lecture 5 project analysis and selection

8/8/2019 Lecture 5 Project Analysis and Selection

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Chapter

Project Management: A Managerial Approach 4/e

By Jack R. Meredith and Samuel J. Mantel, Jr.

And any Financial Management Book

1

Lecture 5: Project Analysis& Selection


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Project Selection

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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 achievedManagers 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 problems structure and can beuseful in selecting and evaluating projects


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Criteria for Project SelectionModels

3

Realism - reality of managers decision

Capability- able to simulate different scenarios and optimize the

decision

Flexibility - provide valid results within the range of conditionsEase 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 SelectionModels

4

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

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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 competitiveposition

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

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The process of determining whether or notprojects such as building a new plant orinvesting in a long-term venture areworthwhile.

Capital budgeting involves planningexpenditure for assets, the return fromwhich will be realised in future periods.

There are two fundamental types ofdecisions:Investment selectionFinancing investment


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Investment Selection

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Expansion decisions (new plant,building, machinery etc)Replacement decisions (replacement of

existing equipment or facilities)

Seed investment decisions (research& development, advertisement, marketingresearch, training, professional consultingservices)Operating investment decisions

(inventories, account receivables,development of new product line)


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Financing Investment

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The amount and kind (debt or equity) offinancial capital to be raised

The amount of dividends to be paid to theowners and the amount of earnings to beretained in the corporation and invested ontheir behalf.


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Capital Budgeting Process

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External:

Capital Markets

Internal:

Accumulated Earnings

Dividends and

Interest paid

Capital Expenditures

Selected (rate of return

on Investment)

(explicit cost) (opportunity cost)

Cost of Capital

(immediater

etu

rn)

(future

return)

SOURCES OF CAPITAL

THE FIRM


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Capital Budgeting ConceptsCapital Budgeting ConceptsCapital Budgeting ConceptsCapital Budgeting Concepts

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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 Budgetings place inFinance

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Project A

Sources of Funds:

Equity (Stocks)

Debt (Bonds)

Retained Earnings

$

Proceeds fromProceeds from

Projects repayProjects repay

InvestorsInvestors


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Payback Period Calculation

Calculated as:

For example, if a project cost $100,000and was expected to return $20,000

annually, the payback period would be$100,000 / $20,000, or 5 years.

InflowsCashAnnual

ProjectofCost=PeriodPayback

14


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Payback Period: Uneven CashFlows

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To compute payback period, keep adding the cashflows 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

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Is a 3.33 year payback period good?Is it acceptable?

Firms that use this method will comparethe payback calculation to some standardset by the firm.

If our senior management had set a cut-

off of5 years for projects like ours, whatwould be our decision?

Accept the project.


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Drawbacks of PaybackPeriod:

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Firm cutoffs are subjective.Does not consider time value of money.

Does not consider any required rate ofreturn.

Does not consider all of the projects cashflows.


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Payback Pros & Cons

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ProsSimple to understand

Decent measure of Liquidity

Probably related to risk

ConsWhat 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

Payback is a usefulmeasure. But it should

not be the single

criteria to select projects


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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 ofcash outflows. NPV is used to analyze the profitability of aninvestment or project.

NPV analysis is sensitive to the reliability of future cashinflows that an investment or project will yield.

Formula:

NPV compares the value of a dollar today versus the value ofthat same dollar in the future, after taking inflation and

return into account.

If the NPV of a prospective project is positive, then it shouldbe accepted. However, if it is negative, then the projectprobably should be rejected because cash flows arenegative.

0

1 )1(C

rCNPV

n

tt

t +

==

19


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Net Present Value

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Present Value of all costs and benefits of aproject.

Concept is similar to Intrinsic Value of asecurity but subtracts of cost of project.

NPV = PV of Inflows - Initial Outlay

NPV = + + ++ IOCF1

(1+ k)

CF2

(1+ k)2

CF3

(1+ k)3

CFn

(1+ k)n

CFn = Cash flow at time n

k = required rate of return

IO = Initial Investment


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NPV Decision Rules

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ACCEPT B only If projects areIf projects are mutuallymutually

exclusiveexclusive, accept project, accept projectwith higher NPV.with higher NPV.

ACCEPT A & B If projects areIf projects areindependent then acceptindependent then accept

all projects with NPVall projects with NPV 0.0.

