LECTURE HANDOUT 2

TOPIC –SELECTION OF PROJECTS

COURSE- PROJECT MANAGEMENT
MBM PROGRAM, IIUC
Manjurul Alam Mazumder*
LEARNING OBJECTIVES:
2.1 Project selection models
2.2 Criteria for project selection models
2.3 Choosing a project selection model
2.4 Decision rules under profitability models
2.5 Understanding profitability models
2.6 Problems to be resolved

DISCUSSIONS ON THE LEARNING OBJECTIVES:

2.1 Project Selection Models
There are basically two categories of project selection model. These are: Numeric, Nonnumeric.
Numeric models are of two types: Profit / Profitability and Scoring. Different project selection
models are given below:

Nonnumeric Methods:
i. Scared Cow
ii. Operating Necessity
iii. Competitive Necessity
iv. Product Line Extension
v. Comparative Benefit

Numeric Models: Profit / Profitability

i. Net Present Value - NPV
ii. Internal Rate of Return – IRR1
iii. Ratio Analysis2
iv. Payback Period –PB
v. Benefit Cost Ratio - BCR
vi. Average Rate of Return - ARR

Numeric Models: Scoring

i. Un-weighted 0-1 Factor Model
ii. Un-weighted Factor Scoring Model
iii. Weighted Factor Scoring Model
iv. Constrained Weighted Factor Scoring Model
(See Project Management by Meredith pp.45-61 for details)

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Due to inflation IRR should be 6% higher than cost of investment in Bangladesh. If the cost is 13%, IRR
should be 18%.
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Ratios will be analyzed from the projected balance sheet. These ratio are Break Even Point, Current Ratio,
Return on Investment, Sales, Operating Profit, Net Profit etc.
2.2 – Criteria for Project Selection Models
Models do not make decisions, people do. The manager, not the model, bears responsibility for
the decision. But a good model is very much helpful to a manager in making appropriate
decisions. In fact, a firm chooses a project selection model considering the following criteria:

(i) Realism: the model should reflect the reality of the manager’s decision situation including the
multiple objectives of both the firm and its managers. Without a common measurement system
direct comparison of different projects is impossible. The model should take into account the
realities of the firm’s limitations on facilities, capital, personnel, etc. The model should also
include factors that reflect project risks, including the technical risks of performance, cost, and
time as well as the market risks of customer rejection and other implementation risks.

(ii) Capability: The model should be sophisticated enough to deal with multiple time periods,
simulate various situations both internal and external to the project ( e.g. strikes, interest rate
changes, etc.) and optimize the decision. An optimizing model will make the comparisons that
management deems important, consider major risks and constraints on the projects and them
select the best overall project or set of projects.

(iii) Flexibility: The model should give valid results within the range of conditions that the firm
might experience. IT should have the ability to be easily modified or to be self adjusting in
response to changes in the firm’s environment. e.g. tax laws change, goals change etc.

(iv) Ease to use: the model should be reasonably convenient, not take a long time to execute and
be easy to use and understand.

(v) Cost: Data gathering and modeling costs should be low relative to the cost of the project and
must surely be less than the potential benefits of the project.

(vi) Easy computerization: It must be easy and convenient to gather and store the information in
a computer data base and to manipulate data in the model through use of widely available,
standard computer package (Vide PM by Meredith pp- 40-41 for details).

2.3 – Choosing a Project Selection Model

Selecting the type of model to aid the selection process depends on the wishes and decisions of a
management. But there is strong favor for weighted scoring models for three fundamental
reasons:
a. Weighted factor scoring models 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.
b. Scoring models are easily adapted to changes in managerial philosophy or changes in the
environment.
c. Scoring models do not suffer from the bias towards the short run that is inherent in
profitability models that discount future cash flows.

