Understanding a range

of investment decision
support tools

Aim of
Lecture / How each tool works
Tutorial

Advantages and
disadvantages of each
 Project Selection

Numeric Models

Financial Models Scoring Models

 Project Selection

Numeric Models
(a) Financial Models
• Payback Period
• Return on Investment (ROI)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
 Project Selection

Payback Period

Year Cashflow: Machine A Cashflow: Machine 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
Payback Period 4 years 3 years

Projects may be selected on the basis

of the shortest payback period  B
 Project Selection
Payback Period
Advantages of Payback Period Method:

• Simple and Easy to use.

• Employs readily available data to determine Cash Flows.
• Reduces projects exposure to risk and uncertainty by selecting the project which has the
shortest payback period.
• Future cash-flow uncertainty is reduced.
• Appropriate to High Technology projects.
• Faster payback has favourable short-term effect on earnings per share.
 Project Selection
Payback Period

Disadvantages of Payback Period Method:

• Does not consider the Time Value of money

• It is not suitable for evaluation of long term projects due to varying inflation and interest
rates.
• Based upon cash-flow only, all other data is ignored.
• Payback period reduces the duration of risk but it does not quantify the level of risk exposure.
• It does not look at the TOTAL project (i.e. what happens after the payback period)
Project Selection
Payback Period

Same payback period even

though cashflow profiles are
different. May choose “C”
because initial cashflow is
higher.

“E” has the shorter payback

period and higher initial
cashflow. However, may
choose “F” because overall
returns are higher.
 Project Selection
Return on Investment (ROI)
Year Cashflow: Machine A Cashflow: Machine 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 Returns £120,000 £105,000
Machine A: ROI per Yr = Average Annual Profits / Original Investment x 100%
ROI = (£40,000 / 5) / £80,000 x 100%
ROI / yr = 10%
ROI Life of Project = 50%

Machine B: ROI = Average Annual Profits / Original Investment x 100%

ROI = (£25,000 / 5) / £80,000 x 100%
ROI / yr = 6.25%
ROI Life of Project = 31.25%
 Project Selection

Return on Investment (ROI)

MAIN ADVANTAGES:
• Simple technique
• Considers cash-flow over the whole
project.

MAIN 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).
 Project Selection

Discounted Cash Flow Techniques

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)
 Net Present Value (NPV)
𝑛
NVP = Σ 𝑡
1+𝑖

n = Cash Flow for year

i = Interest / inflation / discount value
t = year

“This is the sum of the present value of cash flows

(positive and negative) for each year associated with
the investment, discounted so that it’s expressed in
today’s dollars.”
Harvard Business Review. (2018). A Refresher on Net Present Value. [online] Available at:
https://hbr.org/2014/11/a-refresher-on-net-present-value [Accessed 3 Dec. 2018].
 Project Selection

Net Present Value (NPV)

Years Project Cash Discount Present

X =
Flow Factor Value
0
1
2
3
Total NPV
Proforma for NPV Calculations
 Project Selection

Net Present Value (NPV)

• Takes into account the reduction in the value of
money caused by inflation. Like compound interest in
reverse!
• If inflation runs at 10% per annum, then £100 invested
would be worth £110 after Year 1 and £121 after Year 2
etc.
• Hence 2 years into the future, the value of your £121 is
only £100 in today’s terms. This is the Net Present Value
(NPV) of £121 two years into the future.
• If the NPV is POSITIVE, project is good. Preference
should be given to a project with the highest NPV.
 Project Selection

Net Present Value (NPV)

Mathematically:

• Cash Flow (at any future time, t) = Income – Expenditure

• NPV = Cash Flow x Discount Factor
• This Discount Factor derives from the compound interest
formula.
n
• Discount Factor = 1 / (1 + i) […where n is the number of years]

NPV = Future Cash Flow

(1 + i)n
 Project Selection

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 Selection

Net Present Value (NPV)

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
 Project Selection
Net Present Value (NPV)

General Procedure.
• Assume a discount factor
• Insert the cash-flow
• Transfer the discounting factors from the table.
• Calculate present value (multiply cash-flow by
discount factor)
• Aggregate the present values to give the NPV
• See example
 Project Selection

Net Present Value (NPV)

Machine A: Inflation (Discount) Rate = 5%

Years Project Cash Flow Discount Factor Present Value
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
 Project Selection

