MBA 430

MBA 430
Selecting
SelectingProjects:
Projects:
Using
UsingFinancial
FinancialModels
Models

Prashant Reddy - s98006573 Rupen Nand - s91027870

 Content
Content
Project Classification

Project Goals
Selection Criteria
• IRR
IRR •
• NPV
Financial
FinancialModels
Models
NPV
• ROI
ROI
•
•
• Payback
Payback •

Application to Scenario
Ranking & Selection
Conclusion
Conclusion
 Project Classification
Project Classification

Support current Support long-term

operations -↓ cost, mission - ↑ revenue
↑ efficiency & Compliance
Operational Projects
Strategic Project
Projects & market share
performance Compliance
Operational Projects
Strategic Project
Projects

Must do – regulations &

Must do – regulations &
emergency
emergency

• Compliance projects ignores selection criteria as it is a must do project.

• All other projects are evaluated and selected using criteria’s linked to
organization strategy
 Project Goals
Project Goals

Strate
Strate
gic
gic
Align
Strategy is Every project
Align
ment
implemented should have
ment
through clear link to
projects strategy
Portfolio Management
Portfolio Management

Project Management
Project Management
• Selection criteria need to ensure that each project is prioritized and
contributes to strategic goals however some organizations fail to do this.

• Evidence shows organizations do not develop a process to align project

selection to strategic goals resulting in underutilization of resources.
Adopted from “Project Management – The Managerial Process”
 Selection Criteria
Selection Criteria
• Selection criteria are typically identified as financial or nonfinancial.
• Using purely either one of these for selection often leads to unbalanced
portfolios and projects that aren’t strategically oriented.
• A number of models have been developed for each of these criteria.

Non-financial Models
Non-financial Models
Checklist Model
Checklist Model
Multi-Weighted Scoring Model
Multi-Weighted Scoring Model

Financial Models
Financial Models
Payback Period
Payback Period
Return on Investment (ROI)
Return on Investment (ROI)
Net Present Value (NPV)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Internal Rate of Return (IRR)
 Payback Model
Payback Model

Payback model measures the time taken to recover the project investment.

Total Project Cost

Payback Total Project Cost
--------------------------------
Payback --------------------------------
Average Annual Return
Average Annual Return
• Advantages:
1. Payback model is the simplest & most widely used.
2. Emphasizes cash flow which is a key factor in business.
• Limitations:
1. Ignores time value of money.
2. Does not take into account cash flow beyond payback period.
3. Does not consider profitability.
 Return on Investment (ROI) Model
Return on Investment (ROI) Model

ROI model measures annual return (profit/cash) on total project investment

in ratio or percentage.

Average Annual Return

Average Annual Return
ROI --------------------------------
ROI --------------------------------
Total Project Cost
Total Project Cost
• Advantages:
1. ROI model is simple to calculate & is widely used.
2. Emphasizes cash flow and profit both integral to business.
• Limitations:
1. Comparison between projects ignores initial investment value.
2. Does not take into account the time value of money.
 Net Present Value (NPV) Model
Net Present Value (NPV) Model

NPV model is based on time value of money and uses RRR to discount all
the future net cash flows for a project to a present value.
Projects with positive NPV is eligible for further consideration.
Where:
n CCt
∑∑ n C = net cash flow
NPV tt
-------------------- t = time period
NPV (1 + r) --------------------
t n = number of periods
t = 0 (1 + r) r = required rate of return
t=0
• Advantages:
1. Considers the time value of money (cash).
2. Emphasizes cash flow throughout the project.
3. Uses multiple RRR when considering projects with different risks.
• Limitations:
1. Comparison between projects ignores initial investment value.
2. Does not provide a percentage return on total investment.
 Internal Rate of Return (IRR) Model
Internal Rate of Return (IRR) Model
NPV
$

IRR (NPV = 0)
0 Discount Rate
%

IRR is the discount rate at which NPV of a project is equal to zero.

Projects with higher IRR than the RRR is used for further consideration.

n CCt
IRR NPV 0
0 ∑∑
t=0
n
(1 + r)
tt
--------------------
--------------------
(1 + r)
t

t=0
• Advantages:
1. Provides a percentage return on total investment.
2. Can be easily compared to benchmarks for selection.
• Limitations:
1. Comparison between projects ignores initial investment value.
2. Complex to calculate manually and can be done by trail & error.
 Application to Scenario
Application to Scenario
Strategic Project A - Developing Real Estate
Strategic Project A - Developing Real Estate
• Initial investment of $350,000.
• • Initial investment of $350,000.
Projected cash inflow :
•$200,000
Projected
in cash inflow
the 2nd :
year.
$200,000ininthe
$300,000 the3rd
2ndyear.
year.
$300,000
$150,000 in the
in the 4th 3rd year.
year.
$150,000 in the 4th year.

