Project Selection Models

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. The proper choice of investment projects is crucial to the long-run survival of every firm. Daily we witness the results of both good and bad investment choices.

Decision Models

Models abstract the relevant issues about a problem from the Heap of detail in which the problem is embedded. Reality is far too complex to deal with in its entirety. This process of carving away the unwanted reality from the bones of a problem is called modeling the problem. The idealized version of the problem that results is called a model.

Models may be quite simple to understand, or they may be extremely complex. In general, introducing more reality into a model tends to make the model more difficult to manipulate.

Criteria for Project Selection Model

Realism (technical-, resource-, market-risk) Capability (adequately sophisticated) Flexibility (valid results over large domain) Ease of Use (no expert needed to run model) Cost (much less than project benefit) Easy Computerization (use standard software)

Numeric and Non-Numeric Models

Both widely used, Many organizations use both at the same time, or they use models that are combinations of the two. Nonnumeric models, as the name implies, do not use numbers as inputs. Numeric models do, but the criteria being measured may be either objective or subjective. It is important to remember that:

the qualities of a project may be represented by numbers, and that subjective measures are not necessarily less useful or reliable than objective measures.

Nonnumeric Models

Nonnumeric models are older and simpler and have only a few subtypes to consider.

The Sacred Cow

Suggested by a senior and powerful official in the

organization. Often initiated with a simple comment such as, If you have a chance, why dont you look into . . ., and there follows an undeveloped idea for a new product, for the development of a new market, for the design and adoption of a global data base and information system, or for some other project requiring an investment of the firms resources. Sacred in the sense that it will be maintained until successfully concluded, or until the boss, personally, recognizes the idea as a failure and terminates it.

The Operating Necessity

If a flood is threatening the plant, a project to build a protective dike does not require much formal evaluation, which is an example of this scenario. If the project is required in order to keep the system operating, the primary question becomes: Is the system worth saving at the estimated cost of the project?

The Competitive Necessity

The decision to undertake the project based on a desire to maintain the companys competitive position in that market.
Investment in an operating necessity project takes precedence over a competitive necessity project Both types of projects may bypass the more careful numeric analysis used for projects deemed to be less urgent or less important to the survival of the firm.

The Product Line Extension

A project to develop and distribute new products judged on the degree to which it fits the firms existing product line, fills a gap, strengthens a weak link, or extends the line in a new, desirable direction. Sometimes careful calculations of profitability are not required. Decision makers can act on their beliefs about what will be the likely impact on the total system performance if the new product is added to the line.

Q-Sort Method

Of the several techniques for ordering projects, the QSort is one of the most straightforward. First, the projects are divided into three groupsgood, 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.

The Q-Sort Method

The Q-Sort Method

1. Is a genuinely dependable and responsible person. 2. Is a talkative individual. 3. Behaves in a sympathetic or considerate manner. 4. Feels a lack of personal meaning in life. 5. Regards self as physically attractive. 6. Is calm, relaxed in manner. 7. Over-reactive to minor frustrations; irritable. 8. Keeps people at a distance; avoids close interpersonal relationships. 9. Is basically distrustful of people in general; 10. Is unpredictable and changeable in behavior and attitudes. 11. Is concerned with philosophical problems; e.g., religions, values, the meaning of life, 12. Behaves in a masculine/feminine style and manner

Numeric Models: Profit/Profitability

A large majority of all firms using project evaluation and selection models use profitability as the sole measure of acceptability.

Models
Present & Future Value Benefit / Cost Ratio Payback period Internal Rate of Return

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
+/- Cash Flows

Net Present Value (NPV)

The Net Present Value of an investment it is simply the difference
between cash outflows and cash inflows on a present value basis.

NPV = Present Value (Cash Benefits) - Present Value (Cash Costs)

Present Value Example

Initial Investment: Project Life: Salvage Value: Annual Receipts: Annual Disbursements: Annual Discount Rate:

$100,000 3 years $ 20,000 $ 40,000 $ 22,000 12%,

What is the net present value for this project? Is the project an acceptable investment?

Present Value Example Solution

Future value F=p(1+r)n P = F/(1+r)n Net Present Value

Greater than zero, therefore acceptable project

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
+/- Cash Flows

Future Value Example

Initial Investment: Project Life: Salvage Value: Annual Receipts: Annual Disbursements: Annual Discount Rate:

$100,000 3 years $ 20,000 $ 40,000 $ 22,000 12%, 18%

What is the net future value for this project? Is the project an acceptable investment?

Future Value Example Solution

Net Future Value

Positive value, therefore acceptable project Can be used to compare with future value of other projects

PV/FV
No theoretical difference if project is evaluated in present or future value

Benefit/Cost Ratio

The benefit/cost ratio is also called the profitability index and is defined as the ratio of the sum of the present value of future benefits to the sum of the present value of the future capital expenditures and costs.

B/C Ratio Example

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 Annual Net Cash Flows 4 5 6 7

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

End of Year Cummulative Net Cash Flow (45,000) (34,500) (23,000) (10,500) Pay Back Period Fraction of First Positive Year Pay Back Period

3,000 16,500 30,000 43,500 57,000 70,500 84,000 b 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 Alternative A (120) Annual Net Cash Flows 4 5 6 7

10

10

10

50

50

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow (120) (110) (100) (50) 0 50 Pay Back Period Fraction of First Positive Year Pay Back Period

100

150

200

250

300

1.00 4.00

Example:
Calculate the payback period for the following investment proposal
Initial Investment Alternative A (120) Annual Net Cash Flows 4 5 6 7

10

10

10

50

50

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow (120) (110) (100) (50) 0 50 Pay Back Period Fraction of First Positive Year Pay Back Period

100

150

200

250

300

1.00 4.00

Example:
Calculate the payback period for the following investment proposal
Initial Investment Alternative A (120) 1 2 3 Annual Net Cash Flows 4 5 6 7 8 9 10

10

10

50

50

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow (120) (110) (100) (50) 0 50 Pay Back Period Fraction of First Positive Year Pay Back Period

100

150

200

250

300

1.00 4.00

Example:
Calculate the payback period for the following investment proposal
Initial Investment Alternative A (250) 1 2 3 Annual Net Cash Flows 4 5 6 7 8 9 10

86

50

77

52

41

70

127

24

40

End of Year Cummulative Net Cash Flow (250) (164) (115) (38) 14 55 Pay Back Period Fraction of First Positive Year Pay Back Period

124

252

276

282

322

0.73 3.73

Example:
Calculate the payback period for the following investment proposal
Initial Investment Alternative A (250) 1 2 3 Annual Net Cash Flows 4 5 6 7 8 9 10

86

50

77

52

41

70

127

24

40

End of Year Cummulative Net Cash Flow (250) (164) (115) (38) 14 55 Pay Back Period Fraction of First Positive Year Pay Back Period

124

252

276

282

322

0.73 3.73

Example:
Calculate the payback period for the following investment proposal
Initial Investment Alternative A (250) 1 2 3 Annual Net Cash Flows 4 5 6 7 8 9 10

86

50

77

52

41

70

127

24

40

End of Year Cummulative Net Cash Flow (250) (164) (115) (38) 14 55 Pay Back Period Fraction of First Positive Year Pay Back Period

124

252

276

282

322

0.73 3.73