E CONOMIC P ROJECT

S ELECTION C RITRIA

September 2015 Hisham Haridy, PMP, PMI-RMP

 ECONOMIC PROJECT SELECTION CRITERIA

CAPITAL BUDGETING

 Project managers are often called upon to be active participants during the

benefit-to-cost analysis of project selection. It is highly unlikely that companies

will approve a project where the costs exceed the benefits.

 Benefits can be measured in either financial or nonfinancial terms.

 The process of identifying the financial benefits is called capital budgeting,

which may be defined as the decision-making process by which organizations

evaluate projects that include the purchase of major fixed assets such as

buildings, machinery, and equipment.

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA

CAPITAL BUDGETING

 Sophisticated capital budgeting techniques take into consideration depreciation

schedules, tax information, and cash flow.

 The following are economic models for selecting a project:

1) Present value

2) Net present value

3) Internal rate of return

4) Payback period

5) Benefit-cost ratio.

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
1. Present Value (PV):
 The value today of future cash flows.
 This is the method of determining today’s value of future money.

FV
PV =
Where:
(1+i)n
PV: Present Value
FV: Future Value
i : Interest rate
n: number of time periods

Example
 What is the present value of $300,000 received three years from now if we expect the interest
rate to be 10 percent?

300000
PV = = $225,394
(1+0.1)3

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
2. Net Present Value (NPV)
 The sum of the present value of all income and expenditures of a project. (> 0 is ok).
 It is the present value of the total benefits (income or revenue) minus the costs over many
time periods.
 NPV= PV (all cash inflows) – PV (all cash outflows)
FV
NPV= ∑ - Initial investment
(1+k+i)n
Where:
k: Annual inflation rate

Example
 You have two projects to choose from. Project A will take three years to complete and has an
NPV of $45,000. Project B will take six years to complete and has an NPV of $85,000. Which
one would you prefer?

Project “B”

Key selection: Maximum NPV

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA

Example
 Cash flow as follow with interest 10%.
 NPV?

Time Income / Present Value of Income at Present Value of Cost at

Costs
Period Revenue 10% Interest Rate 10% Interest Rate

0 0 0 200 200

1 50 45 100 91

2 100 83 0 0

3 300 225 0 0

Total 353 291

NPV= 353 - 291 = $ 62

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
3. Internal Rate of Return (IRR)
 The determination of the discount rate at the point of NPV = 0
 The rate (read it as "interest rate") at which the project inflows (revenues) and project
outflows (costs) are equal.
 Calculating IRR is complex and requires the aid of a computer.

FV
0= ∑ - Initial investment
(1+k+i)n
Where:
i: Rate of return
Example
 You have two projects to choose from; Project A with an IRR of 21 percent will be
completed in 4 years or Project B with an IRR of 15 percent will be completed in one year.
Which one would you prefer?
Project “A”
 Although the project B has a smaller duration than project A does not
matter because time is already taken into account in IRR calculations

Key selection: Greatest IRR

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA

4. Payback Period

 The payback period is the length of time required to recover an initial investment through

cash flows generated from the investment.

 The shorter the time period, the better the investment opportunity.

 Payback period is the least precise of all capital budgeting methods because the calculations

are in dollars and not adjusted for the time value of money.

Initial Investment
Payback Period=
(Annual cash inflows)

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Example
 A project costs $100,000 to implement and has annual net cash inflows of $25,000.

100,000
Payback Period= = 4 years
25,000

Example
 Project A has an investment of $ 500,000 and payback period of 3 years. Project B has an
investment of $ 300,000 and payback period of 5 years. Using the payback period criteria,
which project will you select?

Project “A”

Key selection: Lowest Payback period

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Example

Years 0 1 2 3 4
Cash flow -1000 500 400 300 100
Net Cash flow -1000 -500 -100 200 300

Payback period = 2.33 years

Example

Years 0 1 2 3 4
Cash flow -1000 100 300 400 600
Net Cash flow -1000 -900 -600 -200 400

Payback period = 3.33 years

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA

5. Benefit Cost Ratio (BCR)

 A comparison of revenue to costs. Greater than 1 is good.
Benefits (or Payback or Revenue)
BCR=
Costs
 BCR of > 1 means that benefits (i.e. expected revenue) is greater than the cost. Hence it
is beneficial to do the project.

Example
 Project A has an investment of $ 500,000 and BCR of 2.5 Project B has an investment of $
300,000 and BCR of 1.5 Using the Benefit Cost Ratio criteria, which project will you select?

Project “A”

 Although the project B has a smaller investment than project A will not impact the selection

Key selection: Greatest BCR

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA

Exercise:

Time Period Project “A” Project “B” Selection

NPV $ 95,000 $ 75,000 A

IRR 13 % 17 % B

Payback Period 16 months 21 months A

Benefit : Cost ratio 2.79 1.3 A

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Sunk Cost
 The cost that has already been incurred – therefore cannot be avoided going forward.

Example
 Project A had initial budget of $ 1,000 out of which $ 800 has already been spent. To
complete project A, we will need additional $ 500. Another Project B will require $ 1200
for completion. Which project do you want to select?

Project “A”

 $ 800 spent in project A i.e it is sunk cost – hence should be ignored. So, at this point of
time,
 Cost of completing project A = $ 500
 Cost of completing project B = $ 1200

Key selection: Ignore the sunk costs “because they have already been incurred and cannot be avoided”

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Opportunity Cost
 The opportunity given up by selecting one project over another.
 The cost of passing up the next best choice when making a decision.
 Once the best option is decided, the Opportunity cost of not doing the other next option is
determined – this is used to calculate opportunity cost.

Example
 You have two projects to choose from: Project A with an NPV of $45,000 or Project B with
an NPV of $85,000. What is the opportunity cost of selecting project B?

Project “$45,000”

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Economic Value Added (EVA)
 This concept is concerned with whether the project returns to the company more value
than it costs.
 The amount of added value the project produces for the company's shareholders above
the cost of financing the project
 EVA= Net Operating profit after tax - Capital charge

Working Capital
 The amount of money the company has available to invest, including investment in
projects.
 Net Working Capital = Current assets - Current liabilities for an organization.

PROJECT COST MANAGEMENT September 2015

 ECONOMIC PROJECT SELECTION CRITERIA
Depreciation
 Large assets (e.g., equipment) purchased by a company lose value over time.
 There are two forms of depreciation:
1. Straight Line Depreciation
2. Accelerated Depreciation
 Accelerated depreciation depreciates faster than straight line.

Straight Line Depreciation Accelerated Depreciation

The same amount of depreciation is taken There are two forms:

each year.
Example: A $1,000 item with a 10-year
useful life and no salvage value (how much
the item is worth at the end of its life)
Would be depreciated at $100 per year.
1. Double Declining Balance
2. Sum of the Years Digits
Example: A $1,000 item with a 10-year useful life
and no salvage value (how much the item is worth at
the end of its life)
Would be depreciated at $180 the first year, $150 the
second, $130 the next, etc.

PROJECT COST MANAGEMENT September 2015