BUSM 1273 - Project Management Techniques
Introduction to Project Selection Models
Dr. Frank Boukamp
http://frank.boukamp.net
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Project Selection Models
If we have to choose between 2 projects, how do we choose?
• Two Critical Facts:
• Models do not make decisions - People do!
• All models are only partial representations of reality
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Question: Which Option is better?
The table below lists the annual profit/loss for each of the upcoming 5 years for
Machine A and Machine B.
Years Machine A Machine B
0 ($35,000) ($32,000)
1 $22,000 $13,000
2 $13,000 $13,000
3 $12,000 $11,000
4 $10,000 $11,000
5 $3,000 $10,000
It’s not easy to tell, which option is better.
“Better” may also be a question of perspective.
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Payback period
• Ratio is number of years required to pay back the investment
• Time to recover project investment
• Payback Period in years:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
• or
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
• Widely used; emphasis on Cashflow
• Proxy for risk i.e. shorter is less risky
• Simplistic – ignores “time value of money”
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Payback period
Example:
• Project costs $100,000
• Annual net cash inflows $25,000
• PP = $100,000/$25,000 = 4 years
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Payback Period:
Question: Which one is better?
Years Machine A Machine B
0 ($35,000) ($32,000)
1 $22,000 $13,000
2 $13,000 $13,000
3 $12,000 $11,000
4 $10,000 $11,000
5 $3,000 $10,000
Payback Period:
Machine A: ~ 2 years
Machine B: ~ 3 years
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Return on Investment (ROI)
(Average Rate of Return)
• Ratio of average annual profit (before or after taxes) to average investment
in the project;
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 − 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
• Example:
• Project costs: $100,000
• Annual net cash inflows: $25,000
• Average annual profits: $15,000 ROI = $15,000/$100,000 = 0.15 = 15%
• Simplistic – no time value of money
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Return on Investment (ROI)
Years Machine A Machine B
0 ($35,000) ($32,000)
1 $22,000 $13,000
2 $13,000 $13,000
3 $12,000 $11,000
4 $10,000 $11,000
5 $3,000 $10,000
• Machine A: • Machine B:
• Average annual profit= • Average annual profit=
(60,000-35,000)/5=5,000 (58,000-32,000)/5=5,200
• ROI= • ROI=
5,000/35,000=14% 5,200/32,000=16%
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Time Value of Money
• $1 today is worth more than $1 in the future because:
• cash can be invested
• Inflation
Suppose cash can be invested at k% and the inflation rate is p% per year.
The value of $X today is worth X(1 + k + p)t in t years’ time.
Suppose we have $Y in t years. Its present value is Y/(1 + k + p)t .
This is less than $Y, i.e. it is discounted.
1
Discount Factor =
(1+𝑖𝑖)𝑛𝑛
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Net Present Value
Machine A:
Year Cash flow Discount factor Present value
0 ($35,000) 1 ($35,000)
1 $22,000 0.95 $20,900
2 $13,000 0.91 $11,830
3 $12,000 0.86 $10,320
4 $10,000 0.82 $8,200
5 $3,000 0.78 $2,340
Total NPV $18,590
1
Discount Factor = , i=5%
(1+𝑖𝑖)𝑛𝑛
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Net Present Value
Machine B:
Year Cash flow Discount factor Present value
0 ($32,000) 1 ($32,000)
1 $13,000 0.95 $12,350
2 $13,000 0.91 $11,830
3 $11,000 0.86 $9,460
4 $11,000 0.82 $9,020
5 $10,000 0.78 $7,800
Total NPV $18,460
1
Discount Factor = , i=5%
(1+𝑖𝑖)𝑛𝑛
NPV (Machine A): $18,590
NPV (Machine B): $18,460
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Recap
Which one is better?
Criteria Machine A Machine B
Cost $35,000 $32,000
Payback ~2 years ~3 years
Period
ROI 14% 16%
NPV $18,590 $18,460
Conclusion?
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Questions?
Dr. Frank Boukamp
e-mail: frank.boukamp@rmit.edu.au
Office hours: https://frank.boukamp.net/office-hours
This course material by Dr. Frank Boukamp is licensed under a
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