Lecture 5: Project Analysis

& Selection
Chapter
Project Management: A Managerial Approach 4/e
By Jack R. Meredith and Samuel J. Mantel, Jr.
And any Financial Management Book

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 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
Managers often use decision-aiding models to extract
the relevant issues of a problem from the details in
which the problem is embedded
Models represent the problem’s structure and can be
useful in selecting and evaluating projects

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 Criteria for Project Selection
Models
 Realism - reality of manager’s decision

 Capability- able to simulate different scenarios and optimize the

decision
 Flexibility - provide valid results within the range of conditions

 Ease of Use - reasonably convenient, easy execution, and easily

understood
 Cost - Data gathering and modeling costs should be low relative
to the cost of the project
 Easy Computerization - must be easy and convenient to gather,
store and manipulate data in the model

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 Nature of Project Selection
Models
Two Basic Types of Models
Nonnumeric
Numeric – Capital Budgeting
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

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 Nonnumeric Models
 Sacred Cow - project is suggested by a senior and powerful official in
the organization
 Operating Necessity - the project is required to keep the system
running
 Competitive Necessity - project is necessary to sustain a competitive
position
 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 the
one with the most benefit to the firm is selected

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 Capital Budgeting
The process of determining whether or not
projects such as building a new plant or
investing in a long-term venture are
worthwhile.
Capital budgeting involves planning
expenditure for assets, the return from
which will be realised in future periods.
There are two fundamental types of
decisions:
Investment selection
Financing investment

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 Investment Selection
Expansion decisions (new plant,
building, machinery etc)
Replacement decisions (replacement of
existing equipment or facilities)
‘Seed’ investment decisions (research
& development, advertisement, marketing
research, training, professional consulting
services)
Operating investment decisions
(inventories, account receivables,
development of new product line)

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 Financing Investment
The amount and kind (debt or equity) of
financial capital to be raised
The amount of dividends to be paid to the
owners and the amount of earnings to be
retained in the corporation and invested on
their behalf.

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 Capital Budgeting Process
SOURCES OF CAPITAL

External: Internal:
Capital Markets Accumulated Earnings

(future return)
(explicit cost) (opportunity cost)

Cost of Capital
i(
) nr ut er et ai de mm

Dividends and Capital Expenditures

Interest paid Selected (rate of return
on Investment)
THE FIRM
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 Capital Budgeting Concepts
 Capital Budgeting - deciding which projects to accept.
 Estimate future expected cash flows
 Evaluate project based on evaluation method
 The Ideal Evaluation Method should:
 include all cash flows that occur during the life of the project,
 consider the time value of money,
 incorporate the required rate of return on the project.

 Classify Projects
 Mutually Exclusive - accept ONE project
 Independent - accept ALL profitable projects

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 Capital Budgeting’s place in
Finance
Sources of Funds:
Equity (Stocks)
Debt (Bonds)
Retained Earnings
Proceeds from
Projects repay
Investors

Project A
$

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 Capital Budgeting
Techniques
Payback period
Net Present Value Method
Internal Rate of Return
Profitability Index

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 Payback Period
The length of time required to recover the
cost of an investment.
The number of years it takes including a fraction of the
year to recover initial investment is called payback
period

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Payback Period Calculation
Calculated as:

Cost of Project
Payback Period =
Annual Cash Inflows
For example, if a project cost $100,000
and was expected to return $20,000
annually, the payback period would be
$100,000 / $20,000, or 5 years.

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 Payback Period: Uneven Cash
Flows
To compute payback period, keep adding the cash
flows till the sum equals initial investment
How long will it take for the project to generate
enough cash to pay for itself?

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 Payback Conclusions
Is a 3.33 year payback period good?
Is it acceptable?

Firms that use this method will compare

the payback calculation to some standard
set by the firm.
If our senior management had set a cut-
off of 5 years for projects like ours, what
would be our decision?
Accept the project.

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 Drawbacks of Payback
Period:
Firm cutoffs are subjective.
Does not consider time value of money.
Does not consider any required rate of
return.
Does not consider all of the project’s cash
flows.

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 Payback Pros & Cons
Payback is a useful
Pros measure. But it should
 Simple to understand
not be the single
 Decent measure of “Liquidity”
criteria to select projects
 Probably related to risk

Cons
What is a “Good” or “Bad” Payback
Ignores when cash is received (TVM)
Ignores cash flows after PB period
It is not consistent with wealth maximization

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Net Present Value (NPV)
 An approach used in capital budgeting where the present
value of cash inflows is subtracted by the present value of
cash outflows. NPV is used to analyze the profitability of an
investment or project.
 NPV analysis is sensitive to the reliability of future cash
inflows that an investment or project will yield.
 Formula: n
C
NPV = ∑ t
− C0
t =1 (1 + r ) t

 NPV compares the value of a dollar today versus the value of

that same dollar in the future, after taking inflation and
return into account.

 If the NPV of a prospective project is positive, then it should

be accepted. However, if it is negative, then the project
probably should be rejected because cash flows are
negative.

