PROJECT SELECTION
CHAPTER 4
“To invest or Not to invest, that
is the question!”
PROJECT SELECTION
Project: A complex, non-routine effort limited by
time, budget, resources and performance
specifications designed to meet customer need
Mutually exclusive projects means that if one
project is taken on, the other must be rejected
Independent projects means that the selection of
one project does not affect the other project
Project Selection Methods:
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Pay back period
4. Benefit Cost Ratio (B/C ratio)
2. INTERNAL RATE OF RETURN (IRR)
The IRR is defined as the discount rate that forces the
project’s NPV to equal zero.
COMPUTATIONAL METHODS FOR IRR
The most practical methods are-
Direct-solution method,
Trial-and-error method.
Strategies:
1. Check if the projects fulfilled the selection criterion .(IRR>given
rate)
2. If mutually exclusive, the project with higher IRR will be
selected
3. If independent, both the project can be selected
Example 2.2;
A company is considering a project with the following cash flows:
Year 0 1 2 3 4
-10000 4,000 4,000 3,000 2,000
We want to calculate the IRR
Answer:
PAYBACK PERIOD
payback period, defined as the number of years required to
recover a project’s cost from operating cash flows.
Two types-
conventional-payback period-doesn’t consider the cost of fund
discounted-payback period- considers the cost of fund
EXAMPLE -1: CONVENTIONAL PAYBACK PERIOD
Ashland Company has just bought a new spindle machine at a cost
of $105,000 to replace one that had a salvage value of $20,000.
Calculate the payback period.
Solution:
Payback Period = 3 + 10,000/45,000 = 3.22 years
Discounted Payback Period
Calculation:
Period 0: -$85,000
Period 1: $15,000 / (1 + 0.15) = $13,043.48
Period 2: $25,000 / (1 + 0.15)^2 = $18,903.59
Period 3: $35,000 / (1 + 0.15)^3 = $23,013.07
Period 4: $45,000 / (1 + 0.15)^4 = $25,728.90
Period 5: $45,000 / (1 + 0.15)^5 = $22,372.95
End of Year 3:
Cumulative Discounted Cash Flow = -$30,039.86
End of Year 4:
Cumulative Discounted Cash Flow = -$4,310.97
End of Year 5:
Cumulative Discounted Cash Flow = $18061.98
So, the discounted cash flow is around = 4 + 4,310.97/
22372.95 = 4.23 years
Example 2 (Conventional Payback Period calculation)
Example 2 (Calculate Discounted Payback Period
calculation at 10 %)
Discounted Payback Calculations at 10% Cost of Capital
BENEFIT COST ANALYSIS
Define users as the public and sponsors as the government.
The general framework can be summarized as-
Overall users’ benefit= benefits- disbenefits
Sponsor's costs = capital costs + operating and maintenance
costs - revenues
BENEFIT-COST RATIO
Example 1: A public project being considered by a local
government has the following estimated benefit-cost profile-
Assume that i = l0%, N = 5, Compute Benefit cost ratio B/C. And
decide whether the project should be selected or not
EXAMPLE-1
Solution:
We calculate B as follows:
B = $16.53+$ 22.54 + $ 20.5 + $12.42 = $71.98.
We calculate C as follows:
C =$ 10 + $9.09 + $4.13 + $3.76 + $5.46 + $ 4.96 = $37.41
………CONTINUED
We calculate B/C ratio as follows
The B/C ratio exceeds one. so the user's benefits exceed
the sponsor's costs.