(Vide Meredith p.60-61 for details)

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2.4 –Decision Rules under Profitability Models:
Criteria General Rule Additional rules when selecting among several
(For one project) projects
Mutually exclusive Input constraint
projects
NPV NPV > 0 NPVa > NPVb NPVj/inputj>copNPV

IRR IRR > i IRRa > IRRb IRRj > copIRR

BCR BCR > 1 BCRa > BCRb BCRj > copBCR

PB PB < Yrs PBa < PBb PBj <copPB

ARR ARR > i ARRa > ARRb ARRj > copARR

DRC DRC <SER DRCa < DRCb DRCj < copDRC

Or DRC < 1
Notes:
NPV = Net Present Value
BCR = Benefit Cost Ratio
IRR = Internal Rate of Return
PB = Pay Back Period or POP = Pay-out Period
COP = Cut-off Point, chosen in such a way that selected projects exactly exhaust the
constrained
input. The cop differs according to the criteria used in the table.
i = Discount Rate Selected or Opportunity Cost of Capital
SER = Shadow Exchange Rate
Yrs = Number of Years Selected
j = No. of Projects

Note that European Union follows about 30 decision rules in project selection and
evaluation process
(Adapted the presentation of Prof. Dr. R. Renard, IDPM, RUCA, Belgium)

2.5 Understanding Profitability Indices:

2.5.1. PB (Payback):
The payback period, also known as break even period is the length of time a project takes to
recover its initial cash outlay. It is the expected number of years required to recover the capital
investment. It is a traditional model used in project selection / capital budgeting of projects. The
shorter the payback period, the more favorable is the project regarded.

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Calculation:
Payback period = Cash outlays (investment) / Annual cash flows

Uncovered cost at start of year

Or, Payback period = Year before full recovery +
Cash flow during year

Decision rule: PB< years

Advantages:
1. It is a widely used method.
2. It is easy to compute and understand.
3. It may be used to select those investments yielding a quick return of cash, thus placing an
emphasis on liquidity.
4. It permits a company to determine the length of time required to recapture its original
investment, thus offering a possible indicator of the degree of risk of each investment.
Such an indicator is especially useful when the danger of obsolescence is great.
Disadvantages:
1. It ignores the time value of money.
2. It ignores cash flows beyond the payback period.
3. It does not consider profitability of a project.
4. It does not consider salvage value, which may exist after the payback.

Example:
Select a project from A & B, considering PB period.

Year Project A Project B

0 (1000) (1000)
1 200 300
2 200 300
3 200 300
4 200 300
5 200 300
6 150 500
7 300 450
450 1,450
Project B will get preference, as it takes comparatively shorter period of time to get the capital
returned.

2.5.2 - ARR (Accounting Rate of Return):

The accounting rate of return (ARR), also known as the return on investment (ROI), uses
accounting information, as revealed by financial statements, to measure the profitability of an
investment. The accounting rate of return is found out by dividing the average annual net cash
flows by the net cash outlays. The average investment would be equal to half of the original

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investment if it is depreciated constantly. Alternatively, it can be found out dividing the total of
the investment’s book values after depreciation by the life of the project.

Calculation: Average cash inflows (NCBs)

ARR = Net cash outlays (NCOs) * 100

Decision rule: ARR > Cost of capital

Or
ARR > Selecting a project

Advantages:
1. It is easy to calculate as it facilitates more readily available data from accounting records.
2. It considers income over the entire life of the project.
3. It allows a comparison of projects, which require different amounts of capital investment.

Disadvantages:
1. It ignores the time value of money. Two projects might have the same average return, yet
vary considerably in the pattern of flow of cash.
2. Inflations effects are expected to be included in cash flow estimates. But a calculation of
net income based on historical cost depreciation and the expression of net income as a
return on an investment, which is also stated at historical cost, may be quite misleading.
3. The average return on the original invest technique in applicable if any of the investment
is made after the beginning of the project.

Example:
Suppose, you are considering a project costing $60,000 with an estimated useful life of 5 years
after which the expected residual value is $10,000. Expected cash flows before depreciation and
tax (CFBT) over next 5 years are as follows:

Year Cash flows

1 $12,000
2 14,000
3 16,000
4 18,000
5 20,000

Assuming 50% tax rate calculate ARR of the project.

Solution:
YEAR PBDT DEP. PBT TAX PAT
1 $12,000 $10,000 $2,000 $1,000 $1,000
2 14,000 10,000 4,000 2,000 2,000
3 16,000 10,000 6,000 3,000 3,000
4 18,000 10,000 8,000 4,000 4,000
5 20,000 10,000 10,000 5,000 5,000

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Depreciation = ($60,000 – $10,000)/5
= $10,000
(1000  2000  3000  4000  5000 ) / 5
ARR =  100
$60,000
= 0.05  100
= 5%
2.5.3 - NPV (Net Present Value):
Net Present Value method discounts all cash flows considering the time value of money. Hence,
it is also known as discounted cash flow method. To calculate NPV of a project the summation
of present values of the net cash outflows are deducted from the summation of the present values
of cash proceeds (CFAT) in each year. A project is acceptable while NPV is positive. Notably, a
decision maker will be indifferent in a Cross Over Ratio – COR (a discounting rate) where NPV
of two projects is equal.
Calculation:
Bt Ct
NPV =  (1  i) t  (1  i) t


