Exe

ercise 4

Thee Strategy of
o Project Seelection

1. The prooject sponsor of the prroposed Tex xas Project has come tto you for p project charrter
assistan
nce. The Ex xecutive Co
ommittee of Outwest C Company has sent bacck the propo osal
for morre informattion. The Present
P Valuue report off the expectted benefitss will be diffficult
to judg
ge on its merits with thhe companyy structure o of financiall analysis. T
The CFO haas
asked, based
b on th
he expectedd cash flowss in the Texxas Project, what would d be the
internnal rate off return (IR RR)? Therre are six exxpense or benefit item ms in the pro oposal
for the next five yeears:

TEXAS PROJEC
T CT 
Item  Year  FV 
1  0  ‐$50,000 
2  1  $5,000 
3  2  $15,000 
4  3  $15,000 
5  4  $15,000 
6  5  $15,000 

2. The Ouutwest Com mpany Execu utive Comm mittee comppares propo osals to a baaseline of raates of
return that are ava ailable as allternate inv
vestments oof the comppany’s cash assets. The Chief
Financial Officer (CFO)
( can get
g a 7% ratte with speccific investmments that are in line w with
the com
mpany’s risk k tolerance. What is th his rate callled when ap
pplied as an n approval metric
for projject propossals? ____ _________ ________ _________ ___

3. When the
t CFO seees the internal rate of return
r (IRRR) of the Teexas Projectt, what wou
uld you
expect as a result of
o the approval consid
deration and
d why?

4. In revieewing the cash

c flows frrom the Texxas Projectt, where an initial inveestment of
$50,0000 creates a benefit in each follow
wing year, wwhat is the p
period of tim me from thhe
investm
ment until the
t breakev ven point, allso known aas the paybback period?

The Strategy
S of Pro
oject Selection – Exercise 4 Page 1
Copyright 20
016, Velociteach
h
 Exe
ercise 4

Thee Strategy of
o Project Seelection

5. Anotheer project proposal,

p th
he Arizona Project,
P con
nveys expeccted cash flo
ows similarr to the
Texas Project,
P as shown
s below. If the Ex xecutive Co
ommittee wwere to deciide betweenn these
two proojects for ad
dding to thee portfolio based
b on paayback periiod, which project pro
oposal
is moree advantageeous?

AR
RIZONA PROJJECT 
Item  Year  FV 
1  0  ‐$100,000
2  1  $25,000
3  2  $50,000
4  3  $75,000
5  4  $100,000
6  5  $125,000

6. What iss the Opporrtunity Cost of each prroject when

n comparingg the Texass and the Arrizona
projectts?

7. If the Executive
E Co
ommittee were
w to mak ke a propossal decisionn between th
he two projects,
Texas and
a Arizona a, based on the cost off a lost oppo
ortunity, whhat would b
be the resullting
decision?

The Strategy
S of Pro
oject Selection – Exercise 4 Page 2
Copyright 20
016, Velociteach
h
 Exe
ercise 4

Thee Strategy of
o Project Seelection

ANSWER
RS

1. The prooject sponsor of the prroposed Tex xas Project has come tto you for p project charrter
assistan
nce. The Ex xecutive Co
ommittee of Outwest C Company has sent bacck the propo osal
for morre informattion. The Present
P Valuue report off the expectted benefitss will be diffficult
to judg
ge on its merits with thhe companyy structure o of financiall analysis. T
The CFO haas
asked, based
b on th
he expectedd cash flowss in the Texxas Project, what would d be the
internnal rate off return (IR RR)? Therre are six exxpense or benefit item ms in the pro oposal
for the next five yeears:

TEXAS PROJECT  5%    Rate  N

NPV 
Item  Year  FV  Rate  PV    5%  $
$5,418 
1  0  ‐$50,000  5%  ‐$50,000   10%  ‐$
$2,229 
2  1  $5,000  5%  $4,762   7.5%  $
$1,386 
3  2  $15,000  5%  $13,605   88.75%  ‐$470 
4  3  $15,000  5%  $12,958   88.25%  $260 
5  4  $15,000  5%  $12,341   8.5%  ‐$107 
6  5  $15,000  5%  $11,753 88.427%  $0 
      NPV: $5,418 IRR   

To solve
s for IR
RR, use an itterative meethod to “hoome in” on the IRR. FFirst, it is
recoommended d to set up a spreadsheet of the ca sh flows to quickly asssess the Nett
Present Value. Inserting 5% as the RateR provid
des an NPV of $5418. Using a 10% % rate
givees an NPV ofo -$2,229. The IRR iss the rate th hat providees an NPV o
of $0. Using g an
iterative trial-a
and-error, you
y discoveer that the IIRR is 8.427%. Productive “guessing”
occuurs when yo ou use the “binary
“ spliit” method of guessingg—half the d difference
betwween conseecutive guessses. For ex xample, if tthe IRR is b
between 5%% and 10%, n next
try 7.5%.
7 The IRR is betw ween 7.5% and
a 10%, so o next try 8.75%, and sso on.