Net Present Value (NPV)

Machine B: Inflation (Discount) Rate = 5%

Years Project Cash Flow Discount Factor Present Value
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

Machine A has the higher NPV after 5 years

 Project Selection

Net Present Value (NPV)

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
inflation figures.
• It provides more accurate profit and loss forecast.
 Project Selection

Net Present Value (NPV)

Disadvantages of NPV;

• Accuracy is dependent upon predicted cash

flows and interest rates.
• Biased towards short term projects.
• May assume fixed rate for duration of the
project.
 Project Selection

Internal Rate of Return (IRR)

• Also called the Discounted Cash Flow Yield
• It can be calculated by plotting the NPV
against the IRR.
• The IRR value corresponds to the Discount
Factor at the point where the NPV goes from
positive to negative (i.e. at NPV = 0).
• IRR may therefore also be regarded as the
maximum rate of inflation that the project can
accommodate while still returning a positive NPV.
• Consider the following examples.
 Project Selection
Internal Rate of Return (IRR)
To find the IRR, we need to determine the inflation
(discount) rate at which the NPV after 5 years goes to
zero.As a first approximation, assume a rate of 10%.

Machine A: Inflation (Discount) Rate = 10%

Years Project Cash Flow Discount Factor Present Value
0 -£80,000 1 -£80,000
1 £10,000 0.9091 £9,091
2 £20.000 0.8264 £16,528
3 £20,000 0.7513 £15,026
4 £30,000 0.6830 £20,490
5 £40,000 0.6209 £24,836
NPV = £5971

The NPV is still positive. Hence the IRR (discount rate

at which the NPV = 0) must be greater than 10%. Let’s
try 15% and observe the results.
 Project Selection

Internal Rate of Return (IRR)

The NPV is still positive so we need to assume a higher
inflation rate. Now assume a rate of 15%.

Machine A: Inflation (Discount) Rate = 15%

Years Project Cash Flow Discount Factor Present Value
0 -£80,000 1 -£80,000
1 £10,000 0.8696 £8,696
2 £20.000 0.7561 £15,122
3 £20,000 0.6575 £13,150
4 £30,000 0.5718 £17,154
5 £40,000 0.4972 £19,888
NPV = - £5990
The NPV has gone negative. Hence the inflation
(discount) rate at which the NPV = 0 must lie
between 10% and 15%.
 Project Selection

Internal Rate of Return (IRR)

The previous results would tend to suggest that the IRR
lies around 12% to 13% (Why?).

We can find the IRR by a graphical method, plotting

NPV against discount rate and determining where the
line crosses the x-axis (i.e. at NPV = 0).

Consider the data presented in the above slides. At a

discount rate of 10% the NPV was £5971 and at 15% it
was - £5990. The points may be plotted and the IRR
found from the graph.
 Project Selection

Internal Rate of Return (IRR)

IRR plot for Machine A
8000

6000

4000

2000
Total NPV

-2000
IRR ≈ 12.5%
-4000

-6000

-8000
8 9 10 11 12 13 14 15 16
Rate (%)
 Project Selection

Scoring Models – Non-Weighted

The table below follows a model employed by Burke.

Scoring Factors Select Reject

Profit > 20% x
Enter New Market x
Increase Market Share x
Use Existing Under-Utilised Equipment x
Use Existing Under-Utilised Workforce x
No Additional Energy Expenditure x
No Additional Expertise Required x
No External Consultants Required x
Minimal Environmental Impact x
Payback Period < 2 Years x
Consistent with Company Strategic Plan x
Total 7 4
 Project Selection

Scoring Models – Weighted

1. Brainstorm all the important criteria on which to evaluate

the projects. Suppose five criteria were identified. In a real
life project appraisal many more might be identified.

