Project Selection

EEE 399 -01-MW

Prepared by: Masud Karim

19 October 2020
 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
Nature of Project Selection Models

 2 Basic Types of Models

 Numeric

 Nonnumeric

 Two Critical Facts:

 Models do not make decisions - People do!

 All models, however sophisticated, are only partial

representations of the reality the are meant to reflect

 Nonnumeric Models
 The Sacred Cow In this case the project is suggested by a senior and powerful
official in the organization. Often the project is initiated with a simple comment
such as, “If you have a chance, why don’t you look into…,”
 The Operating Necessity -the project is required in order to keep the system
operating. If a flood is threatening the plant, a project to build a protective wall
does not require much formal evaluation.
 The Competitive Necessity – project is necessary to sustain a competitive
position. Many business schools are restructuring their undergraduate and MBA
programs to stay competitive with the more forward-looking schools.
 The 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 one with the
most benefit to the firm is selected
Numeric Models: Profit/Profitability
 Payback period - initial fixed investment/estimated annual
cash inflows from the project
 Average Rate of Return - average annual profit/average
investment
 Discounted Cash Flow - Present Value Method
 Internal Rate of Return - Finds rate of return that equates
present value of inflows and outflows
 Profitability Index - NPV of all future expected cash
flows/initial cash investment

Chapter 2-5
Numeric Project Selection Model
Payback period
 The payback method is the simplest way of looking at one or more major
project ideas. It tells you how long it will take to earn back the money
you'll spend on the project.

Payback period =
initial fixed investment in the project / estimated annual net cash inflows
 The ratio of these quantities is the number of years required for the
project to repay its initial fixed investment.
 For example, assume a project costs $100,000 to implement and has
annual net cash inflows of $25,000. Then
 Payback period $100,000/$25,000 = 4 years
 Example 1: Payback Period
 Seagull plc has identified that it could make operating cost savings in production
by buying an automatic press. There are two suitable such presses on the market,
the Zenith and the Super. The relevant data relating to each of these are as
follows:
Zenith Super
$ $
Cost (payable immediately) 20,000 23,000
Annual Savings:
Year 1 4000 8000
2 6000 6000
3 6000 5000
4 7000 6000
5 6000 8000
Find out the anticipated payback period of the two machine and which you will
select?
Solution: Example 1-Payback Period
 Payback Period Calculation: Zenith
 Year Initial Invest Cash Inflow Accumulated Inflow Balance
0 -$20,000 0 0 -$20,000
1 $4,000 $4,000 -16,000
2 $6,000 $10000 -10,000
3 $6,000 $16,000 -4,000
4 $7,000 $23,000 +3,000

The final year can be estimated by dividing the remaining balance by the next year
cash inflows.
$4,000/$7,000 = 0.5714 × 12 = 6.857 months = 6 months 26 days
It will take Zenith Press about 3 years and 6 months and 26 days to recover its initial
investment if the cash flow estimates are correct
Solution: Example 1-Payback Period……..continue
 Payback Period Calculation: Super
 Year Initial Invest Cash Inflow Accumulated Inflow Balance
0 -$23,000 0 0 -
$23,000
1 $8,000 $8,000 -15,000
2 $6,000 $14,000 -9,000
3 $5,000 $19,000 -4,000
4 $6,000 $25,000 +2,000
The final year can be estimated by dividing the remaining balance by the next year
cash inflows.
$4,000/$6,000 = 0.6667 × 12 = 8 months
It will take Super Press about 3 years and 8 months to recover its initial investment.
Based on Payback Period Model we will select ZENITH.
 Example 2- Payback Period
In 2019 Consumer Reports listed old Milwaukee beer as the
winner in its taste test. If Old Milwaukee wants to expand
production to take advantage of the increased sales, it will have
to purchase additional facilities. Assume that expansion of its
brewery will cost $1,000,000. This will generate after tax cash
inflows of $235,000 each year but cash inflows will decline 10%
in 2nd year and 15% per year there-after. What is the pay back?
Solution: Example 2-Payback Period
 Year Initial Invest Cash Inflow Accumulated Inflow Balance
0 -$1,000,000 0 0 -$1,000,000
1 $235,000 $235,00 -765,000
2 $211500 $446500 -553,500
3 $179775 $626275 -373725
4 $152808.75 $779083.75 -220916.25
5 $129887.44 $908971.19 -91028.81
6 $110404.32 1019375.51 +19375.51
The final year can be estimated by dividing the remaining balance by the next year
cash inflows.
$91,028.81/$110,404.32 = 0.824 × 12 = 9.89 months
It will take Old Milwaukee about 5 years and 10 months to recover its initial
investment if the cash flow estimates are correct (5 years + 9.89 months).
Advantages of PB
Principal Advantages of Payback Method is its simplicity. It also
provides information about how long funds will be tied up in a project.
The shorter the payback is, the greater the project’s liquidity.