Mutually Exclusive:

Means that the acceptanceof 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

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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

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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 theinterest rate that makes net present valueof all cash flow equal zero.

Essentially, this is the return that acompany would earn if they expanded orinvested in themselves, rather than


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Internal Rate of Return

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Determine the mathematical solution for IRR

Internal Rate of ReturnInternal Rate of Return

0 = NPV= + ++ IOCF1

(1+ IRR)

CF2

(1+ IRR)2

CFn

(1+ IRR)n

IO= + ++CF1

(1+ IRR)

CF2

(1+ IRR)2

CFn

(1+ IRR)n

Outflow = PV of Inflows

Solve for Discount Rates


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Decision Rule for Internal Rate ofReturn

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Independent Projects

Accept Projects with

IRR required rate

Mutually Exclusive Projects

Accept project with highest

IRR required rate


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IRR: Strengths andWeaknesses

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StrengthsIRR number is easy to interpret: shows the return theproject generates.Acceptance criteria is generally consistent with

shareholder wealth maximization.WeaknessesRequires knowledge of finance to use.Difficult to calculate need financial calculator.

It is possible that there exists no IRR or multiple IRRs fora project and there are several special cases when the IRRanalysis needs to be adjusted in order to make a correctdecision (these problems will be addressed later).


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Profitability Index

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PI = PV of InflowsInitial Outlay

Very Similar to Net Present ValueVery Similar to Net Present Value

Instead of Subtracting the Initial Outlay from the PVInstead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initialof Inflows, the Profitability Index is the ratio of Initial

Outlay to the PV of Inflows.Outlay to the PV of Inflows.

+ + ++CF1(1+ k)

CF2

(1+ k)2

CF3

(1+ k)3

CFn

(1+ k)n

PI =Initial Outlay


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Capital Budgeting MethodsCapital Budgeting Methods

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Profitability Index for Project BProfitability Index for Project B

+ + +500(1+ .1)

500

(1+ .1)24,600

(1+ .1)3

10,000

(1+ .1)4

10,000PI =

PI =11,154

10,000= 1.1154


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Capital Budgeting Methods

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Profitability Index for Project BProfitability Index for Project B P R O J E C TTime A B

0 (10,000.) (10,000.)

1 3,500 500

2 3,500 500

3 3,500 4,600

4 3,500 10,000

+ + +500(1+ .1)

500

(1+ .1)24,600

(1+ .1)3

10,000

(1+ .1)4

10,000PI =

PI = 11,15410,000 = 1.1154

Profitability Index for Project AProfitability Index for Project A

10,000PI =

PI =11,095

10,000

= 1.1095

3,500( )1

.10(1+.10)4

1

.10


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Which technique is superior?

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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 isIRR is a measure of safety margin in a project.

Higher IRR means more safety margin in theprojects estimated cash flows

PI is a measure of cost-benefit analysis. Howmuch NPV for every dollar of initial investment


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Numeric Models: Scoring

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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

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A number of relevant factors are selected and projectsare 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

FactorsFactors Project AProject A Project BProject B

TechnologyTechnology

AvailableAvailable00 11

FinancingFinancingPossiblePossible

11 11

Future GrowthFuture Growth 11 11

Reputation ofReputation of

firmfirm00 11

RatingRating 22 33

34


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Weighted Scoring Model

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A weighted scoring model is a tool that provides asystematic process for selecting projects based on manycriteriaFirst identify criteria important to the project selection processThen assign weights (percentages) to each criterion so they add up

to 100%Then assign scores to each criterion for each projectMultiply the scores by the weights and get the total weighted scores

The higher the weighted score, the better

Sample Weighted Scoring Model for


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Sample Weighted Scoring Model forProject Selection

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Risk Versus Uncertainty

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Analysis Under Uncertainty - The Management ofRiskThe difference between risk and uncertaintyRisk- when the decision maker knows the probability of each

and every state of nature and thus each and every outcome. Anexpected 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

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Principal contribution of risk analysis is to focus theattention 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 indetermining the desirability of an investment project


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I f ti B f


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Information Base forSelections

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Accounting Data

MeasurementsSubjective vs. Objective

Quantitative vs. Qualitative

Reliable vs. Unreliable

Valid vs. Invalid

Technological Shock


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Weighting

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Fac


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Project Scoring

Factors

lecture 5 project analysis and selection

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