Projects are undertaken for various reasons. Each project should have clear justification and methods defined to show it's 'worth' taking it. Strategic goals of organization, Market Need, Technological Advancement, Competitive Advantage, Profitability, Project/Portfolio Management Office (PMO), and Sponsors are key in project selection.
Below I presented the list of few widely-used project selection methods. Decisions are made based on the best information in hand about a particular project at a given point of time. One can use either Benefit Measurement Methods (Comparative approach) or Constrained Optimization Methods (Mathematical approach) or both to arrive to conclusion on project selection. Out of these two benefit measurement method is most commonly used.
Benefit measurement methods are based on measuring the benefits in taking up the project and comparing the results against other projects or a strategy benchmark. Cost-Benefit Analysis, Scoring Models, Economic Models, Discounted Cash Flow (DCF), Net Present Value (NPV), Internal Rate of Return are different types under Benefit measurement methods.
Constrained optimization methods uses complex mathematical calculation based on different worst/best case scenarios and probability of outcome and then selecting project on best results. Generally known methods are linear programming, nonlinear programming, and multi objective programming.
Also, for the PMP exam, you will need to understand several cost accounting concepts that are frequently used when performing the project-selection process, especially any of the benefit measurement methods. You are not expected to be a cost accountant or even to perform the associated accounting calculations. However, you are expected to understand each of these accounting concepts and to know how to use them during the project-selection activity. Table 2.0 summarizes these accounting concepts and how they relate to project selection.
Table 1.0 Project Selection Accounting Concepts
Accounting Concept | Description | Keys for Project Selection | Notes |
Present value (PV) | Value today of future cash flows. | The higher the PV, the better. | PV= FV/(1+r)n |
Net present value (NPV) | Present value of cash inflow (benefits) minus present value of cash outflow (costs). | A negative NPV is unfavorable. The higher the NPV, the better. | Accounts for different project durations. |
Internal rate of return (IRR) | The interest rate that makes the net present value of all cash flow equal zero. | The higher the IRR, the better. | The return that a company would earn if it invests in the project. |
Payback period | The number of time periods needed to hit the break-even point. | The lower the payback period, the better. |
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Benefit cost ratio (BCR) | A ratio identifying the relationship between the cost and benefits of a proposed project. | A BCR less than 1 is unfavorable. The higher the BCR, the better. |
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Opportunity cost | The difference in return between a chosen investment and one that is passed up. |
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Sunk costs | A cost that has been incurred and cannot be reversed. | This should not be a factor in project decisions. |
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In addition to the accounting concepts directly related to project selection, PMI expects a project manager to understand other accounting concepts. Table 2.0 summarizes these additional accounting concepts.
Table 2.0 Other Relevant Accounting Concepts
Accounting Concept | Description | Notes |
Variable costs | A cost that changes in proportion to a change in a company's activity or business. | Example: fuel. |
Fixed costs | A cost that remains constant, regardless of any change in a company's activity. | Example: lease payment. |
Direct costs | A cost that can be directly traced to producing specific goods or services. | Example: team member salaries. |
Indirect costs | A cost that cannot be directly traced to producing specific goods or services. | Example: insurance, administration, depreciation, and so on. |
Working capital | Current assets minus current liabilities. |
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Straight-line depreciation | A method of depreciation that divides the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used. | This is the simplest method. |
Accelerated depreciation | Any method of depreciation that allows greater deductions in the (DDB) earlier years of the life of an asset. | Double declining balance. |
Lifecycle costing | This includes costs from each phase of a project's or product's lifecycle when total investment costs are calculated. |
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A. Non Discounted Cash Flow Methods
1. Payback method (or Payback Period)
The payback period is the number of years required to return the original investment from the net cash flows (net operating income after taxes plus depreciation).
Example
Assume the firm is considering two projects; project A and project B, each requires an investment of $100 millions. The cost of capital is 10%. Below is the summary of expected net cash flows in millions.
Net Cash Flow Summary
Year | Project A | Project B |
1 | 50 | 10 |
2 | 40 | 20 |
3 | 30 | 30 |
4 | 10 | 40 |
5 | 1 | 50 |
6 | 1 | 60 |
Payback Period = Cash outlay (Investment) / Annual Cash Inflows
The payback from the two projects is
Project A: 2 and1/3 years
Project B: 4 years
If the firm has the policy of employing three years payback period, project A will be accepted but project B will be rejected.
