Approaches to Project Selection

Not all projects are same. Also not all projects are initiated for similar reason. Some projects are related to the
new products/services, some are related to the extension of existing products/services, and some may be
related to make alterations in the method of production etc.

There is no ironclad method of selection of projects for an organization. Rather there are some potential
methods that any project selection committee/authority can use to verify whether a certain project will benefit
the organization more than the others even they lack the suitable way to exactly specify or measure the
proposed benefit.

A. Non-Numeric Project Selection Models

1. The Operating Necessity

If a business-critical system is threatened with collapse, a project to rescue it is a necessity, with little
further formal justification. For example, if a plant is threatened by the flood then it is not much complex
and effortful to start a project for developing protective works. Certain questions come in front of the project
is needed in order to keep the system functioning like is whether the estimated cost of the project is
effective for the system? If the answer to such an important question is yes, then the project costs should
be analyzed to ensure that these are maintained as the minimum and compatible with the success of the
project.

2. The Competitive Necessity

An organization may need to take action to maintain its competitive position. Any organization has to
survive and grow in this age of fierce competitive market. For example, large mobile phone manufacturers
are bringing new model of mobile phones each year to stay competitive and if possible, be ahead of their
competitors.

3. The Product Line Extension

A project to develop and distribute new products may be judged on the degree to which it fits the firm’s
existing product line. In case of the product line extension, a project considered for development &
distribution of new products will be evaluated on the basis of the extent to which it suits the company’s
current product lines, fortify a weak line, fills a gap, or enhanced the line in a new & desirable direction.
4. Comparative Benefit Model
Projects offering the greatest benefits to the organization are selected for implementation in this approach.
According to this selection model, there are several projects that are being considered by the organization.
That subset of the projects that are selected by the senior management of the organization can provide
the most benefits to the company.

5. The Sacred Cow

A project is suggested by a senior and powerful leader in the organization – and others have no option but
to implement it. The project is created as an immediate result of this bland approach for investigating
whatever the boss has proposed. The sacredness of the project reflects the fact that it will be continued
until ended or until the boss himself/herself announces the failure of the idea & ends it.

B. Numeric Project Selection Models

B1. The Benefit Measurement Methods
Although time-consuming, employing these methods is beneficial for an effective business plan. There are
a variety of documented methods for selecting a project, but the basic thumb rule is: for small projects that
aren’t very complex, the Benefit Measurement Model is useful, whereas if it’s a large, complex project, the
Constrained Optimization Method is a better fit.

1. Payback period

The payback period is the length of time required to recover the cost of an investment. Payback is a method
of calculating how rapidly a project returns the initial investment back to the company. If this time period is
within or equal to a set date, the project can be accepted. The longer it takes to achieve payback, the less
attractive the project.

Payback period is usually expressed in years. Starting from investment year by calculating Net Cash Flow
for each year:

Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1.

Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3,
etc.)

Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

It can also be calculated using the formula:

Payback Period = (p - n)/p + ny

= 1 + ny – n/p (unit: years)
Where
 ny= the number of years after the initial investment at which the last negative value of cumulative
cash flow occurs.
n= the value of cumulative cash flow at which the last negative value of cumulative cash flow
occurs.
p= the value of cash flow at which the first positive value of cumulative cash flow occurs.

Example:
Company A invests $1 million in a project that will save the company $250,000 every year. The payback
period is calculated by dividing $1 million by $250,000, which is four. In other words, it will take four years
to pay back the investment. Another project that costs $200,000 won't save the company money, but it will
make the company an incremental $100,000 every year for the next 20 years, which is $2 million. Clearly,
the second project can make the company twice as much money, but how long will it take to pay the
investment back? The answer is $200,000 divided by $100,000, or 2 years. Not only does the second
project take less time to pay back, but it makes the company more money. Based solely on the payback
method, the second project is better.

Advantage:
a) Payback method is easy to calculate and also easy to understand, and allowed quick decisions to
be made on go, no-go rules. It works well as a project screen.

Limitation:
a) The main disadvantage is that payback did not incorporate the time value of money, and therefore
is not a preferred way to evaluate payback. Cash in the future is not worth as much as cash today.
b) Also Payback emphasis is on breakeven, not cashflow itself which might not provide solution when
more than one projects have same payback period, but year-wise cashflow pattern.
c) Payback also ignores the cash flows beyond the payback period.

2. Benefit/cost ratio
This, as its name suggests, is the ratio between the Present Inflow Value to Present Outflow Value. The
former is the cost invested in any project and the latter is the project’s value return. Preferred projects are
those which have more Benefit Cost Ratio.

A concept: ‘Time Value of Money’ concept

The time value of money (TVM) is the idea that money available at the present time is worth more than the
same amount in the future due to its potential earning capacity. This core principle of finance holds that,
provided money can earn interest, any amount of money is worth more the sooner it is received.
 Figure: The present value of $1,000, 100 years into the future. Curves represent constant discount rates
of 2%, 3%, 5%, and 7%.

3. Discounted Cash flow (DCF) and Net Present Value (NPV)

A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment
opportunity. It takes into account that the value of money today is more than the value of money received
in the future – the time value of money concept. DCF analysis uses future free cash flow projections and
discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment.
If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity
may be a good one. Here all future estimated cash flows are discounted by using cost of capital to give
their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present
value (NPV), which is taken as the value or price of the cash flows in question.

Discounted Cash flow is calculated as:

Discounted Cash flow (DCF) and Net Present Value (NPV) compare the value of money today to the value
of that same money in the future, taking inflation, cost of capital or returns into account. If the NPV of a
project is positive, it may be accepted. However, if NPV is negative, the project should probably be rejected
because cash flows will also be negative.