2. Identify any criteria that are mandatory, i.e. the project

must meet that criterion otherwise it will not be considered
to be viable. In the example below, Criterion 1 is deemed to
be mandatory.
 Project Selection

Scoring Models – Weighted

3. Identify the most important of the non-mandatory criteria

and assign it a weight of 10.Then compare the remaining
criteria with the most important and assign them a relative
weighting. In the above example, Criterion 2 was considered
most important and assigned a weight of 10. Criteria 3 and 4
were deemed to be 80% as important as Criteria 2 and were
each assigned a weight of 8. Criteria 5 was deemed to be half
as important as Criteria 2 and assigned a weight of 5.
4. Rate each project against each criterion on a numeric scale.
In the above example a scale of 1 to 10 was used.
 Project Selection

Scoring Models – Weighted

5. For each project, multiply the criteria weight by the rating

to arrive at a weighted score. For the purpose of this
example the weights are shown in italics and the rates in
bold type. On Criteria 2, Project A is rated at 10, which when
multiplied by the weighting of 10 gives a maximum weighted
score of 100. Project B is rated as 7 which when multiplied
by the weighting of 10 gives a weighted score of 70 on
Criteria 2.
6.When all projects have been rated and scored on
all criteria, add the scores to give an overall score
for the projects.
 Project Selection

Scoring Models – Weighted

Weighted Score (= Score x Weighting)
Criterion Weight Project A Project B Project C
Criterion 1 Mandatory Yes Yes No
Criterion 2 10 9 x 10 = 90 8 x 10 = 80 9 x 10 = 90
Criterion 3 8 9 x 8 = 72 8 x 8 = 64 9 x 8 = 72
Criterion 4 6 6 x 6 = 36 7 x 6 = 42 9 x 6 = 54
Criterion 5 4 7x 4 = 28 8 x 4 = 32 9 x 4 = 36
Total Score 226 218 252
 Project Selection

Scoring Models

ADVANTAGES of SCORING MODELS

• Encourages objectivity in decision-making
• Multiple criteria widen range of evaluation
• Simple structure / Easy to use
• Selection of factors by management
 reflects company goals.
• Easy to change factors
• Weightings reflect importance ( low
weighted factors can be removed)
 Project Selection

Scoring Models

DISADVANTAGES of SCORING
MODELS
• May encourage a long list of trivial
factors resulting in a waste of
management time
• If factors are not weighted then all
entries have equal importance.
 Project Selection

BREAK-EVEN
ANALYSIS
Above the
Below means Components Variable
BE value Fixed Costs Revenue.
A MEANS OF FINDING THE loss are: Costs
means profit
POINT, IN VALUE AND UNITS,
AT WHICH COSTS EQUAL
REVENUES.
 Project Selection

Fixed Costs: Costs that are present even if no production

occurs, e.g, rent, indirect labour, interest payments

Variable Costs: Cost that only occur when production happens

and will vary with volume, e.g direct labour, parts costs, machine
energy costs, proportional costs (heating, lighting etc)
THE
COMPONENTS
Revenue: Value generated from the sale of goods

Selling price – variable cost = contribution (contribution

of paying fixed costs (overhead))
 Project Selection

BREAK-EVEN POINT SINGLE

PRODUCT

• BEPu = break-even point in units • BEP = Total Revenue = Total Costs

• TR = total revenue
• Break-even in units (BEPu) =
• BEPv = break-even point in value
Total fixed cost / (Price - Variable cost)
• F = fixed costs
• P = price per unit (after all discounts)
• Break-even in value (BEPv) =
• V = variable costs per unit
Total fixed cost / (1 -(Variable cost
• U = number of units produced / Price))
• TC = total costs = F + Vx
 Project Selection

SIMPLE BREAK-EVEN EXAMPLE

• Cost and revenue lines at straight, in reality these

could well be curved.
• This being due to variances in selling prices and
costs with large volume production.
• What selling and variances costs do you think
could affect the straight line?
• Discounted initial selling price.
• Direct labour cost (overtime, extra staff), energy
costs.
• Miscalculation or incorrect data
 Project Selection

MULTIPRODUCT BEP VALUE

• With a variety of products, we proceed

with break-even analysis just as in a
single-product case, except that we
weight each of the products by its
proportion of total sales.
 TASK 30 MINS

• Find other possible project selection

tools / methods / finical indicators
• Return and we with list and discuss.
 Project Selection

• Cashflow Forecasts
• EBITDA (Earns Before Interest Tax Depreciation &
Amortisation
OT H E R M E A S U R E S C O U L D B E • ROAE (Return On Assets Employed)
• ROS (Return of Sales)
• Profit and Loss
• Balance Sheet
 Project Selection

We have considered:

A range of Project
Selection Models.
IN SUMMARY
Their application.

The advantages &

disadvantages.