CHAPTER 2

PROJECT SELECTION

2-1
APPROACHES TO PROJECT SELECTION

Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
Financial models

2-2
FINANCIAL MODELS

Based on the time value of money principal

 Payback period

 Net present value

 Internal rate of return

 Options models

 Profitability Index

All of these models use discounted cash flows

2-3
PAYBACK PERIOD

Determines how long it takes for a project to

reach a breakeven point
Investment
Payback Period 
Annual Cash Savings

Cash flows do not be discounted

Lower numbers are better (faster payback)

2-4
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 five years. What is
the payback period?
Year Cash Flow Cumulative
0 ($200,000) ($200,000)
1 $75,000 ($125,000)
2 $75,000 ($50,000)
3 $75,000 $25,000
2-5
NET PRESENT VALUE
Projects the change in the firm’s stock value if a
project is undertaken.

Ft
NPV  I o  
(1  r  pt )t
where Higher NPV
Ft = net cash flow for period t values are
better!
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t 2-6
NET PRESENT VALUE EXAMPLE
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.

Year Net flow Discount NPV

0 -$60,000 1.0000 -$60,000.00
1 $15,000 0.9009 $13,513.51
2 $15,000 0.8116 $12,174.34
3 $15,000 0.7312 $10,967.87
4 $15,000 0.6587 $9,880.96
5 $15,000 0.5935 $8,901.77
2-7
PROJECTS WITH UNEQUAL LIVES
 Suppose a firm chooses between two
machines of unequal lives. They are mutually
exclusive. How do you decide which one to
purchase?
 In this case, if you use NPV, you will ignore
the fact that you need to buy a new machine
sooner in one case than the other!

2-8
 EXAMPLE
Two machines have the following maintenance
expenses during their lives: (r = 10%)

0 1 2 3 4
Machine - - - -
A 50 12 120 120
0 0
Machine - - - - -
B 60 10 100 100 100
0 0
METHODS TO HANDLE THIS…
 Use replacement chains
 Matching Cycle Approach

 Annualized NPV approach or The Equivalent

Annual Cost Method (EAC)

2-10
REPLACEMENT CHAINS
Calculate PV (costs) for the same time
horizon.
In this example, Machine A has a
lifetime of 3 years, and Machine B has a
lifetime of 4 years.
If we repeat the analysis over a period
of 12 years, A would have 4
replacement cycles and B would have 3.

2-11
MATCHING CYCLE APPROACH
 Repeat projects until they end at the same time
 Assumption: the projects can be repeated
 The easiest: repeat the projects forever

 Compare NPV of the “repeated projects”

 NPV(T) : NPV of the original project of T years
 NPV(T,∞) = NPV(T) / (1 – (1+R)-T) : NPV of the original
project replicated at const scale to ∞

2-12
 ANNUALIZED NPV APPROACH
(OR EQUIVALENT ANNUAL COST – EAC)

 ANPV = value of the level payment annuity that

has the same NPV as the original set of cash
flows.
 NPV = ANPV × ART
 If only costs: EAC (Equivalent Annual Cost)
 Compare ANPV (or EAC)
 This method requires less restrictive assumptions

2-13
 ANNUALIZED NPV APPROACH
(OR EQUIVALENT ANNUAL COST – EAC)

Idea: Amortize the cash flows to get a per-year

cost for each piece of equipment. This gives the
Equivalent Annual Cost of each machine.

0 1 2 3 4
Machine A - - -120 -120
500 120
EAC EACa EACa
a

Machine B - - -100 -100 -100

2-14
600 100
EAC EAC EAC EAC
EXERCISE:

 Consider a factory which must have an

air cleaner.
 There are two mutually exclusive
choices (r = 10%):
 The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100 and lasts for 10
years.
 The “cheaper cleaner” costs $1,000 today, has
annual operating costs of $500 and lasts for 5
years.
 Which one to select? 2-15
APPLICATION: EXAMPLE OF REPLACEMENT
PROJECTS
A Belgian Dentist needs an autoclave to sterilize
his instruments. He has an old one that is in use,
but the maintenance costs are rising. So he is
considering replacing it.
New Autoclave
 Cost = $3,000 today,
 Maintenance cost = $20 per year
 Resale value after 6 years = $1,200
 NPV of new autoclave (at r = 10%):

2-16
EXISTING AUTOCLAVE
Year 0 1 2 3 4 5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600 500
Total Annual Cost

2-17
INTERNAL RATE OF RETURN
A project must meet a minimum rate of return
before it is worthy of consideration.

t
ACFt Higher IRR values
IO  
n 1 (1  IRR )t are 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
2-18
INTERNAL RATE OF RETURN EXAMPLE
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 17%; does
this project meet the threshold?

Year Net flow Discount NPV

0 -$40,000 1.0000 -$40,000.00
1 $14,000 0.9009 $12,173.91
2 $14,000 0.8116 $10,586.01
3 $14,000 0.7312 $9,205.23
4 $14,000 0.6587 $8,004.55
-$30.30
2-19
PROFITABILITY INDEX
 Benefit cost ratio
 NPV divided by initial cash investment

 Ratios greater than 1.0 are good

2-20
PROFITABILITY INDEX (PI)

 With the constraints of budgets/resources, the

Profitability Index can be used
 The highest weighted average PI becomes a
criterion for selecting a project.

2-21
PROFITABILITY INDEX (PI)

NPV
Profitability Index 
Investment
Example
We have maximum $300,000 for investment

Proj NPV Investment PI

A230,000 200,000 1.15
B141,250 125,000 1.13
C194,250 175,000 1.11
D 162,000 150,000 1.08
2-22
ADVANTAGES OF PROFITABILITY
MODELS
 Easy to use and understand
 Based on accounting data and forecasts
 Familiar and well understood
 Gives a go/no-go indication
 Can be modified to include risk

2-23
 DISADVANTAGES OF PROFITABILITY
MODELS
 Ignore nonmonetary factors
 Some ignore time-value of money
 Biased toward the short-term
 Payback ignores cash flow after
payback
 IRR can have multiple solutions
 All are sensitive to errors
 Nonlinear
 Dependent on determination of cash 2-24
flows