PROFESSIONAL
ENGINEERING
MANAGEMENT
TECHNIQUES
Lecture 3:
Project Selection
LEARNING OUTCOMES
On completion of this lesson you should be able to:
Understand and apply a range of financial models to the
appraisal and selection of projects.
FEASIBILITY STUDY LIFECYCLE
PHASES (BURKE)
KEY CHARACTERISTICS OF A
FEASIBILITY STUDY
Initiation
Plan
Client needs
Constraints analysis (Inc. stakeholder analysis)
Alternatives & options
Information gathering
Value Management
Cost Benefit Analysis
FINANCIAL FEASIBILITY OF
PROJECTS
A cost-benefit analysis is generally based on the following
economic principles:
Pareto improvement criteria
‘The project should make some people better off without making anyone worse off’.
Hicks – Kaldor test
‘The aggregate gains should exceed the aggregate losses’.
Willingness-to-pay test
To determine how much the clients are willing to pay for the product
(Micro-economics - supply, demand & prices)
PROJECT SELECTION
PROJECT SELECTION
The selection of the right project for future investment is a
crucial decision for the long-term survival of your company.
A process is required to select and rank projects on the basis
of beneficial change to your company.
This topic on project selection will outline a framework for
evaluating and ranking prospective projects using numeric
methods.
NUMERIC MODELS
A numeric model is usually financially focused and quantifies the
project in terms of either time to repay the investment (payback or
return on investment).
The main purpose of these models is to aid decision-making
leading to project selection.
The model evaluates projects by how well they meet a company's
strategic goals and corporate mission.
TYPE OF NUMERIC MODELS
Numerical
Models
Scoring Financial
Models Models
Return On Internal Rate
Pay Back Net present
Investment of Return
Period value (NPV)
(ROI) (IRR)
1. PAYBACK PERIOD
It is the time taken to gain a financial return equal to the
original investment.
The time period is usually expressed in years and
months.
EXAMPLE 1
A company wishes to buy a new machine for a four year project. The manager
has to choose between machine A or machine B, so it is a mutually exclusive
situation. Although both machines have the same initial cost ($35,000) their
cash-flows perform differently over the four year period as shown in Table 1.
Year Cash flow : Machine A Cash flow: Machine B
0 £35,000 £35,000
Table 1:
1 £20,000 £10,000 Cashflow for
2 £15,000 £10,000 Machine A and
3 £10,000 £15,000 Machine B
4 £10,000 £20,000
Year Cash flow : Project A Cash flow: Project B
0 £35,000 £35,000 Original investment
1 £20,000 £10,000
2 £15,000 £10,000
3 £10,000 £15,000 Gains per year
4 £10,000 £20,000
Payback
? ?
Period
Conclusion?
Machine A will recover its outlay one year sooner than machine B. Where project's are
ranked by the shortest payback period, machine A is selected in preference to machine
B
EXAMPLE 2
Table 2 shows cash flow for two projects with different cash flow over five years. Choose a
suitable project using payback period.
Table 2 : Cashflow for Project A and Project B
Year Cash flow: Project A Cash flow: Project B
0 -£80,000 -£80,000
1 £10,000 £35,000
2 £20,000 £25,000
3 £20,000 £20,000
4 £30,000 £15,000
cc 5 £40,000 £10,000
Cash flow: Cash flow: Project
Year
Project A B
Original investment 0 -£80,000 -£80,000
1 £10,000 £35,000
2 £20,000 £25,000
Gains per year 3 £20,000 £20,000
4 £30,000 £15,000
5 £40,000 £10,000
Payback Period ? ?
Conclusion:
• Project A takes 4 years to gain the initial investment.
• Project B takes 3 years to gain the initial investment.
Projects may be selected on the basis of the shortest payback
period .
ADVANTAGES OF PAYBACK
PERIOD METHOD
It is simple and easy to use.
It uses readily available accounting data to determine cash-flows.
It reduces the project's exposure to risk and uncertainty by selecting the
project that has the shortest payback period.
The uncertainty of future cash-flow is reduced.
It is an appropriate technique to evaluate high technology projects where the
technology is changing quickly and the project could run the risk of being left
holding out of date stock.
It is an appropriate technique for fashion projects where the market demand
tends to change seasonally.
Faster payback has a favourable short-term effect on earnings per share.
The payback period quantifies the selection criteria in terms the decision-
makers are familiar with.
DISADVANTAGES OF PAYBACK
PERIOD METHOD
It does not consider the time value of money.
The payback period is indifferent to the timing of the cash-flow.
The project with a high, early income (cash-inflow) would be ranked equally with a
project which had late income if their payback periods were the same (see figure 1).
