MBA ZG523/ PGBA ZG523/ QM ZG523

PROJECT MANAGEMENT
Dr. Rajesh Matai, Department of Management, BITS Pilani
BITS Pilani
Pilani Campus
 BITS Pilani
Pilani Campus

Project Selection

Lecture No. 4
Lecture Outline

 Financial Criteria of Project selection

 NPV, Payback Period, Exercises
 Non-Financial multi criteria techniques of Project
Selection
 Analytic Hierarchy Process (AHP)

BITS Pilani, Pilani Campus

Project Selection Methods
Based on Financial Criteria
• Discounting Criteria
– Net Present Value (NPV)
– Benefit Cost Ratio (BCR)
– Internal Rate of Return Method

• Non-discounting Criteria
– Return on Investment (ROI)
– Payback Period

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NET PRESENT VALUE (NPV)

• NPV is the Sum of the Present Values of all the Cash

Flows – Positive as well as Negative - that are expected
to occur over the Life of the Project.
NPV = ∑ Ct / (1 + r ) n – Investment
for the period t=1 to t=n
where Ct = cash flow at the end of year t
n = life of the project
r = discount rate

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Project Selection Methods
Based on Financial Criteria
• Accept the Project if the NPV is Positive
• Reject the Project if the NPV is Negative

• Value of Firm = ∑ Present Value of Projects + ∑ Net

Present Value of Prospective Projects
• When a Firm Terminates an Existing Project Which has
Negative NPV Based on its Expected Future Cash
Flows, the Value of the Firm Increases by that Amount.

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EXAMPLE 1

YEAR CASH FLOW

0 (-1,000,000)*
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
Discounting Rate = r = 10%
* Initial Investment (outflow)

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 Project Selection

NPV = - 1,000,000 + 200,000 + 200,000 +

(1.10)0 (1.10)1 (1.10)2
(Initial Investment)
300,000 + 300,000 + 350,000
(1.10)3 (1.10)4 (1.10)5
_

[(-1000000)
+ (181818.18 + 165289.2562 + 225394.44
+ 204904.04 + 217322.46)]
= - Rs. 5271.26

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BENEFIT COST RATIO

BENEFIT COST RATIO (BCR) = (PVB) / I

PVB = PRESENT VALUE OF BENEFITS
I = INITIAL INVESTMENT

NET BENEFIT COST RATIO (NBCR) = BCR – 1 =(NPV / I)

BCR NBCR RULE

>1 >0 ACCEPT
=1 =0 INDIFFERENT
<1 <0 REJECT

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EXAMPLE 2

INITIAL INVESTMENT (I) : 100,000

Year Cashflow
YEAR 1 25,000
YEAR 2 40,000
YEAR 3 40,000 {25000 / (1.12)1} {40000 / (1.12)3}
YEAR 4 50,000 {40000 / (1.12)2}
BCR = PVB / I r = 12% {50000 / (1.12)4}

PVB = 22,321.43+31,887.76+28,471.21+31,775.90
= 1,14,456.30
BCR = PVB / I = 114456.30 / 100000 = 1.14456 = 1.145
NBCR = BCR – 1 = 0.145 {(114456.30–100000)/100000}
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IRR Method

IRR is defined as that value of discount rate, which would

make the NPV of the project equal to zero.

If the value of IRR is higher than a certain rate specified by

the Organization (often called “hurdle rate”), the project
is accepted and if it is lower, the project is rejected.

