Topic 9

Project Selection

Lecture: PhD. Đinh Bá Hùng Anh

Tel: 01647.077.055/090.9192.766
Mail: [email protected]
Contents

1. Project selection
2. Non-financial methods
3. Financial methods.

9-2
Project Selection

 Evaluate needs, costs, benefits

 Select project
• Develop criteria
• List assumptions
• Gather data
• Evaluate each opportunity
 Combine “gut” feelings and quantitative information to
make decision.

9-3
Project Selection

Project evaluation and selection

Evaluation criteria Project A Project B Project C
Investment ($) 700.000$ 2.100.000$ 1.200.000$
Return in Investment 9.1% 18.3% 11.5%
Time to Market 10 months 16 months 12 months
Increase in Market share 2% 5% 3%
Risk Low High Medium
Chance of Success High Medium High

Comments
Project A: Major competior already has similar product and may reduce price
Project B: New technology may not work as expected.
Project C: Product features may not be accepted in some international markets.
9-4
Non-financial methods

A set of Criteria in Project Selection

For example
• Alignment with company goals
• Anticipated sales volume
• Increase in market share
• Establishment of new markets
• Anticipated retail price
• Investment required
• Estimated manufacturing cost per unit
• ….

9-5
Non-financial methods

Non-financial: projects of strategic importance to the firm.

 Checklist model

 Simplified scoring models

 Analytic hierarchy process

 Profile models.

9-6
Non-financial methods

Checklist Model
List of criteria applied to possible projects.
 Requires agreement on criteria
 Assumes all criteria are equally important
 Checklists are valuable for recording opinions and encouraging
discussion.

9-7
Non-financial methods
Checklist Model
Performance on Criteria
Project Criteria High Medium Low
Project  Cost X
Profit potential X
Time to market X
Development risks X
Project  Cost X
Profit potential X
Time to market X
Development risks X
Project  Cost X
Profit potential X
Time to market X
Development risks X
9-8
Non-financial methods

Scoring Models
 Each project receives a score that is the weighted sum of its
grade on a list of criteria.

 Scoring models require:

• Agreement on criteria
• Agreement on weights for criteria
• A score assigned for each criteria
Score   (Weight  Score)
Relative scores can be misleading!

9-9
 Non-financial methods

Scoring Models
Criteria weight Project 1Project 2Project 3Project 4
Support key business objectives 25% 90 90 50 20
Has strong internal sponsor 15% 70 90 50 20
Has strong customer support 15% 50 90 50 20
Uses realistic level of technology 10% 25 90 50 70
Can be implemented in one year or less 5% 20 20 50 90
Provides positive NPV 20% 50 70 50 50
10% 20
Has low risk in meeting scope, time, and cost goals 50 50 90
Weighted Project Scores 100% 56 78.5 50 41.5

9-10
Non-financial methods

Scoring Models

Weighted Score by Project

100

80
Project 2
60

40 Project 1
Project 3
Project 4
20

0
Projects

9-11
Non-financial methods

Analytic Hierarchy Process

The AHP is a four step process:
1. Construct a hierarchy of criteria and subcriteria
2. Allocate weights to criteria
3. Assign numerical values to evaluation dimensions
4. Scores determined by summing the products of numeric
evaluations and weights.

9-12
Contents..

1. Project selection
2. Non-financial methods
3. Financial methods

9-13
Financial Models

Based on the time value of money principal

 Payback period (PP) – Thời gian hoàn vốn
 Net present value (NPV) - Hiện giá lợi ích ròng
 Internal rate of return (IRR) – Nội suất thu hồi vốn
 All of these models use discounted (chiết khấu) cash flows

9-14
Financial Models

Payback Period
• Determines how long it takes for a project to reach a breakeven
point.
• The pay-out period measures the number of years it will take for
the positive net cashflows to repay the investment.

