economic selection criteria

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E CONOMIC CONOMIC P ROJECT ROJECT S ELECTION ELECTION C RITRIA RITRIA Hisham Haridy, PMP, PMI-RMP February 2016

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Page 1: Economic Selection Criteria

EECONOMICCONOMIC PPROJECTROJECT

SSELECTION ELECTION CCRITRIARITRIA

Hisham Haridy, PMP, PMI-RMPFebruary 2016

Page 2: Economic Selection Criteria

CAPITAL BUDGETING

� Project managers are often called upon to be active participants during the

benefit-to-cost analysis of project selection.

� It is highly unlikely that companies will approve a project where the costs exceed

the benefits.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

� Benefits can be measured in either financial or nonfinancial terms.

� The process of identifying the financial benefits is called capital budgeting,

which may be defined as the decision-making process by which organizations

evaluate projects that include the purchase of major fixed assets such as

buildings, machinery, and equipment.

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 3: Economic Selection Criteria

CAPITAL BUDGETING

� Sophisticated capital budgeting techniques take into consideration depreciation

schedules, tax information, and cash flow.

� The following are economic models for selecting a project:

1) Present value

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

2) Net present value

3) Internal rate of return

4) Payback period

5) Benefit-cost ratio.

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 4: Economic Selection Criteria

1. Present Value (PV):

� The value today of future cash flows.

� This is the method of determining today’s value of future money.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

PV =FV

(1+i)nWhere:

PV: Present Value

FV: Future Value

Example

� What is the present value of $300,000 received three years from now if we expect the interest

rate to be 10 percent?

FV: Future Value

i : Interest rate

n : number of time periods

PV =300000

= $225,394(1+0.1)3

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 5: Economic Selection Criteria

2. Net Present Value (NPV)

� The sum of the present value of all income and expenditures of a project. (> 0 is ok).

� It is the present value of the total benefits (income or revenue) minus the costs over many

time periods.

� NPV= PV (all cash inflows) – PV (all cash outflows)

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

NPV= ∑FV

- Initial investment(1+k+i)n

Where:

Example

� You have two projects to choose from. Project A will take three years to complete and has an

NPV of $45,000. Project B will take six years to complete and has an NPV of $85,000. Which

one would you prefer?

Key selection: Maximum NPV

Project “B”

Where:

k: Annual inflation rate

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 6: Economic Selection Criteria

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Time

Period

Income /

Revenue

Present Value of Income at

10% Interest RateCosts

Present Value of Cost at

10% Interest Rate

0 0 0 200 200

Example

� Cash flow as follow with interest 10%.

� NPV?

NPV= 353 - 291 = $ 62

0 0 0 200 200

1 50 45 100 91

2 100 83 0 0

3 300 225 0 0

Total 353 291

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 7: Economic Selection Criteria

3. Internal Rate of Return (IRR)

� The determination of the discount rate at the point of NPV = 0

� The rate (read it as "interest rate") at which the project inflows (revenues) and project

outflows (costs) are equal.

� Calculating IRR is complex and requires the aid of a computer.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

0 = ∑FV

- Initial investment(1+k+i)n

Where:

Project “A”

� Although the project B has a smaller duration than project A does not

matter because time is already taken into account in IRR calculations

Example

� You have two projects to choose from; Project A with an IRR of 21 percent will be

completed in 4 years or Project B with an IRR of 15 percent will be completed in one year.

Which one would you prefer?

Key selection: Greatest IRR

Where:

i : Rate of return

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 8: Economic Selection Criteria

4. Payback Period

� The payback period is the length of time required to recover an initial investment through

cash flows generated from the investment.

� The shorter the time period, the better the investment opportunity.

� Payback period is the least precise of all capital budgeting methods because the calculations

are in dollars and not adjusted for the time value of money.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

are in dollars and not adjusted for the time value of money.

Payback Period=Initial Investment

(Annual cash inflows)

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 9: Economic Selection Criteria

Example

� A project costs $100,000 to implement and has annual net cash inflows of $25,000.

Example

� Project A has an investment of $ 500,000 and payback period of 3 years. Project B has an

investment of $ 300,000 and payback period of 5 years. Using the payback period criteria,

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Payback Period=100,000

= 4 years25,000

investment of $ 300,000 and payback period of 5 years. Using the payback period criteria,

which project will you select?

Project “A”

Key selection: Lowest Payback period

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 10: Economic Selection Criteria

Example

Example

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Years 0 1 2 3 4

Cash flow -1000 500 400 300 100

Net Cash flow -1000 -500 -100 200 300

Payback period = 2.33 years

Example

Years 0 1 2 3 4

Cash flow -1000 100 300 400 600

Net Cash flow -1000 -900 -600 -200 400

Payback period = 3.33 years

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 11: Economic Selection Criteria

5. Benefit Cost Ratio (BCR)

� A comparison of revenue to costs. Greater than 1 is good.