 B1 B2 B3 Bn 
Or, NPV =             n 
 C n
 (1  i ) 1
(1  i ) 2
(1  i ) 3
(1  i ) 

Decision rule:
Select a project when NPV>0
Advantages:
1. It is considered as highly acceptable modern technique for project selection.
2. It considers the time value of money.
3. It considers cash flow over the entire life of the project.

Disadvantages:
1. It is bit difficult to compute and understand.
2. Management must determine a discount rate to be used.
3. It may be misleading while dealing with alternative projects or limited funds under the
condition of unequal lives, in that the alternative with the higher net present value may
involve longer economic life to the point that it would be less desirable than an
alternative having a shorter life.

Example:
The initial cost of a project is $25,000.It is expected that the net cash inflows during next 5 years
will be as follows: 1st year $9,000, 2nd year 8,000, 3rd year $7,000, 4th $6,000, 5th year $5,000. In
case the cost of capital is 10%, Find NPV of the project and comment on it.

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Solution:
Year CFs FV (10%) PV
1 $9,000 0.909 $8181
2 8,000 0.8264 6611
3 7,000 0.7513 5259
4 6,000 0.6830 4098
5 5,000 0.6209 3105

Total PV $27,254
Less: initial project cost 25,000
NPV $2,254

Since NPV is positive and much more higher, the project is acceptable.

2.5.4 - IRR (Internal Rate of Return):

The IRR is that selected rate of return where NPV = 0. It may also be defined as that discount
rate which equals the present value of a project’s expected cash inflows to the present value of
the project’s cost.

Calculation:
IRR = L+ C / D (H - L)

Where
L = Lower discounting rate.
H = Higher discounting rate.
C = NPV at this lower discount rate.
D = Difference between NPV at higher discount rate and NPV at lower rate.

Decision Rule: IRR > Cost of Capital

Advantages:
1. Using computer technology, it is very easy to find IRR of a project.
2. IRR is a “breakeven” that makes it useful in evaluating capital budget of a project.

Disadvantages:
1. If the cash flows are not constant, manually it is difficult to find the IRR

Example:
The cost of a project is $16,200.It is expected that the NCBs of next 3years will be as follows:
1st year $8,000,2nd $7,000 and 3rd year $6,000. Find out IRR and comment on it.

Solution:
Suppose NPV at 14% = $ 254
NPV at 20% = ($1204)

Now using the above mentioned formula, we find-

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 254
IRR= 0.14+  (0.20  .014)
254  (1204 )
254
= 0.14+  0.06
1458
= 0.1504
=15.04%

Cost of capital must be lower than 15.04% (IRR) to accept the project.

2.5.5 - BCR (Benefit-Cost Ratio):

BCR is another technique for project selection. It is also known as the profitability index. It is
similar to the NPV approach. The PI method provides a solution to this kind of problem. It is, in
other words, a relative measure. It may be defined as the ratio, which is obtained dividing the
present value of future cash inflows by the present value of cash outlays. Notably, Cross Over
Rate (COR) is a discount rate at which NPV of two projects are equal.
Calculation:
Bt Ct
BCR=    (1  i) t
(1  i ) t

NCBs
Or, BCR=
NCOs

Decision Rule: BCR>1

Example:
The initial investment of a project is $1,00,000.The estimated cash inflows of next four years is,
$40,000, $30,000, $50,000, and $20,000 respectively. If the cost of capital or discount rate is
10%, Find out BCR and comment on it.

Solution:

Year CFs FV (10%) PV

1 40,000 0.909 36360
2 30,000 0.8864 24792
3 50,000 0.7513 37565
4 20,000 0.6830 13660
Total PVs 1, 12,377
Less: initial project cost 1, 00,000
NPV 12,377

NCBs
BCR=
NCOs

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 12,377
=
10,000
= 1.2377
Since BCR is higher than 1, the project is acceptable.

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COURSE TEACHER:
Manjurul Alam Mazumder
Assistant Professor, DBA, IIUC
01816054012, manjurulm4@gmail.com.