Transcript Engineering Economics

Project Selection Models
Nadeem Kureshi
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 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
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Models abstract the relevant issues about a problem
from the plethora 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.
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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
1. Realism
2. Capability
3. Flexibility
4. Ease of use
5. Cost
6. Easy computerization
Numeric and Non-Numeric Models
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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:
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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
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Nonnumeric models are older and simpler and
have only a few subtypes to consider.
The Sacred Cow
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Suggested by a senior and powerful official in the
organization. Often initiated with a simple comment
such as, “If you have a chance, why don’t 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 firm’s 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
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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
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The decision to undertake the project based on
a desire to maintain the company’s 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.
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The Product Line Extension
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A project to develop and distribute new products
judged on the degree to which it fits the firm’s 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.
Comparative Benefit Model
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Organization has many projects to consider but the
projects do not seem to be easily comparable. For
example, some projects concern potential new
products, some concern changes in production
methods, others concern computerization of certain
records, and still others cover a variety of subjects not
easily categorized (e.g., a proposal to create a daycare
center for employees with small children).
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No precise way to define or measure “benefit.”
Q-Sort Method
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Of the several techniques for ordering projects, the QSort is one of the most straightforward.
First, the projects are divided into three groups—good,
fair, and poor—according 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
Numeric Models: Profit/Profitability
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A large majority of all firms using project
evaluation and selection models use profitability
as the sole measure of acceptability.
Models
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Present & Future Value
Benefit / Cost Ratio
Payback period
Internal Rate of Return
Annual Value
Variations of IRR
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.
In this context, the discount rate equals the minimum rate of return
for the investment
Where:
NPV = ∑ Present Value (Cash Benefits) - ∑ Present Value (Cash Costs)
Present Value Example
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Initial Investment:
Project Life:
Salvage Value:
Annual Receipts:
Annual Disbursements:
Annual Discount Rate:
$100,000
10 years
$ 20,000
$ 40,000
$ 22,000
12%, 18%
What is the net present value for this project?
Is the project an acceptable investment?
Present Value Example Solution
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Annual Receipts
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$ 226,000
Salvage Value
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$40,000(P/A, 12%, 10)
$20,000(P/F, 12%, 10)
$ 6,440
Annual Disbursements
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$22,000(P/A, 12%, 10)
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Initial Investment (t=0)
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Net Present Value
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-$124,000
-$100,000
$ 8,140
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
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Initial Investment:
Project Life:
Salvage Value:
Annual Receipts:
Annual Disbursements:
Annual Discount Rate:
$100,000
10 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
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Annual Receipts
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$ 20,000
$22,000(F/A, 12%, 10)
-$386,078
Initial Investment
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$20,000(year 10)
Annual Disbursements
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$ 701,960
Salvage Value
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$40,000(F/A, 12%, 10)
$100,000(F/P, 12%, 10)
Net Future Value
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-$310,600
$ 25,280
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
PV of $ 25,282
$25,282(P/F, 12%, 10)
FV of $ 8,140
$8,140(F/P, 12%, 10)
$ 8,140
$ 25,280
Annual Value
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Sometimes it is more convenient to evaluate a
project in terms of its annual value or cost. For
example it may be easier to evaluate specific
components of an investment or individual
pieces of equipment based upon their annual
costs as the data may be more readily available
for analysis.
Annual Analysis Example
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A new piece of equipment is being evaluated for
purchase which will generate annual benefits in the
amount of $10,000 for a 10 year period, with annual
costs of $5,000. The initial cost of the machine is
$40,000 and the expected salvage is $2,000 at the end
of 10 years. What is the net annual worth if interest on
invested capital is 10%?
Annual Example Solution
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Benefits:
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$
125
$5,000 per year
-$ 5,000
Investment:
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$2,000(P/F, 10%, 10)(A/P, 10%,10)
Costs:
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$10,000
Salvage
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$10,000 per year
$40,000(A/P, 10%, 10)
Net Annual Value
-$ 6,508
-$1,383
Since this is less than zero, the project is expected to earn less than the acceptable rate of 10%,
therefore the project should be rejected.