� BCR of > 1 means that benefits (i.e. expected revenue) is greater than the cost. Hence it

is beneficial to do the project.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Example

BCR=Benefits (or Payback or Revenue)

Costs

Project “A”

Example

� Project A has an investment of $ 500,000 and BCR of 2.5 Project B has an investment of $

300,000 and BCR of 1.5 Using the Benefit Cost Ratio criteria, which project will you select?

Key selection: Greatest BCR

� Although the project B has a smaller investment than project A will not impact the selection

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 12: Economic Selection Criteria

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Time Period Project “A” Project “B” Selection

NPV $ 95,000 $ 75,000

IRR 13 % 17 %

Exercise:

AA

BB

Payback Period 16 months 21 months

Benefit : Cost ratio 2.79 1.3

AA

AA

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 13: Economic Selection Criteria

Sunk Cost

� The cost that has already been incurred – therefore cannot be avoided going forward.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Example

� Project A had initial budget of $ 1,000 out of which $ 800 has already been spent. To

complete project A, we will need additional $ 500. Another Project B will require $ 1200

for completion. Which project do you want to select?

Project “A”

Key selection: Ignore the sunk costs “because they have already been incurred and cannot be avoided”

� $ 800 spent in project A i.e it is sunk cost – hence should be ignored. So, at this point of

time,

� Cost of completing project A = $ 500

� Cost of completing project B = $ 1200

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 14: Economic Selection Criteria

Opportunity Cost

� The opportunity given up by selecting one project over another.

� The cost of passing up the next best choice when making a decision.

� Once the best option is decided, the Opportunity cost of not doing the other next option is

determined – this is used to calculate opportunity cost.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Example

Project “$45,000”

� You have two projects to choose from: Project A with an NPV of $45,000 or Project B with

an NPV of $85,000. What is the opportunity cost of selecting project B?

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 15: Economic Selection Criteria

Economic Value Added (EVA)

� This concept is concerned with whether the project returns to the company more value

than it costs.

� The amount of added value the project produces for the company's shareholders above

the cost of financing the project

� EVA= Net Operating profit after tax - Capital charge

Working Capital

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Working Capital

� The amount of money the company has available to invest, including investment in

projects.

� Net Working Capital = Current assets - Current liabilities for an organization.

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 16: Economic Selection Criteria

Depreciation

� Large assets (e.g., equipment) purchased by a company lose value over time.

� There are two forms of depreciation:

1. Straight Line Depreciation

2. Accelerated Depreciation

� Accelerated depreciation depreciates faster than straight line.

ECONOMIC PROJECT SELECTION CRITERIAECONOMIC PROJECT SELECTION CRITERIA

Straight Line Depreciation Accelerated DepreciationStraight Line Depreciation Accelerated Depreciation

The same amount of depreciation is taken

each year.

There are two forms:

1. Double Declining Balance

2. Sum of the Years Digits

Example: A $1,000 item with a 10-year

useful life and no salvage value (how much

the item is worth at the end of its life)

Would be depreciated at $100 per year.

Example: A $1,000 item with a 10-year useful life

and no salvage value (how much the item is worth at

the end of its life)

Would be depreciated at $180 the first year, $150 the

second, $130 the next, etc.

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 17: Economic Selection Criteria

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Double Declining Balance Sum of the Years Digits

� A uniform rate of depreciation is applied

annually to the undepreciated value as

of the end of the previous year.

� The rate used is double the depreciation

rate used in the straight line method.

� The depreciation charge is calculated as follows:

1. Calculate the sum of years' digits as SYD=

n(n+1/2).

2. For each year, calculate the sum of years' digits

fraction as the ratio of the number of remaining

� In the first year, this depreciation rate is

applied to the initial cost of the asset

without subtracting the salvage value.

� 5 years, 100,000 (40%), 100,000 *40%,

60*40%, ..etc

fraction as the ratio of the number of remaining

years over the sum of years' digits.

3. Multiply the sum of years' digits fraction by

depreciable cost.

4. 5 years, (5+4+3+2+1), 5/15, 4/15, 3/15, 2/15,

1/15

ECONOMIC PROJECT SELECTION CRITERIA February 2016

Page 18: Economic Selection Criteria

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� Another form of depreciation is called Units of Activity (or Production)

� In this method, the depreciation charge is calculated as follows:

1. Divide the depreciable cost over the expected useful life of the asset (in hours, miles, or similar

units) to obtain the depreciation rate per unit.

2. At the end of each year, multiply the depreciation rate per unit by the actual usage during that

year.

� In the units of activity (or production) method, the depreciation charge is not known in advance� In the units of activity (or production) method, the depreciation charge is not known in advance

for each year. It is calculated after the conclusion of each year's activities.

� An organization, or an individual, may choose the depreciation method that best fits their business

needs.

� In depreciating real estate, only the straight line method is allowed.

� An organization, or an individual, may switch the depreciation method, during the life of the asset,

only once and only to the straight line method.

ECONOMIC PROJECT SELECTION CRITERIA February 2016