Decision Rule
• If payback < acceptable time limit, accept project
• If payback > acceptable time limit, reject project
Advantages of PB method.
• It is very easy to calculate, but it can lead to wrong decision
• Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in meeting other needs.
• Easy to apply (Simple to understand
Problems with the Payback Method
• Does not consider post-payback cash flows
• Does not consider time value of money
• Does not explicitly consider risk
• The "acceptable" time period is arbitrary
In case two projects need initial outflow of $30m and has the following expected net cash inflows
Year | Project A | Project B |
1 | 20 | 10 |
2 | 10 | 20 |
3 | 10 | 10 |
The above two projects have two years payback period hence will be equally desirable using payback method. But if the projects are mutually exclusive, project A is much desirable.
2. Accounting Rate of Return (ARR)
It uses the data from income statement. This is not-discounting cash flow project appraisal model.
ARR = Average Net Profit / Average Annual Investment
or
ARR = Increase in expected average operating income / Initial increase investment
ARR = O-D / I
Where O = Average annual incremental and inflows from operation
D = The incremental average annual depreciation
I = The initial incremental amount invested
ARR is also known as accrual accounting rate of return unadjusted rate of return model and the book value model.
Its compilations is related with
- Conventional accounting models of calculating income and required investment
- Shows the effect of an investment on project's financial statement.
Example: Assume the company invested in the constructor of business machine whose investment cost is $607,500 useful life is 4 year estimated disposal value is zero, and expected annual cash inflow from operation is $200,000.
Annual depreciate would be = Original Investment / Useful Life = $607,500 / 4 = $151,875
ARR = $200,000 - $151,875 / $607,500 = 7.92%
Advantages of using ARR
• It is simple to calculate using accounting data
• Earning of each year is included in the calculating the profitability of the project
Disadvantages of using ARR
• It is inconsistency with wealth maximization as the objective of the firm
• Since it uses the accounting data it includes the amount of accruals in calculating the earnings "net profit".
• It is based on the familiar accrual accounting.
• It ignores the time value of money i.e. expected future dollars are erroneously regarded as equal to present dollars.
B: Discounted Cash Flow Methods
1. Net Present Value Method (NPV)
It is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money.
This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project.
In case the present value is positive, the project will be accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen.
Problems with NPV
• Difficult to explain to non-finance people
• Solution is in dollars, not percentage rates of return
2. Internal Rate of Return (IRR)
The IRR is estimated rate of return for a proposed project, given its incremental cash flow or the discount rate that makes the present value of a project's cash flows (PVcf) equal its initial investment.
IRR Decision Rules
Independent Projects: Accept all as long as the IR ? hurdle rate
Mutually Exclusive Projects: Compute (IRR - hurdle rate) for each project, rank from highest to lowest and accept the highest ranking project [assuming the computation (IRR - hurdle rate) > 0]
IRR--Advantages/Disadvantages
1) Advantages
• Considers all cash flows
• Considers time value of money
• Comparable with hurdle rate
2) Disadvantages
• Does not show dollar improvement in value of firm if project is accepted
• IRR can be affected by the scale (size) of the project
• Possible existence of multiple IRRs
Relationship between IRR and the NPV Profile
1) When the IRR = the firm's hurdle rate, NPV = 0
2) When the IRR < the firm's hurdle rate, NPV < 0
3) When the IRR > the firm's hurdle rate, NPV > 0
NPV and IRR Methods: Possible Decision Conflicts
An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept"
Note: When projects are independent, no accept/reject conflict will arise
A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR.
Note: Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects
Ranking conflicts arise because of:
1) Timing differences in incremental cash flows
2) Magnitude differences in incremental cash flows
When a conflict arises among mutually exclusive projects, pick the one with the highest NPV
3. Profitability index
It is sometimes called Benefit Cost Ratio or present value index. It is calculated by taking the present value of cash inflows divided by the present value of cash outflows. The decision criteria is to accept project with a Profitability Index (PI) greater than one.
PI = Present values of cash inflows / Cost (Initial Out flow)
This ratio gives the return in the present terms per unit invested. Using this criterion, projects will be ranked from the one with highest PI down to one with the lowest, and then project would be selected in the order of ranking up to the point where the budget is exhausted.
This criterion is simple but suffers from two basic limitations.
It cannot be used to except in cases where there is only a single constraint. In case where the capital is rationed in more than one period or where the capital is not the only constraint, the criteria will not provide the best solution.
It looks projects individually and does not take into account the overall portfolio where correlation of projects' returns is important
