PROJECT SELECTION METHOD

1. Benefit Measurement Method

2. Constrained Optimization Method

Two Types of Project

Selection Methods
• Benefit/Cost Ratio
• Economic Model (Economic Value Added)
• Scoring Model
• Payback Period
• Net Present Value
• Discounted Cash Flow
• Internal Rate of Return
• Opportunity Cost

The Techniques in
Benefit Measurement Method
• Linear Programming
• Non Linear Programming
• Integer Programming
• Dynamic Programming
• Multiple Objective Programming

The Techniques In Constraint

Optimization Methods
A technique that is used in selecting projects which are
based on the present value of estimated cash outflow and
inflow.
  
A  .....Uniform amount per interest period
    F .......Future worth, value, or amount
    P ......Present worth, value or amount
    n ..... at time n
    i ...... interest rate per interest period

Benefit Measurement
Methods
The future value (F) of an amount (P) initially invested at
(n) compounding periods at interest rate (i) per period. For
continuous compounding; r = nominal annual interest rate,
and n = years

Single Payment Compound Amount

(future value, compound interest)
The present value (P) of a future amount (F) based on (n)
compounding periods at interest rate (i) per period. For
continuous compounding; r = nominal annual interest rate,
and n = years

Single Payment Present Worth

(Present Value)
The uniform series payment/investment (A) required to be
made every period for (n) periods, at interest rate (i) per
period to produce a future amount (F). For continuous
compounding; r = nominal annual interest rate, and n =
years

Uniform Series Sinking

Fund (payments)
 The series of uniform payment, income, or amount (A)
required for n periods at interest rate (i) per period to pay
off a debt or to recover an initial capital investment (P). For
continuous compounding; r = nominal annual interest rate,
and n = years

Capital Recovery  (Amortization)

•A  B/C ratio greater than or equal to 1.0 indicates that the
project under consideration is economically advantageous.

Benefit-Cost Ratio
Formula
1. The city of Boracay is considering extending the
runways of its Municipal Airport so that commercial jets
can use the facility. The land necessary for the runway
extension is currently farmland, which can be purchased to
be Php 30M, and the additional annual maintenance costs
for the extension are estimated to be Php 1,125,000. If the
runways are extended, a small terminal will be constructed
at a cost of Php 12,500,000. The annual operating and
maintenance costs for the terminal are estimated at Php
3,750,000. Finally, the projected increase in flights will
require the addition of two air traffic controllers, at an
annual cost of Php 5M.

Problem/s:
(Continuation)
Annual benefits of the runway extension have been estimated as
follows:

Rental receipts from airlines

Php 16,250,000
leasing space at the facility
Airport tax charged to
Php 3,250,000
passengers
Convenience benefit for
Php 2,500,000
residents of Boracay
Additional tourism peso for
Php 2,500,000
Boracay

Apply the B/C ratio method with a study period of 20 years and an
interest rate of 10% to determine whether the runways at Boracay
Municipal Airport should be extended.
2. Three mutually exclusive alternative public
works projects are currently under consideration.
Their respective costs and benefits are included in
the table below. Each of the projects has a useful
life of 50 years, and the interest rate is 10 percent
per year. Which, if any, of these projects should be
selected?
  Project A Project B Project C

Capital investment Php8,500,000 Php10,000,000 Php12,000,000

Annual O&M costs 750,000 725,000 700,000

Salvage value 1,250,000 1,750,000 2,000,000

Annual benefit 2,150,000 2,265,000 2,500,000
3. Using the B/C ratio method, which of
the projects shown below should be
selected? Each having 30-year
projected
Project useful
Initial lives
Investment and
Annual coststhe interest
Annual Benefits

rate Ais 10%Phpper year.

12,000,000 Php 1,250,000 Php 3,250,000
B 20,000,000 4,500,000 8,000,000
C 10,000,000 750,000 1,250,000
D 14,000,000 1,850,000 4,050,000
•  
The project with the shortest payback period is accepted.

Payback Period Formula

 4. Analysis period is 15 years and
  interest rate is 9%.
Project 1 Project 2 Project 3

Capital Investment Php1,240,000 Php1,763,000 Php1,475,000

Salvage value (end of year 15) 90,000 150,000 120,000

Annual O&M costs 215,000 204,000 201,000

Annual benefits 462,800 522,000 485,500

The sum of the present values of all cash inflows
minus
•   the sum of the present values of all cash
outflows.
If the present worth of the net cash flows is equal
to, or greater than zero, the project is justified
economically.

Net Present Value (NPV)

5. A capital investment of Php 500,000 can
be made in a project that will produce
uniform annual revenue of Php 265,500 for
five years and then have a salvage value of
Php 100,000. Annual expenses will be Php
150,000. The company is willing to accept
any project that will earn at least 10% per
year, before income taxes, on all invested
capital. Determine whether it is acceptable
by using the NPV method.
6. What is the NPV for an investment that
costs Php500,000 today, Php400,000 one
year from today, Php250,000 two years from
today and pays Php750,000 three years from
today and Php1,250,000 four years from
today if future cash flows are discounted at
10%.
7. Using the NPV method, which of the
projects shown below should be selected?
Each having 30-year projected useful lives
and the interest rate is 10% per year.
• Is the rate of interest at which
• The present value of expected cash
inflows from a project
• Equals

• The present value of expected cash

outflows of the project.

