the two and not
both, then projects X and Y are said to be mutually exclusive.
 MCQ- Project Selection
Which of the following statements is correct?
A. If the NPV of a project is greater than 0, its PI will equal 0.
B. If the IRR of a project is 0%, its NPV, using a discount rate, k,
greater than 0, will be 0.
C. If the PI of a project is less than 1, its NPV should be less than
0.
D. If the IRR of a project is greater than the discount rate, k, its PI
will be less than 1 and its NPV will be greater than 0.

Answer : C
 MCQ- Project Selection
If a company's required rate of return is 10% and, in using the net present
value method, a project's net present value is zero, this indicates that the
a) Project's rate of return exceeds 10%.
b) Project's rate of return is less than the minimum rate required.
c) Project earns a rate of return of 10%.
d) Project earns a rate of return of 0%.

Answer : C
 MCQ- Project Selection
 The process of planning expenditures that will influence the
operation of a firm over a number of years is called
 a. investment.
b. capital budgeting.
c. net present valuation.
d. dividend valuation.

Answer : B
 MCQ- Project Selection
 Which of the following is an example of a capital investment
project?
 a. Replacement of worn out equipment
b. Expansion of production facilities
c. Development of employee training programs
d. All of the above are examples of capital investment projects.

Answer : D
 MCQ- Project Selection
 A firm is considering three investment projects which we will refer to as A,
B, and C. Each project has an initial cost of $10 million. Investment A offers
an expected rate of return of 16%, B of 8%, and C of 12%. The firm's cost of
capital is 6% if it borrows $10 million, 10% if it borrows $20 million, and
12% if it borrows $30 million or higher. Which project(s) should the firm
invest in?
 a. Just A, because it offers the highest rate of return and is the only
investment that has a rate of return higher than 15%
b. All three should be undertaken, because the rate of return on B is above
6%, on C is above 10%, and on A is above 12%.
c. Only A and C should be undertaken because both have rates of return
that are equal or greater than 12%.
d. None of the above is correct.

Answer : C
 MCQ- Project Selection
 In cases where capital must be rationed, a firm should rank projects
according to their
 a. net present values.
b. internal rates of return.
c. profitability indexes.
d. external rates of return.

Answer : C
 MCQ- Project Selection
 A firm can borrow at an interest rate of 10%. Its marginal tax rate is
40%. What is its cost of debt?
 a. 10%
b. 14%
c. 6%
d. None of the above is correct.

Answer : C
 MCQ- ARR
 NATT Ltd is considering undertaking a project that would yield annual
profits (after depreciation) of £68,000 for 5 years. The initial outlay of
the project would be £800,000 and the project's assets would have a
residual value of £50,000 at the end of the project.
What would be the average rate of return for this project?

 a. 16%
b. 8.5%
c. 8%
d. None of the above is correct.

Answer : ARR = average annual profits / average amount invested in the

project = 68,000 / 425,000 x 100 =16%.

The average amount invested in the project = (£800,000 + £50,000) / 2 =

£425,000.
 MCQ- Project Selection
 Bond Ltd is considering two possible projects but can only raise enough funds to
proceed with one of them. Investment appraisal techniques have been used and the
following results found:

Project W Project X
Payback Period 3.8 Years 2.8 Years
Accounting Rate of Return 16% 14%
Net Present Value + TK 880,000 + TK 690,000
Which of the following is the most logical interpretation of the results?
A. Project W should be selected as it gives the longest payback period. incorrect
B. Project W should be selected because it will yield the highest NPV. correct
C. Project X should be selected because it will yield the lowest NPV incorrect
D. The ARR is the most meaningful investment appraisal technique and hence Project
W should be selected. Incorrect

 Answer: B

 Answer:
Project Selection

Questions?