Lecture 3b
Project Selection (part 2)
Which project should be supported?
Anisah Ghoorah
Dept of Digital Technologies
FoICDT
University of Mauritius
Reading and Acknowledgment
• J. K. Pinto (2016) Project Management - achieving
competitive advantage. 4th edition, Pearson
– Chapter 3 Project Selection and Portfolio Management
2
Learning Outcomes
At the end of this lecture, you should be able to:
• Show an understanding of Profile Models, Financial Models and
Option Models
• Learn how to use and apply financial concepts:
– Payback period
– Return on investment
– Net present value
– Internal rate of return
3
Approaches to Project Screening
• Checklist model (lecture 3a)
• Simplified scoring models (lecture 3a)
• Analytic hierarchy process (lecture 3a)
• Profile models (this lecture)
• Financial models (this lecture)
• Option models (this lecture)
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Profile Models (1/3)
●
Profile models allow managers to plot risk/return options for various
alternatives and then select the project that maximizes return while
staying within a certain range of minimum acceptable risk.
• “Risk” is a subjective assessment - it may be difficult to reach overall
agreement on the level of risk associated with a given project.
• Graph showing risk/return options for projects.
– Criteria selection as axes
– Rating each project on criteria
5
Profile Model (2/3)
●
E.g. a company has identified six project candidates for development. The
company focused on two criteria: risk and reward. Because of the cost of
capital to the firm, we will specify some minimum desired rate of return. All
projects will be assigned some risk factor value and be plotted relative to
the maximum risk that the firm is willing to assume.
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Profile Models (3/3)
Observations
• We see that Project X2 and Project X3 have similar expected rates of
return.
• Project X3, however, represents a better selection choice. Why?
Because the company can achieve the same rate of return with Project
X3 as it can with Project X2 but with less risk.
• Likewise, Project X5 is a superior choice to X4: Although they have
similar risk levels, X5 offers greater return as an investment.
• Finally, while Project X6 offers the most potential return, it does so at
the highest level of risk.
• The efficient frontier is the set of project portfolio options that offers
either a maximum return for every given level of risk or the minimum
risk for every level of return.
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Limitation of Profile Models
• They limit decision criteria to just two—risk and return.
Although an array of issues, including safety, quality, and
reliability, can come under the heading of “risk,” the approach
still necessarily limits the decision maker to a small set of
criteria.
• In order to be evaluated in terms of an efficient frontier, some
value must be attached to risk. Expected return is a measure
that is naturally given to numerical estimate. But because risk
may not be readily quantified, it may be misleading to
designate “risk” artificially as a value for comparison among
project choices.
8
Financial Models
Based on the time value of money principal
• Payback period
• Net present value
• Internal rate of return
• Options models
All of these models use discounted cash flows.
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Payback Period
●
The intent of project payback period is to estimate the amount of time
that will be necessary to recover the investment in a project; that is,
how long it will take for the project to pay back its initial budget and
begin to generate positive cash flow for the company.
●
In determining payback period for a project, we must employ a
discounted cash flow analysis, based on the principal of the time
value of money.
●
Determines how long it takes for a project to reach a breakeven point.
●
Payback period = investment/annual cash savings
●
Lower numbers are better (faster payback).
●
The goal of the discounted cash flow (DCF) method is to estimate cash
outlays (investment) and expected cash inflows resulting from
investment in a project.
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Payback Period Example
●
A project requires an initial investment of $200,000 and will generate
cash savings of $75,000 each year for the next five years. What is
the payback period?
Year Cash Flow Cumulative Divide the cumulative
amount by the cash
0 - $200,000 - $200,000 flow amount in the
1 $75,000 - $125,000 third year and subtract
from 3 to find out the
2 $75,000 - $50,000 moment the project
breaks even.
3 $75,000 $25,000
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Payback Period Exercise
A company wants to determine which of two project alternatives is the
more attractive investment opportunity, using a payback period approach.
The initial investment cost of the two projects and the expected revenues
are shown in the following table. Which project should we invest in?
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Payback Period Exercise - Solution
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Net Present Value
●
Projects the change in the firm’s stock value if a project is
undertaken.
Higher NPV values are better!
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Net Present Value (contd)
●
k = rate of return
●
p = rate of inflation
●
t = time period
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Net Present Value Example
Should you invest $60,000 in a project that will return $15,000 per
year for five years? You have a minimum return of 8% and expect
inflation to hold steady at 3% over the next five years.
Year Net flow Discount NPV
0 -$60,000 1.0000 -$60,000.00
1 $15,000 0.9009 $13,513.51
2 $15,000 0.8116 $12,174.34
3 $15,000 0.7312 $10,967.87
4 $15,000 0.6587 $9,880.96
The NPV
5 $15,000 0.5935 $8,901.77 column total is
-$4,561.54 negative, so
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don’t invest!
NPV Exercise
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NPV Exercise - Solution
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Internal Rate of Return (IRR)
• What rate of return will this project earn?
– Project must meet some required “hurdle” rate (applied to all
projects under consideration)
– Project must meet a minimum rate of return before it is worthy of
consideration.
– IRR is the discount rate that equates the present values of a
project’s revenue and expense streams.
• E.g. If you put $1,000 in the bank, the bank pays you interest, and one year
later you have $1,042, it is relatively easy to calculate the rate of return is
4.2%. You simply divide the gain of $42 into your original investment of
$1,000.
• Formula 1: IRR is the reciprocal of the payback period formula, i.e. 1 /
(payback period)
• E.g. in the previous example (slide 11), IRR= 1 / 2.67= 37.45%
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Internal Rate of Return
• Formula 2: Higher IRR values are
better!
