Project Selection Methods – Part 2

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Project selection methods II

This article will cover Benefits Measurement methods in detail.

Benefit measurement methods include comparative methods, scoring models, and cash flow analysis. They are used as project selection tools to determine which project to proceed with or to determine which project among a list of projects should be undertaken.

  • Cost – Benefit Analysis :Already covered
  • Scoring Models
  • Cash flow Analysis Technique

Scoring Models

Another project selection technique in the benefit measurement category is a scoring model, or weighted scoring model. Weighted scoring model is used not only to choose between projects but also to choose between competing bids on outsourced projects. Weighted scoring models are quite simple. The project selection committee decides on the criteria that will be used on the scoring model—for example, profit potential, marketability of the product or service, ability of the company to quickly and easily produce the product or service, and so on. Each of these criteria is assigned a weight depending on its importance to the project committee. More important criteria should carry a higher weight than less important criteria.Then each project is rated on a scale from 1 to 5 (or 1 to 10), with the higher number being the more desirable outcome to the company and the lower number having the opposite effect. This rating is then multiplied by the weight of the criteria factor and added to other weighted criteria scores for a total weighted score. Table 1.1 shows an example that brings this together.

Criteria Weight Project A Score Project A Total Project B Score Project B Total Project C Score Project C Total
Task 1

4

6

24

5

20

3

12
Task 2

3

7

21

4

12

5

15
Task 3

5

3

15

6

30

6

30
Task 4

1

5

5

7

7

5

5
Total

 

 

65

 

69

 

62

In this example, Project B is the obvious choice.

Cash flow Analysis Technique

This technique involve a variety of cash flow analysis techniques, including payback period, discounted cash flows, net present value (NPV), and internal rate of return (IRR). We’ll look at each of these techniques individually.

Payback Period

The payback period is the length of time it takes the company to recoup the initial costs of producing the product, service, or result of the project. This method compares the initial investment to the cash inflows expected over the life of the product or service. For example, say the initial investment on a project is Rs 20 Lac, with expected cash inflows of Rs 2.5 Lac per quarter every quarter for the first two years and Rs 5 Lac per quarter from then on. The payback period is two years and can be calculated as follows:

Initial investment = Rs 20 Lac
Cash inflows = Rs 2.5 Lac * 4 (quarters in a year) = Rs 10 Lac per year total inflow
Initial investment (Rs 2.5 Lac) – year 1 inflows (Rs 10 Lac) = Rs 10 Lac remaining balance
Year 1 inflows remaining balance – Year 2 inflows
Rs 10 Lac – Rs 10 Lac = Rs 0
Total cash flow year 1 and year 2 = Rs 20 Lac

The payback is reached in 2 years.

The payback period is the least precise of all the cash flow calculations. That’s because the payback period does not consider the value of the cash inflows made in later years, commonly called the time value of money. For example, if you have a project with a five-year payback period, the cash inflows in year 5 are worth less than they are if you received them today. The next section will explain this idea more fully.

Discounted Cash Flows

As stated above, money received in the future is worth less than money received today.

The reason for that is the time value of money. If I borrowed Rs 25,000 from my friend today and promised to pay it back in three years, he would expect me to pay interest in addition to the original amount borrowed. As he was a close friend, maybe he wouldn’t, but generally this is the way it works. He would have saved this amount of the Rs 25,000 had he not lent it to me. If he had invested it, he’d receive a return on it. Therefore, the future value of the Rs 25,000 he lent me today is Rs 29,775.4 in 3 years from now at 6 percent interest per year. Here’s the formula for future value calculations:

FV = PV*(1 + i) ^n 

FV=Rs 25,000 * (1+6/100) ^3= Rs 29,775.4

The discounted cash flow technique compares the value of the future cash flows of the project to today’s currency.

Example

Project A is expected to make Rs 80 Lac in two years.
Project B is expected to make Rs1.5 Cr in three years.
If the cost of capital is 11 percent, which project should you choose?
Using the PV formula used previously, calculate each project’s worth:
The PV of Project A = Rs 64.9 Lac
The PV of Project B = Rs 1.09 Cr
Project B is the project that will return the higher investment to the company and should be chosen over Project A.

Net Present Value (NPV)

Projects might begin with a company investing some amount of money into the project to complete and accomplish its goals. In return, the company expects to receive revenues, or cash inflows, from the resulting project.NPV allow you to calculate an accurate value for the project in today’s currency. The mathematical formula for NPV is complicated, and there is no need to memorize it for the exam. However, you do not need to know how to calculate NPV. With NPV, you evaluate the cash inflows using the discounted cash flow technique applied to each period the inflows are expected instead of in one sum. The total present value of the cash flows is then deducted from your initial investment to determine NPV. NPV assumes that cash inflows are reinvested at the cost of capital.