If... It means... Then...

the investment would add
NPV > 0 the project may be accepted
value to the firm
the investment would subtract
NPV < 0 the project may be rejected
value from the firm
We should be indifferent in the decision whether to accept or reject
the investment would neither the project. This project adds no monetary value. Decision should
NPV = 0
gain nor lose value for the firm be based on other criteria, e.g., strategic positioning or other factors
not explicitly included in the calculation.

1
wacc= weighted average cost of capital
 Example:
Cashflow ($) Discount factor (5%) Present value
Now [t=0] -25,000 1.0000 -25,000
End Y1 [t=1] 8,000 0.9524 7,619
End Y2 [t=2] 10,000 0.9070 9,070
End Y3 [t=3] 12,000 0.8638 10,366
NPV = 2,055

Advantage:
a) DCF accounts for the fact that the value of money today is more than the value of same money
received a year from now i.e. the time value of money concept.

Limitation:
a) DCF does not give visibility into how long a project will take to generate a positive NPV due to the
calculations simplicity. The NPV rule tells us to accept all investments where the NPV is greater
than zero. However, the measure doesn't tell when a positive NPV is achieved.
b) Another disadvantage is that there is no certainty in the calculations using the discount figure. With
a project running for a number of years, if the discount figure, which is a calculation, is incorrect,
the discounted cash flow figures will not be accurate [garbage in, garbage out], thus causing
discrepancies in the calculation. Also some errors e.g. “optimization bias” could happen while
calculating the timing of the inflows. 2

4. Internal Rate of Return (IRR)

The internal rate of return is defined as the discount rate where the NPV of cash flows are equal to zero. It
is more desirable to undertake the project the higher a project’s internal rate of return (when the NPV is
zero). When used properly, IRR provides excellent guidance on a project’s value and associated risk.
Internal rate of return offers a way to quantify the rate of return provided by the investment. The term
internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest
rate or inflation).

The IRR can be calculated using trial and error (changing the discount rate until the NPV = 0) or using
spreadsheet software like Microsoft Excel. Generally speaking, the higher a project's internal rate of return
(when the NPV is zero), the more desirable it is to undertake the project. The rule with respect to capital
budgeting or when evaluating a project is to accept all investments where the IRR is greater than the
opportunity cost of capital. Under most conditions, the opportunity cost of capital is equal to the company's
weighed average cost of capital (WACC). The internal rate of return is the highest discount rate at which
the project is viable, so it specifies the maximum cost of finance the project team should accept.

Formula is:

Where

2
The optimism bias is a cognitive bias that causes a person to believe that they are less at risk of experiencing a negative event
compared to others.
 r = discount rate
n = number of time periods
NPV = Net present value

Example

If an investment has the following sequence of cash flows

Year Cash flow ($)

0 -123400
1 36200
2 54800
3 48100

then the IRR is given by

In the calculation, r = .0596. So in this case, IRR is 5.96%.

Advantage:
a) IRR is widely accepted in the project and financial community as a quantified measure of return
and it's also based on discounted cash flows - so accounts for the time value of money. When
used properly, the measure provides excellent guidance on a project's value and associated risk.

Limitation:
a) While IRR is a very popular tool in estimating a project’s profitability, it can be misleading if used
alone. Depending on the initial investment costs, a project may have a low IRR but a high NPV,
meaning that while the pace at which the company sees returns on that project may be slow, the
project may also be adding a great deal of overall value to the company.
b) A similar issue arises when using IRR to compare projects of different lengths. For example, a
project of a short duration may have a high IRR, making it appear to be an excellent investment,
but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns
slowly and steadily, but may add a large amount of value to the company over time.
c) Multiple or no Rates of Return - if evaluating a project that has more than one change in the cash
flow stream, then the project may have multiple IRRs or no IRR at all.

5. Scoring Model
The scoring model is an objective technique: the project selection committee lists relevant criteria, weighs
them according to their importance and their priorities, then adds the weighted values. Once the scoring of
these projects is completed, the project with the highest score is chosen.

B2. Constrained Optimization Methods

Constrained Optimization Methods, also known as the Mathematical Model of Project Selection, are used for
larger projects that require complex and comprehensive mathematical calculations. These mathematical
calculations are based on various best and worst case scenarios, and probability of the project outcome.
Depending on the outcome of these calculations, we can compare the candidate projects and then select a
project with the best outcome. The techniques that are used in Constrained Optimization Methods are as
follows:

1. Linear Programming Method of Project Selection

In this method, we look towards reducing the project cost by efficiently reducing the duration of the project.
We look for running an activity in its normal time or the crash time. The crash time of the activity enables
us to reduce the activity time or the project as a whole.

2. Integer Programming Method

In this method, we look towards a decision that works on integer values and not on fractional values. For
example, producing a number of cars can never be fractional.

3. Dynamic Programming Method

In this method, we break a complex problem into a sequence of simpler problems. This method provides
a general framework of analyzing many problem types. In this framework, we use various optimization
techniques to solve a specific aspect of the problem. This method requires our creativity before we can
decide if the problem needs to use dynamic programming for its solution.

4. Multi Objective Programming Method

In this method, we make decision for multiple problems with mathematical optimization. In case, in a multi
objective programming, a single solution cannot optimize each of the problems, then the problems are said
to be in conflict and there is a probability of multiple optimal solutions. A solution is called as non-dominated
if values of none of the problem can be optimized without degrading values of another problem.

Project appraisal hazards

• Rejecting a project that should have been accepted

• Accepting a project that should have been rejected
• Under-estimating the amount of funding that is needed
• Over-estimating the amount of funding that is needed
• Getting the schedule wrong, so planning the wrong amounts of inappropriate types of
funding for the wrong time periods
• Not reaching the promised rate of return