2. The Ouutwest Com mpany Execu utive Comm mittee comppares propo osals to a baaseline of raates of
return that are ava ailable as allternate inv
vestments oof the comppany’s cash assets. The Chief
Financial Officer (CFO)
( can get
g a 7% ratte with speccific investmments that are in line w with
the com
mpany’s risk k tolerance. What is th his rate callled when ap
pplied as an n approval metric
for projject propossals?
the “hurd
dle rate”

3. When the
t CFO seees the internal rate of return
r (IRRR) of the Teexas Projectt, what wou
uld you
expect as a result of
o the approval consid
deration and
d why?

If th
he “hurdle rate”
r is 7%, then a projject propossal should hhave an IRR
R greater th
han the
hurrdle rate to be
b an attracctive altern
native for th
he use of com
mpany fundds. In this case,
the Texas Project exhibitss an IRR of 8.427%, grreater than 7%, so not withstandiing
otheer decision criteria, th
he Texas Prooject shouldd be approvved.

The Strategy
S of Pro
oject Selection – Exercise 4 Page 3
Copyright 20
016, Velociteach
h
 Exe
ercise 4

Thee Strategy of
o Project Seelection

4. In revieewing the cash

c flows frrom the Texxas Projectt, where an initial inveestment of
$50,0000 creates a benefit in each follow
wing year, wwhat is the p
period of tim me from thhe
investm
ment until the
t breakev ven point, allso known aas the paybback period?

Dettermine thee cumulativee costs and compare to o the cumu ulative beneefits over tim
me. At
the point wherre the two values
v are thhe same, th
his is called the breakeven point. The
time from the initial
i he breakeveen point is the paybacck period.
invesstment to th

Loo
oking at thee numbers, we
w see the breakeven
b p
point is thee end of Yeaar 4. Graph
hing
the values provvides more of a visual regarding tthe breakevven point.

Year  FV 
F Cum
m Cost  Cu
um Benefit 
0  ‐$50,000  $50,000  0
1  $5,000  $50,000  $5,000
2  $15,000  $50,000  $20,000
3  $15,000  $50,000  $35,000
4  $15,000  $50,000  $50,000
5  $15,000  $50,000  $65,000

5. Anotheer project proposal,

p th
he Arizona Project,
P con
nveys expeccted cash flo
ows similarr to the
Texas Project,
P as shown
s below. If the Ex xecutive Co
ommittee wwere to deciide betweenn these
two proojects for ad
dding to thee portfolio based
b on paayback periiod, which project pro
oposal
is moree advantageeous?

ARIZONA P
PROJECT 
Cum 
C
Year  FV  um Cost  Benefit 
Cu B
0  ‐$1
100,000  $100,000  0
1  $25,000 
$ $100,000  $25,000
2  $50,000 
$ $100,000  $75,000
3  $75,000 
$ $100,000  $150,000
4  $1
100,000  $100,000  $250,000
5  $1
125,000  $100,000  $375,000

Checking
C th
he payback period
p for the
t Arizonaa Project shows about 22.5 years. B
Based
on
o a shorterr payback period alonee, then the A Arizona Pro
oject would
d be preferred
since “Smalller is Betterr” for paybaack period ccomparison
ns.

The Strategy
S of Pro
oject Selection – Exercise 4 Page 4
Copyright 20
016, Velociteach
h
 Exe
ercise 4

Thee Strategy of
o Project Seelection

6. What iss the Opporrtunity Cost of each prroject when

n comparingg the Texass and the Arrizona
projectts?

Thee cumulativ
ve benefit off the Texas Project is $
$65,000.
Thee cumulativ
ve benefit off the Arizon
na Project iss $375,000
0.

Theerefore, the Opportuniity Cost of the Texas Prroject is $3

375,000, an
nd the
opp
portunity coost of the Arrizona Project is $65,0
000.

7. If the Executive
E Co
ommittee were
w to mak ke a propossal decision he two projects,
n between th
Texas and
a Arizona a, based on the cost off a lost oppo
ortunity, whhat would b
be the resullting
decision?

Thee Opportuniity Cost of the

t Arizona oper
a Project is less, thereffore it would be the pro
choice based on
o this finanncial measu
ure…

The Strategy
S of Pro
oject Selection – Exercise 4 Page 5
Copyright 20
016, Velociteach
h