Benefit/Cost Ratio
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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
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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
1
Alternative A
(45,000) 10,500
a
2
11,500
3
8
9
10
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
Annual Net Cash Flows
4
5
6
7
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
1
2
3
Alternative A
(120)
10
10
50
Annual Net Cash Flows
4
5
6
7
9
10
50
50
50
50
50
50
End of Year Cummulative Net Cash Flow
(120) (110) (100) (50)
0
50
100
150
200
250
300
Pay Back Period
Fraction of First Positive Year
Pay Back Period
50
8
1.00
4.00
Example:
Calculate the payback period for the following
investment proposal
Initial
Investment
1
2
3
Alternative A
(120)
10
10
50
Annual Net Cash Flows
4
5
6
7
9
10
50
50
50
50
50
50
End of Year Cummulative Net Cash Flow
(120) (110) (100) (50)
0
50
100
150
200
250
300
Pay Back Period
Fraction of First Positive Year
Pay Back Period
50
8
1.00
4.00
Example:
Calculate the payback period for the following
investment proposal
Initial
Investment
1
2
3
Alternative A
(120)
10
10
50
Annual Net Cash Flows
4
5
6
7
9
10
50
50
50
50
50
50
End of Year Cummulative Net Cash Flow
(120) (110) (100) (50)
0
50
100
150
200
250
300
Pay Back Period
Fraction of First Positive Year
Pay Back Period
50
8
1.00
4.00
Example:
Calculate the payback period for the following
investment proposal
Initial
Investment
1
2
3
Alternative A
(250)
86
50
77
Annual Net Cash Flows
4
5
6
7
9
10
41
70
127
24
6
40
End of Year Cummulative Net Cash Flow
(250) (164) (115) (38) 14
55
124
252
276
282
322
Pay Back Period
Fraction of First Positive Year
Pay Back Period
52
8
0.73
3.73
Example:
Calculate the payback period for the following
investment proposal
Initial
Investment
1
2
3
Alternative A
(250)
86
50
77
Annual Net Cash Flows
4
5
6
7
9
10
41
70
127
24
6
40
End of Year Cummulative Net Cash Flow
(250) (164) (115) (38) 14
55
124
252
276
282
322
Pay Back Period
Fraction of First Positive Year
Pay Back Period
52
8
0.73
3.73
Example:
Calculate the payback period for the following
investment proposal
Initial
Investment
1
2
3
Alternative A
(250)
86
50
77
Annual Net Cash Flows
4
5
6
7
9
10
41
70
127
24
6
40
End of Year Cummulative Net Cash Flow
(250) (164) (115) (38) 14
55
124
252
276
282
322
Pay Back Period
Fraction of First Positive Year
Pay Back Period
52
8
0.73
3.73
IRR & Discount Rates
Internal Rate of Return
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Internal Rate of Return refers to the interest rate that the investor
will receive on the investment principal
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IRR is defined as that interest rate (r) which equates the sum of the
present value of cash inflows with the sum of the present value of
cash outflows for a project. This is the same as defining the IRR as
that rate which satisfies each of the following expressions:
∑ PV cash inflows - ∑ PV cash outflows = 0
NPV = 0 for r
∑ PV cash inflows = ∑ PV cash outflows
In general, the calculation procedure involves a trial-and-error solution. The following
examples illustrate the calculation procedures for determining the internal rate of return.
Example
Given an investment project having the following annual cash flows; find the IRR.
Year
Cash Flow
0
(30.0)
1
(1.0)
2
5.0
3
5.5
4
4.0
5
6
7
8
9
17.0
20.0
20.0
(2.0)
10.0
Solution:
Step 1. Pick an interest rate and solve for the NPV. Try r =15%
NPV
= -30(1.0) -1(P/F,1,15%) + 5(P/F,2,15) + 5.5(P/F,3,15) + 4(P/F,4,15)
+ 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15)
= + $5.62
Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a higher interest
rate in order to reduce the NPV value.
Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.
Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%
IRR using Excel
Using Excel you should insert the following function in the
targeted cell C6:
Analysis
The acceptance or rejection of a project based on
the IRR criterion is made by comparing the
calculated rate with the required rate of return, or
cutoff rate established by the firm. If the IRR
exceeds the required rate the project should be
accepted; if not, it should be rejected.
If the required rate of return is the return investors
expect the organization to earn on new projects,
then accepting a project with an IRR greater than the
required rate should result in an increase of the
firms value.
Analysis
There are several reasons for the widespread popularity of
the IRR as an evaluation criterion:
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Perhaps the primary advantage offered by the
technique is that it provides a single figure which
can be used as a measure of project value.
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Furthermore, IRR is expressed as a percentage
value. Most managers and engineers prefer to think
of economic decisions in terms of percentages as
compared with absolute values provided by
present, future, and annual value calculations.
Analysis
Another advantage offered by the IRR method is related
to the calculation procedure itself:
As its name suggests, the IRR is determined internally
for each project and is a function of the magnitude and
timing of the cash flows.
Some evaluators find this superior to selecting a rate prior
to calculation of the criterion, such as in the profitability
index and the present, future, and annual value
determinations. In other words, the IRR eliminates the
need to have an external interest rate supplied for
calculation purposes.