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Undiscounted Future Cash
Flows
RETURN ON INVESTMENT

INVESTMENT = 1MILLION (10 Lacs)

PROFIT BEFORE INTEREST AND TAXES = 2,00,000

ROI = 2,00,000/10,00,000 * 100 = 20%

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PAYBACK PERIOD

• Length Of Time Required To Recover The Initial Cash

Outlay On The Project
• Shorter The Payback Period, More Desirable Is The
Project

Advantages
• It Is Simple Both In Concept And Application
• It Favors Projects Which Generate Substantial Cash
Inflows In Earlier Years And Discriminates Against
Projects Which Bring Cash Inflows In Later Years
• It Is Useful When Company Is Pressed With Problems
Of Liquidity
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LIMITATIONS

• It Fails To Consider The Time Value Of Money

• It Ignores Cash Flows Beyond The Payback Period
• It Is A Measure Of Project’s Capital Recovery, Not
Profitability
• It Measures A Project’s Liquidity But Does Not Indicate
Liquidity Position Of The Firm As A Whole

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DISCOUNTED PAYBACK
PERIOD
• It Takes Into Account Time Value Of Money
• Cash Flows Are Converted To Their Present Values By
Applying Discounting Factors
• Find The Cumulative Net Cash Flow After Discounting
Till We Get Positive Value
• The Corresponding Period Shows The Discounted
Payback Period

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EXAMPLE 3: DISCOUNTED
PAYBACK PERIOD
YEAR CASH FLOW PRESENT VALUE CUM.
0 -10000 -10000 -10000
1 3000 2727 -7273
2 3000 2479 -4794
3 4000 3005 -1789
4 4000 2732 943
5 5000 3105
6 2000 1129
Assuming r = 10% Discounted Payback Period = 3.6548
years (Gives the actual / real picture of recovery)
Undiscounted Payback Period = 3 years

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Exercise

1. A five-year project has a projected net cash flow of

$15,000, $25,000, $30,000, $20,000, and $15,000 in the
next five years. It will cost $50,000 to implement the
project. If the required rate of return is 20 percent,
conduct a discounted cash flow calculation to determine
the NPV.

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NPV Calculation

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Exercise

2. You work for the 3T Company, which expects to earn at

least 18 percent on its investments. You have to choose
between two similar projects. Below is the cash
information for each project. Your analysts predict that
inflation rate will be a stable 3 percent over the next 7
years. Which of the two projects would you fund if the
decision is based only on financial information? Why?

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Exercise

Omega
Year Inflow Outflow Netflow
Y0 0 $225,000 -225,000
Y1 0 190,000 -190,000
Y2 150,000 0 150,000
Y3 220,000 30,000 190,000
Y4 215,000 0 215,000
Y5 205,000 30,000 175,000
Y6 197,000 0 197,000
Y7 100,000 30,000 70,000
Total 1,087,000 505,000 582,000

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Exercise

Alpha
Year Inflow Outflow Netflow
Y0 0 $300,000 -300,000
Y1 50,000 100,000 -50,000

Y2 150,000 0 150,000
Y3 250,000 50,000 200,000
Y4 250,000 0 250,000
Y5 200,000 50,000 150,000
Y6 180,000 0 180,000
Y7 120,000 30,000 90,000
Total 1,200,000 530,000 670,000
BITS Pilani, Pilani Campus
NPV Calculation

BITS Pilani, Pilani Campus

NPV Calculation

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Pay Back Period

Project X has an initial investment of 10,50,000 and projected cash

inflows of 2,37,500 for 5 years.
Project Y has an initial investment of 8,00,000 and projected cash
inflows of 1,80,000 for 5 years.
Payback period (in years) = Estimated Project Cost/Annual Savings
The payback period for Project X is 4.42 years and for Project Y is 4.44
years.
Both the projects are acceptable as they return the initial investment in
less than 5 years.
ROI is reciprocal of Payback.
ROI: Project X = (237500/1050000) ×100 = 22.62 %
Project Y = (180000/800000) × 100 = 22.50 %
Management Criteria: Accept, if Payback Period is less than 5 years
and ROI is more than 15% (desired rate of return). Project X is
slightly more favourable.
BITS Pilani, Pilani Campus
Discounted Pay Back Period

Project X (undiscounted payback period is 4.42 years)

If you were to consider the payback period after
considering the discounted values, assuming r to be 15
percent.
Year Outflow Discounted value of cash inflow
0 10,50,000 -----
1 206521.74 -843478
2 179584.12 -