• “C” has higher initial cash flow
• “D” has lower initial cash flow
• Both has same payback period even
though cash flow profiles are
different.
Figure 1
The payback period calculation does not look at the TOTAL project.
What happens to the cash-flow after the payback period is not considered. A project
that built up slowly to give excellent returns (project F) would be rejected in favour
of project E with lower early returns if the payback period was shorter (see figure
2).
Figure 2
• “E” has the shorter payback period and higher initial cashflow.
• F” has the longer payback period and lower initial cash flow even though overall returns
are higher.
• A project that built up slowly to give excellent returns (project F) would be rejected in
favor of project E with lower early returns if the payback period was shorter.
It is not a suitable technique to evaluate long term projects where the
effects of differential inflation and interest rates could significantly change
the results.
All other financial data are ignored.
Although payback period would reduce the duration of risk, it does not
quantify the risk exposure.
2. RETURN ON INVESTMENT (ROI)
Another popular investment appraisal technique which
does look at the whole project.
A high ROI means the project's gains compare
favorably to its original investment/cost.
ROI relates profits to capital invested.
FORMULA FOR ROI
( 𝑇𝑜𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 ) −(𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼= ×100%
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
EXAMPLE 3
Using the same example 2 but calculate using ROI.
Year Cash flow: Project A Cash flow: Project B
0 -£80,000 -£80,000
1 £10,000 £35,000
2 £20,000 £25,000
3 £20,000 £20,000
4 £30,000 £15,000
5 £40,000 £10,000
Total gains £120,000 £105,000
Project A
( 𝑇𝑜𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 ) −(𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
120,000 −80,000
¿
5
¿8000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼= ×100%
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
8000
¿ ×100%
80,000
¿10%
Project B
( 𝑇𝑜𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 ) −(𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
105,000−80,000
¿
5
¿5000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼= ×100%
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
5000
¿ ×100%
80,000
¿6.25 %
How to choose between Project A and Project B?
High ROI Gain (Profit) > Investment (Capital).
High initial gain can be given priority.
Therefore, for example 3, Project A will be chosen as it
has higher ROI compare to Project B
ADVANTAGES AND
DISADVANTAGES OF ROI
ADVANTAGES:
Simple technique.
Considers cash-flow over the whole project.
DISADVANTAGES:
Averages profit over successive years.
Projects with high initial costs ranked equally with those
with high profits later (early profits should be given
priority).
3. NET PRESENT VALUE (NPV)
Takes into consideration the time value of money.
Eg: A $100 today will not have the same worth or buying power as
a $100 this time next year.
Requires accurate forecast of the cash-flows and prediction of the
interest rates.
The NPV is a measure of the value or worth added to the company
by carrying out the project.
A positive NPV means the company would gain profit by carrying
out the project.
A negative NPV indicates the company would lose money by
carrying out this project.
NPV Calculations
Cash flow (at any future time, t) = Income – Expenditure
NPV = Cash Flow x Discount Factor
Project Cash X Discount
Years = Present Value
Flow Factor
0
1
2
3
Total NPV
Takes into account the reduction in the value of money
caused by inflation.
If inflation runs at 10% per annum, then £100 invested
would be worth £110 after Year 1 and £121 after Year 2
etc.
If the NPV is POSITIVE, project is good. Preference
should be given to a project with the highest NPV.
DISCOUNT FACTORS FOR NPV
Discount Factors for given discount (inflation) rates over a 6-year project
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
Further Discount Factors
Years 10% 11% 12% 13% 14% 15% 16% 17%
1 0.9091 0.9009 0.8929 0.885 0.8772 0.8696 0.8621 0.8547
2 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305
3 0.7513 0.7312 0.7118 0.693 0.675 0.6575 0.6407 0.6244
4 0.683 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337
5 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561
Years 18% 19% 20% 21% 22% 23% 24% 25%
1 0.8475 0.8403 0.8333 0.8264 0.8197 0.813 0.8065 0.8
2 0.7182 0.7062 0.6944 0.683 0.6719 0.661 0.6504 0.64
3 0.6086 0.5934 0.5787 0.5645 0.5507 0.5374 0.5245 0.512
4 0.5158 0.4987 0.4823 0.4665 0.4514 0.4369 0.423 0.4096
5 0.4371 0.419 0.4019 0.3855 0.37 0.3552 0.3411 0.3274
GENERAL PROCEDURE FOR NPV
General Procedure:
Insert the cash-flow
Assume a discount factor
Transfer the discounting factors from the table.
Calculate present value (multiply cash-flow by discount factor)
Aggregate the present values to give the NPV
EXAMPLE 4
Using the same example 2 but calculate using NPV. Using a discount rate of 5%.
