Chapter Four

PROJECT SELECTION
 Good Decision Criteria
• We need to ask ourselves the following questions when
evaluating decision criteria
– Does the decision rule adjust for the time value of money?
– Does the decision rule adjust for risk?
– Does the decision rule provide information on whether we are
creating value for the firm?

2
 Introduction
• There are two types of measures of project appraisal
techniques: undiscounted and discounted.

– The basic underlying difference between these two

lies in the consideration of time value of money in
the project investment.

• Undiscounted measures do not take into account the

time value of money, while discounted measures do.

3
 Introduction
• Many economic decisions
– (for example: fish production involve benefits and
costs that are expected to occur at future time
period.
– The construction of ponds, and fish tank, for example,
requires immediate cash outlay, which with the
production and sale of fish, will result in future cash
inflows or returns
 In order to determine whether the future cash inflows
justify present Initial investment, we must compare
money spent today with the money received in the
future.
4
 4.1 The time value of money
• The time value of money influences many production
decisions. Everyone prefers money today to money in
the future.
• The preference for the Birr now instead of a Birr in the
future arises from three basic reasons:
–Uncertainty - Influences preferences because one
is never sure what will take place tomorrow.
–Reinvestment-The sooner you get the dollar
back, the sooner you can reinvest it and earn a
positive return;
–Inflation - affects the purchasing power of the
money.
5
• The Discounted Cash Flow (DCF) method takes into account
the time value of money
– the value of money will change over time.
• All other things being equal, a dollar received soon is
worth more than a dollar expected to be received in
the distant future
• This is true for three different, yet related reasons:
– Risk/ uncertainty
– Reinvestment-The sooner you get the dollar back, the
sooner you can reinvest it and earn a positive return;
– Due to the forces of economic inflation, the dollar we
receive in the distant future will have proportionately less
buying power than it does today.
• In project management, the time value of money
concept is a foundational element to performing a
financial analysis on a project 6
 4.2 Investment criteria

• Undiscounted methods
1. Inspection by ranking
2. Payback period
 Ranking by inspection
• By this, the assessor will be interested in the
– Investment cost of the project
– Cash flow patterns
• EX: Cash flows of hypothetical investments
Investment Initial cost (Birr) Net cash proceeds per year (Birr)
Year 1 Year 2
A 10,000 10,000 -

B 10,000 10,000 1,100

C 10,000 3,762 7,762
D 10,000 5,762 5,762

• The deficiency of this method:

– It does not take into account the timing of the proceeds

8
 Ranking by inspection

1. Two investments have identical cash flows

– investment B is better than investment A, because all
factors are equal except that B continues to earn
proceeds after A has been retired.
2. Two investments have the same initial outlay
and the same earning life and earn the same
total proceeds.
– Thus, investment D is more desirable than
investment C
• The deficiency of this method:
– It does not take into account the timing of the
proceeds
9
 2. Payback period:
• the length of time required to recover the initial
investment
– using project cash flows, PBP answers 'How long will
it take to pay back its cost?'
• Among alternative projects, the one with the shortest
payback period is more desirable .

Decision Rules:
• • If payback < acceptable time limit, accept project
• If payback >acceptable time limit, reject project
10
 Payback Period - Steps

1 Create cash flow time line.

2 Add a line for cumulative cash flow.
3 Identify the last year that cumulative cash
flow is negative, we will call it A.
4 Payback period is calculated as follows:

CFA
Payback Period = A 
CFA1
11
 Payback Period - Example 1

0 1 2 3 4 5

Step 1

-1,500 450 460 470 480 490

Step 2 -1,500 -1,050 -590 -120 360 850 Cumulative

Step 3 Last negative year is 3 

CFA 120
Step 4 P  A  3  3.25 years
CFA1 480

12
 Payback Period - Example 2

0 1 2 3 4 5

Step 1

-3,000 755 855 955 1,054 1,150

Step 2 -3,000 -2,245 -1,390 -435 619 1,769 Cumulative

Step 3 Last negative year is 3 

CFA 435
Step 4 P  A  3  3.41 years
CFA1 1,054

13
 Decision Criteria Test - Payback
• Does the payback rule account for the time value of money? N
• Does the payback rule account for the risk of the cash flows? N
• Does the payback rule provide an indication about the increase
in value? N
• Should we consider the payback rule for our primary decision
criteria? N

ANSWER: The answer to all of these questions is ‘No’.