Operational Project B – Buying Construction Machine

•
Operational Project B – Buying Construction Machine
Initial investment of $100,000.
• Initial investment
• Projected of $100,000.
cash savings :
• $30,000
Projected in the 1st year. :
cash savings
$30,000
$70,000 in the
in the 2nd1st year.
year.
$70,000
$20,000 ininthethe 2nd
3rd year.
year.
$20,000
$10,000 ininthethe 3rd
4th year.
year.
$10,000 in the 4th year.

Strategic Project C - Constructing Apartments

•
Strategic Project C - Constructing Apartments
Initial investment of $350,000.
• Initial investment
• Projected of:$350,000.
cash inflow
•$150,000
Projected in cash inflow
the 1st year.:
$150,000
$250,000 inin the
the 1styear.
2nd year.
$250,000
$100,000 inin the
the 2nd
3rd year.
year.
$100,000 in the 3rd year.
 Payback Calculation
Payback Calculation

Payback was calculated using the following method.

Real Estate Machine Apartment

Initial Investment $350,000 $100,000 $350,000

Subtract Year 1 cash inflow $0 $30,000 $150,000

Balance to be recovered $350,000 $70,000 $200,000

Subtract Year 2 cash inflow $200,000 $70,000 $250,000

Balance to be recovered $150,000 $0

Subtract Year 3 cash inflow $300,000

Ratio of final year deducted 0.5 0.0 0.8

Payback Period 2.5 Yrs 2.0 Yrs 1.8 Yrs

 ROI Calculation
ROI Calculation

For each of the project the average cash inflow was worked out for the
entire project life.
This was then divided with the initial investment to find ROI.

Real Estate Machine Apartment

Initial Investment (I) $350,000 $100,000 $350,000

Total cash inflow (X) $650,000 $130,000 $500,000

Years of project (Y) 4 Yrs 4 Yrs 3 Yrs

Average of inflow (Z = X/Y) $162,500 $32,500 $166,667

ROI (I/Z) 46.4% 32.5% 47.6%

 NPV Calculation
NPV Calculation
Using the required rate of return of 20% as the discount rate the present
value of each cash flow was calculated as follows:
Apartment
Year 0 Cash Outflow → $350,000/(1+0.2)0 = $350,000
Year 1 Cash Inflow → $150,000/(1+0.2)1 = $125,000
Year 2 Cash Inflow → $250,000/(1+0.2)2 = $173,611 and so on…
This was done to all and then was net-off to find the NPV of the project.

Real Estate Machine Apartment

Initial Investment -$350,000 -$100,000 -$350,000

Year 1 cash inflow $0 $25,000 $125,000

Year 2 cash inflow $138,889 $48,611 $173,611

Year 3 cash inflow $173,611 $11,574 $57,870

Year 4 cash inflow $72,338 $4,823 $0

NPV (total of all) $34,838 -$9,992 $6,481

 IRR Calculation
IRR Calculation

IRR was calculated using excel. NPV was set at zero and the discount rate
which is the IRR was found.
The following shows how the value are used in the formula:
Apartment
IRR:
NPV = 0 = -$350,000/(1+r)0 + $150,000/(1+r)1 + $250,000/(1+r)2
+ $100,000/(1+r)3
The value of r (IRR) was then calculated.

Real Estate Machine Apartment

IRR 24.1% 13.8% 21.2%

 Ranking & Selecting
Ranking & Selecting
• All calculated values using various models is tabulated to be first assessed
against the industry or internal benchmark set by the organization.
•Theses benchmarks should be linked to organization strategies and goals.
•If more than 1 project passes through these criteria then it is prioritized
using other financial or non-financial factors.

Financial Models Real Estate Machine Apartment Benchmark

Payback 2.5 Yrs 2.0 Yrs 1.8 Yrs < 2.5 Yrs
ROI 46.4% 32.5% 47.6% > 20.0%
NPV $34,838 -$9,992 $6,481 > $0
IRR 24.1% 13.8% 21.2% > 20.0%

Pass

Select (Priority)
 Conclusion
Conclusion

Multiple competing projects, limited resources and market pressure act

as forces to link business strategy with project selection.
It is important to utilize multiple criteria that reflect the organization
strategy to rank and select projects.
The few financial model used showed how these criteria can determine
the projects to take up for further consideration using other factors
aligned to organization strategy.
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