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GEN119

Engineering Project Management

Chapter 3:
Economic evaluation and
investment decision methods

Dr: Ayman Zaki


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Methods for Selecting Projects
(Performing economic evaluation)
There are usually more projects than available time and
resources to implement them

It is important to follow a logical process for selecting a


projects to work on

Methods include:
focusing on broad needs
categorizing projects
performing financial analyses
using a weighted scoring model
implementing a balanced score card

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Methods for Selecting Projects
(Performing economic evaluation)

Financial Analysis of Projects


 Financial considerations are often an important
consideration in selecting projects

 Three primary methods for determining the projected


financial value of projects:

1) Net present value (NPV) analysis


2) Return on investment (ROI)
3) Payback analysis

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Financial Analysis of Projects
1) Net present value (NPV) analysis

Net present value (NPV) analysis is a method of calculating


the expected net monetary gain or loss from a project by
discounting all expected future cash inflows and outflows to
the present point in time.

A positive NPV means that the project is expected to add


value to the firm and will therefore increase the wealth of the
owners.

The higher the NPV, the better

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Financial Analysis of Projects
 Computing NPV for the Project

Department of Treasury and Finance ,Economic Evaluation for Business Cases ,August 2013

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Financial Analysis of Projects
 Computing NPV for the Project

NPV 
NPV 
 NCF
NCF nn

((11
 ii)) n
n

Where:

NCF = the net cash flow (i.e. cash inflow – cash


outflow) at time n
t= the time of the cash flow
i= the discount rate (the rate of return that could be
earned on an investment)
Financial Analysis of Projects
 The NPV Decision Rules

If NPV>0, accept the Project.


If NPV=0, accept or reject the
Project.
If NPV<0, reject the Project.

 NPV is typically used for 2 reasons:

 Assessing the value of a project


 Choosing which projects get priority

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Financial Analysis of Projects
Project example information
You are looking at a new project and you have estimated
the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
Your required return for assets of this risk is 12%.
Do you accept or reject the project?
Solution
 NPV   N .CF n

(1  i ) n

63120 70800 91080


 NPV  165000  1
 2
 3
 12627 .38
(1.12) (1.12) (1.12)
NPV = +value (accept the project)
Financial Analysis of Projects
2) Return on Investment (ROI)
Return on investment (ROI) is calculated by subtracting
the project costs from the benefits and then dividing by the
costs.

total discounted benefits  total discounted costs


ROI 
discounted costs

The higher the ROI, the better

Many organizations have a required rate of return or


minimum acceptable rate of return (MARR) on an
investment.
Internal rate of return (IRR) can by calculated by setting
the NPV to zero.
Financial Analysis of Projects
2) Internal rate of return
The internal rate of return of a project is known as the rate
of return where the particular project’s net present value
(NPV) equals to zero.

Formula:
CF 1 CF 2 CF 3
[    ]  Initial Investment  0
(1  i )1
(1  i ) 2
(1  i ) 3

Where:
– CF: Cash Flow
– i: Internal Rate of Return (IRR)

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Financial Analysis of Projects
2) Return on Investment (ROI)
Decision Rule: Accept the project if the IRR is greater
than the required return.

Computing IRR For The Project becomes a trial and error


process.

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Financial Analysis of Projects
Example:
 Suppose an investment will cost $16,000 initially and
will generate the following cash flows:
 Year 1: 3,000
 Year 2: 4,000
 Year 3: 5,000
 Year 4: 7,000
 Year 5: 7,000
 Year 6: 8,000
 The required return is 15%.
 Should we accept or reject the project?
Financial Analysis of Projects
Solution:
 Using try and error
 Try i = 15 %

 NPV   N .CF n

(1  i ) n
3000 4000 5000 7000
 NPV  16000  ( 1
)  ( 2
)  ( 3
)  ( 4
)
(1.15) (1.15) (1.15) (1.15)
7000 8000
( 5
)  ( 6
)  3862
(1.15) (1.15)

 Try i = 25 %

 NPV  1221 .88


Financial Analysis of Projects
Solution:
 i = 15 % -------- NPV =+3862
a c
b  i=X% -------- NPV = 0 d
 i = 25 % -------- NPV = -1221.88

 Using interpolation a c
 
b d
X  15 0  3862
 
25  15  1221 .88  3862

i  X  22.59%

 i = X= 22.59 > MARR (15%) ----- Accept the project


Financial Analysis of Projects
3) Payback Analysis
Another important financial consideration is payback
analysis

The payback period is the amount of time it will take to


recoup, in the form of net cash inflows, the net dollars
invested in a project

Payback occurs when the cumulative discounted benefits


and costs are greater than zero

 Decision Rule :
 Accept if the payback period is less than some preset
limit.
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Financial Analysis of Projects
For the previous example: Is the project acceptable in the
case of 5 years longest acceptable Payback (PB) Period?
At n =0 NPV)0 = -16000
3000
 NPV 1 16000  ( 1
)  13391 .3
(1.15)
3000 4000
 NPV 2 16000  ( 1
)  ( 2
)  10366 .7
(1.15) (1.15)
3000 4000 5000
 NPV 3 16000  ( 1
)  ( 2
)  ( 3
)  7079 .12
(1.15) (1.15) (1.15)
3000 4000 5000 7000
 NPV 4 16000  ( 1
)  ( 2
)  ( 3
)  ( 4
)  3076 .84
(1.15) (1.15) (1.15) (1.15)

3000 4000 5000 7000


 NPV 5 16000  ( )  ( )  ( )  ( )
(1.15)1 (1.15) 2 (1.15)3 (1.15) 4
7000
( )  403 .39
(1.15)5
Financial Analysis of Projects
Solution:
 n = 4 -------- NPV =-3076.84
a c
b  n = X -------- NPV = 0 d
 n = 5 -------- NPV = 403.39

 Using interpolation a c
 
b d
X 4 0  ( 3076 .84 )
 
54 403 .39  ( 3076 .84 )

 n  X  4.88 years

 n = X= 4.88 < nacceptable (5 years) ----- Accept the


project
Non-financial analysis of projects
Weighted Scoring Model
A weighted scoring model is a tool that provides a
systematic process for selecting projects based on many
criteria
- First identify criteria important to the project selection
process
- Then assign weights (percentages) to each criterion
so they add up to 100%
- Then assign scores to each criterion for each project
-Multiply the scores by the weights and get the total
weighted scores

The higher the weighted score, the better.

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Non-financial analysis of projects
Sample Weighted Scoring Model for
Project Selection

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Thank you for your listening !
Any Questions ?

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