Disadvantages of PB
No clearly defined accept/reject criteria
No risk assessment
Ignores cash flows beyond the payback period
Ignores time value of money
Project Selection Model: Net Present Value - NPV
 The difference between the present value of cash inflows and the present
value of cash outflows. NPV is used to analyze the profitability of an
investment or project.
n
CF
PV =

t 1 (1  i ) t

 PV = Present Value
 CF = Future Cash Flow =FV
 i = Discount Rate
 t = Number of Years

 Equation for NPV is

NPV = PV (Cash inflows) – PV (cash outflows)
The 2nd formula is used if the initial investment is paid over a period of
time.
 NPV at various situations
If... It means... Then….

NPV > 0 the investment would add value to the firm the project
should be accepted

NPV < 0 the investment would subtract value from the firm the project
should be rejected

NPV = 0 the investment would neither gain nor lose value for the firm
the project
could be accepted as shareholders obtain required rate of return. This project
adds no monetary value. Decision should be based on other criteria, e.g. strategic
positioning.
Example 3 :Net Present value Calculation

The owner of a Texaco gas station in Nevada is considering

buying a slot machine to put in his small convenience store.
The slot machine will sell for $6,000 and is expected to bring
in about $10 per day after expenses. Owner believes his cash
flow estimate is conservative. If the cost of capital to the gas
station is 15%, should the slot machine be installed? The
machine is expected to last 3 years before a newer model
will be needed to attract gamblers.
Solution – Example 3
 Example 4 : NPV

X Corporation must decide whether to introduce a new

product line. The new product will have startup costs,
operational costs, and incoming cash flows over six
years. This project will have an immediate (t=0) cash
outflow of $100,000 (which might include machinery, and
employee training costs). Other cash outflows for years 1-
6 are expected to be $5,000 per year. Cash inflows are
expected to be $30,000 per year for years 1-6. All cash
flows are after-tax, and there are no cash flows expected
after year 6. The required rate of return is 10%. Should
you introduce the product?
Solution: Example 4: NPV
Solution: Example 4: NPV ( alternation formula) –PV of an annuity
 Example 5-NPV

Not all investments are made in one lump sum/

Sometimes the initiation of the project takes several
years. For example, the Trans-Alaska Pipeline took
3 years to complete, at a total cost of $5 billion.
Suppose $1 billion was spent the first year, $1
billion the second year, $3 billion the last year
(assume all investmentsa are made at the begining
of the year). If the revenues are expected to be $1
billion per year for 10 years and the discount rate is
15%, should the pipeline have been built (assume
all cash inflows occur at the end of the year)?
Solution :Example 5: NPV
 MCQ-Net Present Value
 A project is expected to result in $2 million in five years. The
current interest rate is 5%. What is the PV of the project?
 A. $1,359,252
B. $1,567,398
C. $1,784,972
D. $2 million

 B. - $1,567,398 – Get those PV & FV formulas on your brain dump.

Again, this is one of those problems that may or may not surface
on your exam. It did for me! (But depreciation didn’t.) Present
Value = FV / [(1 + r)^n], where r is the rate of return and n is the
number of years = $2 million / [(1 + .05)^5].
 MCQ - NPV
 You must select one and only one project to take on for your
company. The net present value (NPV) for each project is as
follows: Project A’s NPV is $10K, Project B’s NPV is $20K, and
Project C’s NPV is $30K.
 A. Project A
B. Project B
C. Project C
D. This problem cannot be solved without knowing the interest
rate for each project.

 Simply pick the greatest value. Easy! –Choice is C.

 Profitability Index (PI)
 An index that attempts to identify the relationship between the costs
and benefits of a proposed project through the use of a ratio
calculated as:

PI = PV of Future Cash flow / Initial Investment

 A ratio of 1.0 is logically the lowest acceptable measure on the index.
Any value lower than 1.0 would indicate that the project's PV is less
than the initial investment. As values on the profitability index
increase, so does the financial attractiveness of the proposed project.
 So, if the profitability index yields a 1.5, an investor can expect to get
a return of $1.50 US Dollar (USD) for each dollar invested.
Alternatively, a profitability index is 0.9, an investor can expect to
get $0.90 USD back for each dollar spent, which results in negative
returns.
 Example :6
 Seagull plc has identified that it could make operating cost savings in production by
buying an automatic press. There are two suitable such presses on the market, the Zenith
and the Super. The relevant data relating to each of these are as follows:
Zenith Super
$ $
Cost (payable immediately) 20,000 23,000
Annual Savings:
Year 1 4000 8000
2 6000 6000
3 6000 5000
4 7000 6000
5 6000 8000
Find out the anticipated payback period of the two machine and which you will select?
Find the NPV of both the machine. Which of these machine be bought if the
borrowing/lending rate cost is 12% p.a.?
Calculate PI of both the machine?
Solution – Example 6
 IRR – Internal Rate of Return
 What discount rate would cause the net present value (NPV) of a
project to be $0.
 NPV = PV ( Inflow) – PV (Outflow)
 If NPV = 0, then
 PV(inflow) =PV(outflow)
 Example 7: IRR
Calculate IRR
Initial Investment: USD 25,000
1st Year Revenue: USD 15000
2nd Year Revenue: USD 13500
Solution Example 7-IRR
Project Selection

Questions?

Chapter 2-17