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 Net Present Value
 Present Value of all costs and benefits of a
project.
 Concept is similar to Intrinsic Value of a
security but subtracts of cost of project.
NPV = PV of Inflows - Initial Outlay

CF1 CF2 CF3 CFn

NPV = (1+ k )
+ (1+ k )2
+ +···+ – IO
(1+ k ) 3
(1+ k ) n

CFn = Cash flow at time n

k = required rate of return
IO = Initial Investment

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 NPV Decision Rules
 If projects are ACCEPT A & B
independent then accept
 all projectsare
If projects with NPV ≥ 0.
mutually ACCEPT B only
exclusive, accept project
with higher NPV.
Mutually Exclusive:
Means that the acceptance
of one project precludes
the acceptance of the other
projects under
consideration. (You may
only choose one.)
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 Another Way to Look at NPV
And allow for financing cash flows
Yearly Cash Flows
Year 0 1 2 3
Investment -100 +10 +60 + 80
Financing +100 -10 -10 -110
Net 0 0 +50 - 30
+ 0 .00
+41.32
-22.54
Net Present Value +18.78

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 Internal Rate of Return

 Measures the rate of return on a project

Definition:
The IRR is the discount rate where NPV = 0

Often used in capital budgeting, it's the

interest rate that makes net present value
of all cash flow equal zero.

Essentially, this is the return that a

company would earn if they expanded or
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invested in themselves, rather than
 Internal Rate of Return
Internal Rate of Return
 Determine the mathematical solution for IRR

CF1 CF2 CFn

0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR ) 2
(1+ IRR ) n

CF1 CF2 CFn

IO = + +···+
(1+ IRR ) (1+ IRR ) 2
(1+ IRR )n

Outflow = PV of Inflows
Solve for Discount Rates

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 Decision Rule for Internal Rate of
Return

Independent Projects
Accept Projects with
IRR ≥ required rate

Mutually Exclusive Projects

Accept project with highest
IRR ≥ required rate

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 IRR: Strengths and
Weaknesses
Strengths
IRR number is easy to interpret: shows the return the
project generates.
Acceptance criteria is generally consistent with
shareholder wealth maximization.
Weaknesses
Requires knowledge of finance to use.
Difficult to calculate – need financial calculator.
It is possible that there exists no IRR or multiple IRRs for
a project and there are several special cases when the IRR
analysis needs to be adjusted in order to make a correct
decision (these problems will be addressed later).
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 Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

CF1 CF2 CF3 CFn

(1+ k )
+ (1+ k )2
+ +···+
(1+ k )3 (1+ k )n
PI =
Initial Outlay
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 Capital Budgeting Methods
Profitability Index for Project B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
PI =
10,000
11,154
PI = = 1.1154
10,000

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 Capital Budgeting Methods
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000

Profitability Index for Project A

1 1
3,500( .10 .10(1+.10) )
4

PI =
10,000
11,095
PI = = 1.1095
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10,000
 Profitability Index Decision Rules

Independent Projects
Accept Project if PI ≥ 1
Mutually Exclusive
Projects
Accept Highest PI ≥ 1
Project
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 Which technique is superior?
Although our decision should be based on NPV,
but each technique contributes in its own way.
Payback period is a rough measure of riskiness.
The longer the payback period, more risky a
project is
IRR is a measure of safety margin in a project.
Higher IRR means more safety margin in the
project’s estimated cash flows
PI is a measure of cost-benefit analysis. How
much NPV for every dollar of initial investment

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 Numeric Models: Scoring

Unweighted 0-1 Factor Model

Unweighted Factor Scoring Model

Weighted Factor Scoring Model

Constrained Weighted Factor Scoring Model

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 Unweighted 0-1 Factor Model
A number of relevant factors are selected and projects
are evaluated against those factors.
0 : Project does not qualify
1 : Project qualify
It helps to integrate projects with organisational
strengths and weaknesses.

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Example
Factors Project A Project B

Technology 0 1
Available
Financing 1 1
Possible
Future Growth 1 1

Reputation of 0 1
firm
Rating 2 3
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 Weighted Scoring Model
 A weighted scoring model is a tool that provides a
systematic process for selecting projects based on many
criteria
 First identify criteria important to the project selection process
 Then assign weights (percentages) to each criterion so they add up
to 100%
 Then assign scores to each criterion for each project
 Multiply the scores by the weights and get the total weighted scores
 The higher the weighted score, the better

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 Sample Weighted Scoring Model for
Project Selection

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 Risk Versus Uncertainty
Analysis Under Uncertainty - The Management of
Risk
The difference between risk and uncertainty
 Risk - when the decision maker knows the probability of each
and every state of nature and thus each and every outcome. An
expected value of each alternative action can be determined
 Uncertainty - when a decision maker has information that is not
complete and therefore cannot determine the expected value of
each alternative

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 Risk Analysis
Principal contribution of risk analysis is to focus the
attention on understanding the nature and extent of the
uncertainty associated with some variables used in a
decision making process
Usually understood to use financial measures in
determining the desirability of an investment project

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 Risk Analysis
Probability distributions are determined or subjectively
estimated for each of the “uncertain” variables
The probability distribution for the rate of return (or
net present value) is then found by simulation
Both the expectation and its variability are important
criteria in the evaluation of a project

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 Information Base for
Selections
Accounting Data
Measurements
Subjective vs. Objective
Quantitative vs. Qualitative
Reliable vs. Unreliable
Valid vs. Invalid
Technological Shock

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 Weighting

Fact
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 Project Scoring

Factors

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