Investment
Payback Period 
Annual Cash Savings

 Cash flows should be discounted

 Lower numbers are better (faster payback)

9-15
Financial Models

Payback Period
Example: A project requires an initial investment of $200.000
and will generate cash savings of $75.000 each year for the next
three years; what is the payback period?
Solution
Year Cash Flow Cumulative
200.000
0 ($200.000) ($200.000) PP   2.67 years
75.000
1 $75.000 ($125.000) 1
*
rate of return   37%
2 $75.000 ($50.000) 2.67
3 $75.000 $25.000

(*) the reciprocal of payback yields the average rate of return

9-16
Financial Models

Pay-out or Pay-back period

 The pay-out period measures the number of years it will
take for the undiscounted net benefits (positive net
cashflows) to repay the investment.
 A more sophisticated version of this rule compares the
discounted benefits over a given number of years from the
beginning of the project with the discounted investment
costs.
 An arbitrary limit is set on the maximum number of years
allowed and only those investments having enough benefits
to offset all investment costs within this period will be
acceptable.
Financial Models

Advance Disadvance
 Simple Do not care the cash flow
 Usefull with the high after the payback period.
risk project, need a
fast payback.
Financial Models

Payback Period

Project A Year Cash Flow Cum. Cash Flow

0 ($500.000) ($500.000)
1 50.000 (450.000)
2 150.000 (300.000)
3 350.000 50.000
4 600.000 650.000
5 500.000 1.150.000
Payback = 2.857 years
Rate of Return = 35%.
9-19
Financial Models

Payback Period

Project B Year Cash Flow Cum. Cash Flow

0 ($500.000) ($500.000)
1 75.000 (425.000)
2 100.000 (325.000)
3 150.000 (175.000)
4 150.000 (25.000)
5 900.000 875.000

Payback = 4.028 years

Rate of Return = 24.8%.
9-20
Financial Models

Example: r = 10%
Cash flow
pp
0 1 2 3 4 5
(yr)
PV[NCF(A)] -1000 500 300 200 100 60 3
PV[NCF(B)] -1000 200 300 300 400 300 3.5
1/(1+0.1)t 1 0.909 0.826 0.751 0.683 0.621
PVA -1000 454.5 247.8 150.2 68.3 37.26 -41.94
PVB -1000 181.8 247.8 225.3 273.2 186.3 114.4

 pp(A) < pp(B) but NPV(B) > NPV(A).

3-21
Financial Models

Net Present Value (NPV)

Projects the change in the firm’s stock value if a project is
undertaken.

Ft Higher NPV values

NPV  I o  
(1  r  pt )t are better!

where
Ft = net cash flow for period t
r = required rate of return
I 0 = initial cash investment
pt = inflation rate during period t

9-22
Financial Models
Net Present Value
Should you invest $60.000 in a project that will return $15.000 per
year for five years? You have a minimum return of 8% and expect
inflation to hold steady at 3% over the next five years.
Solution
Year Net flow Discount NPV
0 -$60.000 1.0000 -$60.000 The NPV column
1 $15.000 0.9009 $13.514 total is negative,
so don’t invest!
2 $15.000 0.8116 $12.174
3 $15.000 0.7312 $10.968
4 $15.000 0.6587 $9.881
5 $15.000 0.5935 $8.902
-$4.562 9-23
Financial Models

1. The NPV is the algebraic sum of the discounted values of the

incremental expected positive and negative net cashflows over a
project’s anticipated lifetime.
2. What does net present value mean?
• Measures the change in wealth created by the project.
• If this sum is equal to zero, then investors can expect to
recover their incremental investment and to earn a rate of
return on their capital equal to the private cost of funds
used to compute the present values.
• Investors would be no further ahead with a zero-NPV
project than they would have been if they had left the funds
in the capital market.
 Financial Models

r  constant
Year 0 1 2 3 4
Net Cash Flow -1000 200 300 350 1440
r 18% 16% 14% 12% 10%
200 300 350 1440
NPV  1000 
0
    436.91
1.18 (1.18)(1.16) (1.18)(1.16)(1.14) (1.18)(1.16)(1.14)(1.12)

300 350 1440

NPV  1000(1.18)  200 
1
   515.55
1.16 (1.16)(1.14) (1.16)(1.14)(1.12)