If there are 2 Projects in your selection list,

  • Project A with NPV Rs 400K and duration 5 years
  • Project B with NPV Rs 250K and duration 4 years

Project A has an NPV greater than Project B should be accepted. When you get a positive value for NPV, it means that the project will earn a return at least equal to or greater than the cost of capital.

Rule: If the NPV calculation is greater than zero, accept the project. If the NPV calculation is less than zero, reject the project.

Internal Rate of Return

The internal rate of return (IRR) is the most difficult equation to calculate of all the cash flow techniques discussed so far. It is a complicated formula and should be performed on a financial calculator or computer. IRR can be figured manually, but it’s a trial-and-error approach to get to the answer.

For the exam, you need to know three facts concerning IRR:

  • IRR is the discount rate when NPV equals zero.
  • IRR assumes that cash inflows are reinvested at the IRR value.
  • You should choose projects with the highest IRR value.

A Real World Example

Amusement  Vacation Resorts

Raj is a project manager for Amusement Vacation Resorts. He is working on four different project proposals to present to the executive steering committee for review. Raj visits the various resorts as a guest, for information gathering.
This gives him a feel for what guests experience on their vacations, and it helped him to prepare the project particulars and alternatives.
Raj prepares the project overviews for 4 projects and called upon the experts in Marketing to help him out with the projected revenue figures. He works up the numbers and finds the following:

  • Project A: payback period = 5 years; IRR = 8 percent
  • Project B: payback period = 3 years; IRR = 4 percent
  • Project C: payback period = 2 years; IRR = 5 percent
  • Project D: payback period = 4 years; IRR = 3 percent

Funding exists for only one of the projects. Raj recommends Project A and predicts this is the project the steering committee will choose since the projects are mutually exclusive.

Raj’s turn to present comes up at the steering committee. Let’s listen in on the action:

“Beside all the benefits I’ve just described, Project A provides an IRR of 8 percent, more than 3 percent higher than the other projects we discussed. I recommend the committee to choose Project A.”

“Thank you Raj,” Cathy says. “Good presentation.” Cathy is the executive chairperson of the steering committee and has the authority to make final decisions when the committee can’t seem to agree.

Bennie senior member of committee says “I do agree that an 8 percent IRR is a terrific return, but the payback is just too far out into the future. There are too many risks and unknowns for us to take on a project with a payback period this long.

As you know, our industry is directly impacted by the health of the economy. Anything can happen in five years’ time. I think we’re much better off going with Project C. I recommend we accept Project C. Committee members; do you have anything to add?”

Questions & Answers

  1. You are the project manager of North zone for Informatics, India. You’re considering recommending a project that costs Rs 450,000; expected inflows are Rs 25,000 per quarter for the first two years and then Rs 50,000 per quarter thereafter. What is the payback period?
    • A. 42 months
    • B. 40 months
    • C. 39 months
    • D. 38 months

    Correct Answer: C. Year 1 and 2 inflows are each Rs100,000 for a total of Rs 200,000. Year 3 inflows are an additional Rs 200,000. Add one more quarter to this total, and the Rs 450,000 is reached in three years and three months, or 39 months.

  2. Which of the following is true regarding IRR?
    • A. IRR assumes reinvestment at the cost of capital.
    • B. IRR is not difficult to calculate.
    • C. IRR is a constrained optimization method.
    • D. IRR is the discount rate when NPV is equal to zero.

    Correct Answer: D. IRR assumes reinvestment at the IRR rate and is the discount rate when NPV is equal to zero.

  3. Which of the following is true?
    • A. Discounted cash flow analysis is the least precise of the cash flow techniques because it does not consider the time value of money.
    • B. NPV is the least precise of the cash flow analysis techniques because it assumes reinvestment at the discount rate.
    • C. Payback period is the least precise of the cash flow analysis techniques because it does not consider the time value of money.
    • D. IRR is the least precise of the cash flow analysis techniques because it assumes reinvestment at the cost of capital.

    Correct Answer: C. Payback period does not consider the time value of money and is therefore the least precise of all the cash flow analysis techniques.

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About Aditi Malhotra

Aditi Malhotra is the Content Marketing Manager at Whizlabs. Having a Master in Journalism and Mass Communication, she helps businesses stop playing around with Content Marketing and start seeing tangible ROI. A writer by day and a reader by night, she is a fine blend of both reality and fantasy. Apart from her professional commitments, she is also endearing to publish a book authored by her very soon.

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