Selecting a Discount Rate
“There is nothing so disastrous as a rational investment policy in an irrational
world” John Maynard Keynes
We have discussed the time value of money and illustrated several
examples of its use. In all cases an interest rate or “discount rate” is
used to bring the future cash flows to the present (NPV - Net
Present Value)
The selection of the appropriate discount rate has been the source
of considerable debate and much disagreement. In most
companies, the selection of the discount rate is determined by the
accounting department or the board of directors and the engineer
just uses the number provided to him, but short of just being
provided with a rate, what is the correct or appropriate rate to use?
Example
What is the impact of the discount rate on the investment?
Cash
Cash
Cash
Cash
Cash Flow Cash
Flow Yr 0 Flow Yr 1 Flow Yr 2 Flow Yr 3 Yr 4
Flow Yr 5
-500
IRR
-500
+750
+600
+800
ROR
NPV
2%
1,941
6%
1,581
10%
1,283
15%
981
20%
739
47.82%
0
+1000
Real Option Model
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Recently, a project selection model was developed based on a
notion well known in financial markets. When one invests, one
foregoes the value of alternative future investments. Economists
refer to the value of an opportunity foregone as the
“opportunity cost” of the investment made.
The argument is that a project may have greater net present value
if delayed to the future. If the investment can be delayed, its cost
is discounted compared to a present investment of the same
amount. Further, if the investment in a project is delayed, its
value may increase (or decrease) with the passage of time
because some of the uncertainties will be reduced.
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If the value of the project drops, it may fail the selection process.
If the value increases, the investor gets a higher payoff.
The real options approach acts to reduce both technological and
commercial risk.
Numeric Models: Scoring
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In an attempt to overcome some of the
disadvantages of profitability models,
particularly their focus on a single decision
criterion, a number of evaluation/selection
models hat use multiple criteria to evaluate a
project have been developed. Such models vary
widely in their complexity and information
requirements. The examples discussed illustrate
some of the different types of numeric scoring
models.
Some factors to consider
Unweighted 0–1 Factor Model
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A set of relevant factors is selected by management and then
usually listed in a preprinted form. One or more raters score the
project on each factor, depending on whether or not it qualifies
for an individual criterion.
The raters are chosen by senior managers, for the most part
from the rolls of senior management.
The criteria for choice are:
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(1) a clear understanding of organizational goals
(2) a good knowledge of the firm’s potential project portfolio.
Next slide: The columns are summed, projects with a sufficient
number of qualifying factors may be selected.
Advantage: It uses several criteria in the decision process.
Disadvantage: It assumes all criteria are of equal importance and
it allows for no gradation of the degree to which a specific
project meets the various criteria.
Unweighted Factor Scoring Model
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X marks in 0-1
scoring model are
replaced by numbers,
from a 5 point scale.
Weighted Factor Scoring Model
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When numeric weights reflecting the relative importance of each
individual factor are added, we have a weighted factor scoring
model. In general, it takes the form
n
Si   SijWj
j 1
where
Si the total score of the ith project,
Sij the score of the ith project on the jth criterion, and
Wj the weight of the jth criterion.
Constrained Weighted Factor Scoring
Model
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Additional criteria enter the model as constraints rather than weighted
factors. These constraints represent project characteristics that must be
present or absent in order for the project to be acceptable.
We might have specified that we would not undertake any project that
would significantly lower the quality of the final product (visible to the
buyer or not).
We would amend the weighted scoring model to take the form:
n
v
j 1
k 1
Si   SijWj Cik
where Cik 1 if the i th project satisfies the Kth constraint, and 0 if it does not.
Example: P & G practice
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Would not consider a project to add a new consumer
product or product line:
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that cannot be marketed nationally;
that cannot be distributed through mass outlets (grocery
stores, drugstores);
that will not generate gross revenues in excess of $—million;
for which Procter & Gamble’s potential market share is not at
least 50 percent;
and that does not utilize Procter & Gamble’s scientific
expertise, manufacturing expertise, advertising expertise, or
packaging and distribution expertise.
Final Thought
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Selecting the type of model to aid the
evaluation/selection process depends on the
philosophy and wishes of management.
Weighted scoring models preferred for three
fundamental reasons.
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they allow the multiple objectives of all organizations to be
reflected in the important decision about which projects will
be supported and which will be rejected.
scoring models are easily adapted to changes in managerial
philosophy or changes in the environment.
they do not suffer from the bias toward the short run that is
inherent in profitability models that discount future cash
flows.
ACTIVITY
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Exercise – Project Selection
Approximate Time: 30 minutes