Internal Rate of Return (IRR)

• Try a discount rate and calculate the NPV of the project
using that rate.

• If the NPV is less than zero, try a lower

rate.
• A lower rate will increase the NPV. We are
looking for the rate that will result in zero
NPV.
• If the NPV is greater than zero, try a
higher discount rate.
• Higher rate equals lower NPV.
• A project is accepted if the internal rate
of return exceeds the required rate of
return.
• If IRR > RRR ==>Accept
• If IRR = RRR ==>Accept
• If IRR < RRR ==>Reject

Using the IRR . . .

• Projects with higher IRRs are
preferred to projects with lower
IRRs, all other things being equal.

Using the IRR . . .

8. What is the IRR for an investment that
costs Php5,000,000 today and pays
Php1,000,000 one year from today,
Php1,750,000 two years from today; and
Php3,750,000 three years from today?
Is this a good investment? Required rate of
return is 20%
9. Compute the IRR for an investment that
costs Php4,650,000 today and is expected to
pay Php500,000 at the end of the year for
the next three years; Php750,000 at the end
of years 4 and 5; and Php5,000,000 at the
end of year 6. Required rate of return is 15%
1. Analysis period is 15 years and
interest rate is 9%. Using NPV, find the
best project.

SeatWork
2. A proposed project will require the immediate investment of Php50,000 and
is estimated
Yearto have year-end Revenue
revenues and costs as follows:
Costs
1 Php75,000 Php60,000
2 90,000 77,500
3 100,000 75,000
4 95,000 80,000
5 60,000 47,500

An additional investment of Php20,000 will be required at the end of the second

year. The project would terminate at the end of the 5th year, and the assets are
estimated to have a salvage value of Php25,000 at that time. Using IRR method,
check if this is a good investment if the required rate of return is 15%.
In finance, discounted cash flow
(DCF) analysis is a method of valuing a
project, company, or asset using the
concepts of the time value of money.

Discounted Cash Flow (DCF)

All economic questions and problems arise
from scarcity.
Companies usually do not have the
resources to satisfy/make all the projects.
Therefore, we must make choices about how
to allocate those resources. We make
decisions about how to spend our money and
use our time.

Opportunity Cost
Opportunity cost is the loss of
potential future return from the second
best unselected project. In other words,
it is the opportunity (potential return)
that will not be realized when one
project is selected over another.

Opportunity Cost
Let's say you have five dollars. What
would you like to spend it on? There
are a million things you would love to
spend five bucks on, but let's imagine
there are only three things out there you
really want to buy: gum, soda, and
movie tickets. Look at the price chart
below and answer the questions.
Good Price
1. How many sodas can you
• Gum $ .50 buy instead of one movie
ticket?
• Soda $1.00 2. How many pieces of gum
can you buy instead of one
soda?
• Movie Ticket $5.00

Look at the price chart above

and answer the questions.
• Decisions involve tradeoffs. When you make a
choice, you give up an opportunity to do
something else.

• The highest-valued alternative you give up is the

opportunity cost of your decision.

Trade Offs
1. You are part of a project selection team
evaluating three proposed projects and you
need to select the project that would bring
the best return for the organization. Project A
has an NPV of $25,000 , Project B has an
NPV of $30,000 and Project C has an NPV
of $15,000. What would be the opportunity
cost of selecting Project B over Project A?
2. Assume that you have two hours to
spend at the mall. You can either visit
the bookstore or enjoy a movie at the
theater, which is located next door. The
opportunity cost of watching a movie
is?
3. Assume that land can be used either
for producing corn, or to produce beef
by raising cattle. The opportunity cost
of converting an acre from producing
corn to raising cattle for beef is?
It is an internal management performance measure that
compares net operating profit to total cost of capital.

EVA is also referred to as Economic Profit.

The formula for EVA is:

EVA = Net Operating Profit After Tax – (Capital Invested X WACC)

WACC-weighted-average cost of capital

Economic Value Added (EVA)

Let’s take a look at an example.

Assume that Company XYZ has the following components to use

in the EVA formula:

NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = $0.056 or 5.60%

EVA = ?
Economic Value Added (EVA) is
important because it is used as an
indicator of how profitable company
projects are and it therefore serves as a
reflection of management performance.

Why it matters?
 Popular because a wide variety of factors
can be included in the analysis
 Six steps in the method
1. Develop a list of relevant factors called critical
success factors
2. Assign a weight to each factor
3. Develop a scale for each factor
4. Score each project for each factor
5. Multiply score by weights for each factor for
each project
6. Recommend the project with the highest point
score

Scoring Model