3 156160.11
4 135791.40
5 118079.47
Total 796136.84 BITS Pilani, Pilani Campus
Discounted Pay Back Period
Project X

Year Outflow Discounted value of cash inflow

0 10,50,000 -----
1 206521.74
2 179584.12

3 156160.11
4 135791.40
5 118079.47
6 102677.80
7 89285.05
8 77639.17
Total 1065738.86 (7.7973
years) BITS Pilani, Pilani Campus
Discounted Pay Back Period Project Y
(undiscounted payback period is 4.44
years)
Year Outflow Discounted value of cash inflow
0 8,00,000 -----
1 156521.74
2 136105.86

3 118352.92
4 102915.58
5 89491.81
6 77818.96
7 67668.67
8 58842.32
Total 807717.87 (7.8688
years) BITS Pilani, Pilani Campus
Analytic Hierarchy Process (AHP)

• Based on a hierarchical structure of the

goal, objectives and alternatives
(The Goal at the highest level, alternatives at the lowest
level and objectives or criteria in between)
• The weights of the criteria or objectives
need not be known a priori but are
determined by pair-wise comparisons

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Hierarchical Structure

Goal

Criteria

Alternatives

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Scale for pair-wise comparison

1 Equally preferred
2 Equally to Moderately preferred
3 Moderately preferred
4 Moderately to Strongly preferred
5 Strongly preferred
6 Strongly to Very Strongly preferred
7 Very Strongly preferred
8 Very to Extremely Strongly preferred
9 Extremely preferred
04/19/2024 Project SElection 30
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Steps
Develop hierarchy
Perform pair-wise comparison of attributes
and determine priority vector (B2)
For each attribute perform pair-wise
comparison of the alternatives and
determine priority vector Vi for i =1,…,n
Matrix B3= V1, V2 ,…,Vn
Synthesize to determine scores vector
B3*B2T
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Normalization and averaging
• Divide the elements of each column by
sum of that column
• Add the elements in each resulting row
and divide this sum by the number of
elements in the row

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An example
Anil is about to graduate from college and is
trying to determine which job to join. He has
three options to choose from. He considers
four criteria (objectives) to meet the goal :
– High starting salary
– Quality of life in the city where job is located
– Interest in the type of work
– Nearness of job to family

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Problem hierarchy

Satisfaction with a Job

Nearness to
Starting Salary Life Quality in City Interest in Job
Family

Job A Job B Job C

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Pair-wise comparison at criteria level
Salary Quality Interest Nearness Priority Vector
(B2)
Salary 1 5 2 4 0.51

Quality 1/5 1 1/2 1/2 0.099

Interest 1/2 2 1 2 0.24

Nearness ¼ 2 1/2 1 0.148

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Pair-wise comparison at alternative level

Salary Job A Job B Job C Priority Vector

V1

Job A 1 2 4 0.571

Job B 1/2 1 2 0.296

Job C 1/4 1/2 1 0.143

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Pair-wise comparison at alternative level

Quality Job A Job B Job C Priority

Vector (V2)

Job A 1 1/3 1/2 0.163

Job B 3 1 2 0.540

Job C 2 1/2 1 0.297

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Pair-wise comparison at alternative level

Interest Job A Job B Job C Priority Vector

(V3)

Job A 1 1/3 1/3 0.168

Job B 2 1 2 0.484

Job C 3 1/2 1 0.349

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Pair-wise comparison at alternative level

Nearness Job A Job B Job C Priority Vector

(V4)

Job A 1 1/4 1 0.167

Job B 4 1 4 0.667

Job C 1 1/4 1 0.167

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Finding final scores for the alternatives

V1 V2 V3 V4 B2

0.571 0.163 0.168 0.167 0.51 0.372

Job A

0.099
0.296 0.540 0.484 0.667 = 0.419
0.24
Job B
0.143 0.297 0.349 0.167 0.148 0.210

Job C

Rank in descending order of scores

Job B, Job A, Job C
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Thank You!

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