350 1440
NPV  1000(1.18)(1.16)  200(1.16)  300 
2
  598.04
(1.14) (1.14)(1.12)
Note: All of the transactions are done at the beginning of the year.
Financial Models

r = 10%; NPV?
Cash flow

Year 0 1 2 3 4 5
Bt 900 1500 1500 1500 1700
Ct 2000 500 800 800 800 800
Bt - C t -2000 400 700 700 700 900
1/(1+0.1)t 1 0.909 0.826 0.751 0.683 0.621
PV(NCF) -2000 363.6 587.2 525.7 478.1 558.9
NPV = 459$

 NPV in EXCEL = NPV(r%,CF1:CFn)

3-26
Financial Models

Net Present Value (NPV): Use as a decision criterion to answer

following.
a. To reject projects?
b. Select project(s) under a budget constraint?
c. Compare mutually exclusive projects?
Financial Models

a. Reject a projects?
Rule: “Do not accept any project unless it generates a positive
net present value”
Examples
Project A: Present Value Costs $1 million, NPV + $70,000
Project B: Present Value Costs $5 million, NPV - $50,000
Project C: Present Value Costs $2 million, NPV + $100,000
Project D: Present Value Costs $3 million, NPV - $25,000
Result
Only projects A and C are acceptable.
Financial Models

b. When You Have a Budget Constraint?

Rule: “Within the limit of a fixed budget, choose that subset of the
available projects which maximizes the net present value”
Example: If budget constraint is $4 million and 4 projects with
positive NPV.
Project E: Costs $1 million, NPV + $60,000
Project F: Costs $3 million, NPV + $400,000
Project G: Costs $2 million, NPV + $150,000
Project H: Costs $2 million, NPV + $225,000
Result
• FG and FH are impossible, as they cost too much.
• EG and EH are within the budget.
• Combination EF, which has a total NPV of $460,000. GH is also
possible, but its NPV of $375,000 is not as high as EF.
Financial Models

c. When You Need to Compare Mutually Exclusive Projects?

Rule: “In a situation where there is no budget constraint but a
project must be chosen from mutually exclusive alternatives, we
should always choose the alternative that generates the largest
net present value”
Example
Assume that we must make a choice between the following three
mutually exclusive projects.
Project I: PV costs $1.0 million, NPV $300,000
Project J: PV costs $4.0 million, NPV $700,000
Projects K: PV costs $1.5 million, NPV $600,000
Result
Projects J should be chosen because it has the largest NPV.
Financial Models

Internal Rate of Return (IRR)

A project must meet a minimum rate of return before it is
worthy of consideration.
n
ACFt Higher IRR values are
IO  
t 1 (1  IRR ) t better!

where
ACFt = annual after tax cash flow for time period t
IO = initial cash outlay
n = project's expected life
IRR = the project's internal rate of return

9-31
Financial Models

Internal Rate of Return

A project that costs $40.000 will generate cash flows of $14.000 for
the next four years. You have a rate of return requirement of 15%;
does this project meet the threshold?
This table has
Year Net flow Discount PV been calculated
0 -$40.000 1.0000 -$40.000 using a discount
rate of 15%
1 $14.000 0.8696 $12.174
1IRR
2 $14.000 0.7561 $10.586 A:
-40.000 +
3 $14.000 0.6575 $9.205 PVi/(1 + KA)5 = 0
4 $14.000 0.5718 $8.005 which implies that
-$30.30
KA= …..
 The project doesn’t meet our 15% requirement and should
not be considered further.
9-32
Financial Models
Internal Rate of Return (nội suất thu hồi vốn k)
Còn được gọi suất sinh lợi nội tại là suất chiết khấu làm cho hiện
giá lợi ích ròng của dự án bằng không.
n
Bt  Ct
IRR  k  NPV   0
1  k 
t
t 0

Note: IRR là tỷ số toán học, not finance.