We will not be using this formula to calculate IRR. We will employ an iterative
process to identify the approximate IRR for the project.
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IRR Iterative Method
Question: Does a project meet the required rate of return?
Answering this question requires four steps:
1. Pick an arbitrary discount rate and use it to determine the net
present value of the stream of cash inflows.
2. Compare the present value of the inflows with the initial
investment; if they are equal, you have found IRR.
3. If the present value is larger (or less than) than the initial
investment, select a higher (or lower) discount rate for the
computation.
4. Determine the present value of the inflows and compare it with
the initial investment. Continue to repeat steps 2–4 until you have
determined the IRR.
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Example 1 -- IRR
A project that costs $40,000 will generate cash flows of $14,000 for the next four
years. You have a rate of return requirement of 17%; does this project meet the
threshold?
Lets try discount rate with a rate of return (k) of 15%
Discount factor = 1 / (1 + k )t where k is the rate of return and t is the time period.
(no inflation is considered here)
With k 15%, the NPV is
Discount less than zero. (No
Year Net flow (k 15%) NPV need to try other k
values), the project
0 -$40,000 1.0000 -$40,000.00 doesn’t meet the 17%
1 $14,000 0.8696 $12,173.91 requirement and
should not be
2 $14,000 0.7561 $10,586.01 considered further.
3 $14,000 0.6575 $9,205.23
4 $14,000 0.5718 $8,004.55
-$30.30 22
IRR – Exercise
Suppose that a project required an initial cash investment of
$5,000 and was expected to generate inflows of $2,500, $2,000,
and $2,000 for the next three years. Further, assume that our
company’s required rate of return for new projects is 10%.
The question is: Is this project worth funding?
We know:
Cash investment = $5,000
Year 1 inflow = $2,500
Year 2 inflow = $2,000
Year 3 inflow = $2,000
Required rate of return = 10%
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IRR Exercise – Solution (1/2)
Compare the present value of the inflows with
the initial investment; if they are equal, you have
found IRR. Not found.
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IRR Exercise – Solution (2/2)
Compare the present value of the inflows with
the initial investment; if they are equal, you have
found IRR. Found.
If the IRR is greater than or equal to the company’s required rate of return, the
project is worth funding.
Here, we found that the IRR is 15% for the project, making it higher than the
required rate of 10% and a good candidate for investment. 25
Options Models
●
E.g Let’s say that a firm has an opportunity to build a power
plant in a developing nation. The investment is particularly
risky: The company may ultimately fail to make a positive
return on its investment and may fail to find a buyer for the
plant if it chooses to abandon the project.
●
Both the NPV and IRR methods fail to account for this very real
possibility—namely, that a firm may not recover the money that
it invests in a project. Clearly, however, many firms must
consider this option when making investment decisions.
●
Options models address:
1. Can the project be postponed?
2. Will future information help decide? 26
Example --Option Models (1/3)
• A construction firm is considering whether or not to upgrade
an existing chemical plant. The initial cost of the upgrade is
$5,000,000, and the company requires a 10% return on its
investment.
• The plant can be upgraded in one year and start earning
revenue the following year.
• The best forecast promises cash flows of $1 million per year,
but should adverse economic and political conditions prevail,
the probability of realizing this amount drops to 40%, with a
60% probability that the investment will yield only $200,000
per year.
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Example --Option Models (2/3)
First we calculate the NPV of the proposed investment as follows:
• Cash Flows = 0.4($1 million) + 0.6($200,000) = $520,000
Because the $520,000 is a perpetuity that begins in Year 1, we divide it
by the discount rate of 10% to determine the value of the perpetuity.
• NPV = - $5,000,000 + ($520,000/0.1)
= - $5,000,000 + $5,200,000
= $200,000
●
According to this calculation, the company should undertake the
project. This recommendation, however, ignores the possibility that
by waiting a year, the firm may gain a better sense of the
political/economic climate in the host country. Thus the firm is
neglecting important information that could be useful in making its
decision.
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Example --Option Models (3/3)
Suppose, for example, that by waiting a year, the company determines
that its investment will have a 50% likelihood (up from the original
projection of 40%) of paying off at the higher value of $1 million per
year.
The NPV for the project would now be:
NPV = 0.5 x [ - $5,000,000 + $1,000,000/0.1]
= 0.5 x [ - $5,000,000 + $10,000,000]
= 0.5 x $5,000,000
= $2,500,000
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Project Selection – Conclusions (1)
• To focus on the method that we use in making selection
decisions.
• Be consistent and objective in considering our alternatives.
• Why consultants keep picking losers?
– Failure to even attempt objectivity in their selection methods.
Proposed projects were often “sacred cows” or the pet ideas
of senior managers that were pushed to the head of the line
or, worse, financially “tweaked” until they yielded satisfactory
conclusions.
– Team members knew in advance that such projects would fail
because the projects had been massaged to the point at
which they seemingly optimized the selection criteria.
• The key lies in being objective about the selection process.
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Project Selection – Conclusions (2)
• A wide variety of selection methods may be appropriate for
specific companies and project circumstances.
• Some projects require sophisticated financial evidence of their
viability. Others may only need to demonstrate no more than an
acceptable profile when compared to other options.
• Selection methods may be appropriate under certain situations.
• E.g Weighted scoring models may be favoured on the grounds
that they offer a more accurate reflection of a firm’s strategic
goals without sacrificing long-term effectiveness for short-term
financial gains. Non-financial criteria should not be excluded from
the decision-modeling process.
• Key lies in a selection algorithm broad enough to encompass
both financial and non-financial considerations.
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