Cash flow: Cash flow: Project
Year
Project A B
0 -£80,000 -£80,000
1 £10,000 £35,000
2 £20,000 £25,000
3 £20,000 £20,000
4 £30,000 £15,000
5 £40,000 £10,000
Project A: Inflation (Discount) Rate = 5%
Project Cash Discount
Years Present Value
Flow Factor
0 -£80,000 1 -£80,000
1 £10,000
2 £20,000
3 £20,000
4 £30,000
5 £40,000
NPV =
Net Present Value (NPV)
Discount Factors for given discount (inflation) rates over a 6-
year project
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
Project A: Inflation (Discount) Rate = 5%
Project Cash Discount
Years Present Value
Flow Factor
0 -£80,000 1 -£80,000
1 £10,000 0.9524
2 £20,000 0.9070
3 £20,000 0.8638
4 £30,000 0.8227
5 £40,000 0.7835
NPV =
Take from table of discount rate
Project A: Inflation (Discount) Rate = 5%
Project Cash Discount
Years Present Value
Flow Factor
0 -£80,000 1 -£80,000
1 £10,000 0.9524 £9,524
2 £20,000 0.9070 £18,140
3 £20,000 0.8638 £17,276
4 £30,000 0.8227 £24,681
5 £40,000 0.7835 £31,340
NPV =
Project A: Inflation (Discount) Rate = 5%
Project Cash
Years Discount Factor Present Value
Flow
0 -£80,000 1 -£80,000
1 £10,000 0.9524 £9,524
2 £20,000 0.9070 £18,140
3 £20,000 0.8638 £17,276
4 £30,000 0.8227 £24,681
5 £40,000 0.7835 £31,340
NPV = £20,961
𝑵𝑷𝑽=( 𝟗,𝟓𝟐𝟒+𝟏𝟖,𝟏𝟒𝟎+𝟏𝟕,𝟐𝟕𝟔+𝟐𝟒,𝟔𝟖𝟏+𝟑𝟏,𝟑𝟒𝟎) −𝟖𝟎,𝟎𝟎𝟎=𝟐𝟎,𝟗𝟔𝟏
Project B: Inflation (Discount) Rate = 5%
Project Cash
Years Discount Factor Present Value
Flow
0 -£80,000 1 -£80,000
1 £35,000 0.9524 £33,334
2 £25,000 0.9070 £22,675
3 £20,000 0.8638 £17,276
4 £15,000 0.8227 £12,341
5 £10,000 0.7835 £7,835
NPV =
Project B: Inflation (Discount) Rate = 5%
Project Cash
Years Discount Factor Present Value
Flow
0 -£80,000 1 -£80,000
1 £35,000 0.9524 £33,334
2 £25,000 0.9070 £22,675
3 £20,000 0.8638 £17,276
4 £15,000 0.8227 £12,341
5 £10,000 0.7835 £7,835
NPV = £13,461
𝑵𝑷𝑽=(𝟑𝟑, 𝟑𝟑𝟒+𝟐𝟐, 𝟔𝟕𝟓+𝟏𝟕,𝟐𝟕𝟔+𝟏𝟐,𝟑𝟒𝟏+𝟕,𝟖𝟑𝟓) −𝟖𝟎, 𝟎𝟎𝟎=𝟏𝟑,𝟒𝟔𝟏
Conclusion:
Project A : NPV =£
Project B : NPV =£
Project A is selected because:
Higher NPV indicates that the expected earnings
generated by the project exceeds the expected costs.
ADVANTAGES OF NPV
Introduces time value of money.
All cash flows are presented at today’s values.
It allows for inflation.
It can simulate ‘What if’ analysis using different
values.
It provides more accurate profit and loss forecast
DISADVANTAGES OF NPV
Accuracy is dependent upon predicted cash flows and
interest rates.
Biased towards short term projects.
Assumes fixed rate for duration of the project
4. INTERNAL RATE OF
RETURN (IRR)
IRR is the value of the discount factor when the
NPV is zero.
Calculated by either a trial and error method or
plotting NPV against IRR.
Trial & Error Method
Decrease DF to increase NPV
Increase DF to decrease NPV
As the discount factor increases
the NPV is reducing. The NPV
becomes negative between 24%
and 25%.
Therefore the IRR is between
24% and 25% for machine A.
IRR ≈ 18.2% IRR ≈ 24.8%
The IRR analysis is a measure of the return on investment, therefore,
select the project with the highest IRR.
PROJECT SELECTION
Summary of Key Points
1. Financial criteria are an important
consideration in deciding the feasibility of a
project.
THANK YOU