Calculate IRR
Net flowcash (dòng lưu ròng) NCF :
(B0 – C0), (B1 – C1), (B2 – C2), ………..,(Bn – Cn)
Hay viết ngắn gọn: CF0, CF1, CF2,………., CFn

IRR in EXCEL =IRR(CF0:CFn)

3-33
Financial Models

Sử dụng IRR
(a) Nếu IRR > MARR(Minimum acceptable rate of return), dự
án nên được tiến hành.
(b) Sử dụng IRR để phân hạng dự án. Dự án có chỉ số IRR lớn
nên được chọn.
(c) Lợi thế của IRR là không chỉ sử dụng dữ liệu từ dự án.

3-34
Financial Models

Lưu ý khi sử dụng IRR

Vấn đề 1: Một dự án có thể có nhiều tỷ số IRR.
Bt - C t

+300
Thời gian
-100
-200

Solution 1
K = 100%; NPV= - 100 + 300/(1+1) - 200/(1+1)2 = 0
Solution 2
K = 0%; NPV= -100 + 300/(1+0) - 200/(1+0)2 = 0
3-35
Financial Models

Vấn đề 2: NPV và IRR đưa ra các kết luận khác nhau

Năm 0 1 2 3 … … 
Dự án A -2000 600 600 600 600 600 600
Dự án B -20000 4000 4000 4000 4000 4000 4000
Chi phí cơ hội của quỹ = 10%
NPVA0: 600/0.1 – 2000 = 6000 – 2000 = 4.000
NPVB0: 4000/0.1 – 20000 = 40000 – 20000 = 20.000
Vậy NPVB0 > NPVA0
IRRA: 600/KA - 2000 = 0 hay KA = 0.3
IRRB: 4000/KB - 20000 = 0 hay KB = 0.2
Vậy IRRA > IRRB
NPV và IRR đưa ra kết luận khác nhau khi so sánh 2 dự án có
kích thước khác nhau. 3-36
Financial Models

Vấn đề 3: Dự án có thời gian sống khác nhau và loại trừ lẫn nhau.
Chi phí cơ hội của quỹ đầu tư: 8%.
Dự án A: Chi phí đầu tư: 1000 $ ở năm 0
Lợi nhuận: 3200$ ở năm thứ 5.
Dự án B: Chi phí đầu tư: 1000 ở năm 0.
Lợi nhuận: 5200$ ở năm thứ 10
NPVA0: -1000 + 3200/(1.08)5 = 1177.86
NPVB0: -1000 + 5200/(1.08)10 = 1408.60
Vậy NPVB0 > NPVA0
IRRA: -1000 + 3200/(1 + KA)5 = 0 tức KA = 0.262
IRRB: -1000 + 5200/(1 + KB)10 = 0 tức KB = 0.179
Vậy KA > KB
NPV và IRR đưa ra kết luận khác nhau khi so sánh 2 dự án có
thời gian sống khác nhau. 3-37
Financial Models
Vấn đề 4: Cùng dự án nhưng bắt đầu ở các thời điểm khác nhau.
Dự án A: Chi phí đầu tư = 1000$ ở năm 0
Lợi nhuận = 1500$ ở năm 1
Dự án B: Chi phí đầu tư = 1000$ ở năm 5
Lợi nhuận = 1600$ ở năm 6
NPVA0: -1000 + 1500/(1.08) = 388.88
NPVB0: -1000 + 1600/(1.08)6 = 327.68
Vậy NPVA0 > NPVB0
IRRA: -1000 + 1500/(1 + KA) = 0 tức KA = 0.5
IRRB: -1000 /(1 + KB)5 + 1600/(1 + KB)6 = 0 tức KB = 0.6
Vậy KB > KA
NPV và IRR đưa ra kết luận khác nhau khi thời điểm bắt đầu
của một dự án là khác nhau.
3-38
Home work

r = 12%
Cash flow

Year 0 1 2 3 4 5
NCF(A) -1000 500 300 200 100 60
NCF(B) -1000 200 300 300 400 300
NCF(C) -1000 100 200 300 400 500

a. NPV c. IRR (year 1, year 5)

b. PP d. Chose project (A, B or C?)

9-39