14
Advantages and Disadvantages of Payback

• Advantages • Disadvantages
– Ignores the time value of
– Easy to understand
money
– Adjusts for uncertainty
– Requires an arbitrary cutoff
of later cash flows
point
– Biased towards
– Ignores cash flows beyond
liquidity
the cutoff date
– Biased against long-term
projects, such as research
and development, and new
projects
15
 Exercise

• Determine Payback Period?

16
 Discounted methods
1. NPV
2. IRR
3. Benefit/Cost ratio (profitability index

17
 Net Present Value
• The philosophy behind the net present value (NPV) is how
much should adoption of the project have on the overall value
of the firm.
• NPV is the sum of all outlays in present value terms.
– Since outlays are negative, and inflows are positive, the net
represents addition to value of the firm.

18
 Net Present Value
• How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects of this
risk level.
The third step is to find the present value of the cash flows and
subtract the initial investment.

19
 Discounting
• Discounting: The process of converting future
benefits and costs/Cash flows into today’s
dollars/Birr.
– the recognition that a future payoff amount is worth
something less than that amount today.
 Discount rate, the interest rate used in the discounting
process, reflecting the time value of money.
• It is set by Central Authority (MOFED in Ethiopia)
• It has been estimated to be in the range of 9.96- 10.49
percent with an average percentage figure of 10.23.

20
 NPV
• All future cash flows should be discounted into
present values. The discount factor is:

• Assume that a given project has a life of five

years & a discount rate (r) of 8% is used.
• For example, the discount factor for year 3 (i.e.
t=3) is calculated as follows:

21
 Rationale for the NPV Method

Decision Rules:
If the NPV is positive, accept the project
If the NPV is negative, reject the project.
If the NPV is zero, be indifferent

22
 NPV - Example 1

0 1 2 3 4 5
9%

-$1,500 $450 $460 $470 $480 $490

$412.84
$387.17
$362.93
$340.04
$318.47
$ 321.45 = Net Present Value

23
 NPV - Example 2

0 1 2 3 4 5
9%

-$3,000 $755 $855 $955 $1,054 $1,150

$692.66
$719.64
$737.44
$746.68
$747.42
$ 643.83 = Net Present Value

24
 NPV Decision Rule
If the NPV is positive, accept the project
• A positive NPV means that the project is expected to add value
to the firm and will therefore increase the wealth of the
owners.
• Since our goal is to increase owner wealth, NPV is a direct
measure of how well this project will meet our goal.

25
 Decision Criteria Test - NPV
• Does the NPV rule account for the time value of money? Y
• Does the NPV rule account for the risk of the cash flows? Y
• Does the NPV rule provide an indication about the increase in
value? Y
• Should we consider the NPV rule for our primary decision
criteria? Y
ANSWER: The answer to all of these questions is ‘Yes’

26
 NPV ADVANTAGES
1. NPV gives important to the time value of money.
2. In the calculation of NPV, both after cash flow and before cash
flow over the life span of the project are considered.
3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm's value

27
 NPV DISADVANTAGES
1.NPV is difficult to use.
2. NPV can not give accurate decision if the amount of
investment of mutually exclusive projects are not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of
unequal life.

28
 Internal Rate of Return
• This is the most important alternative to NPV
• It is often used in practice and is intuitively appealing
• It is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere

29
 IRR – Definition and Decision Rule
• Definition: IRR is the return that makes the NPV = 0
• Decision Rule: Accept the project if the IRR is greater than the
required return
• The internal rate of return (IRR) represents the effective
interest earned on the investment.

30
 Decision Rule

• If IRR > cost of capital, accept the project

• If IRR < cost of capital, reject the project
• If IRR = cost of capital, be indifferent.

8-31
 NPV vs. IRR

NPV: Enter r, solve for NPV

n
CFt

t  0 (1  R)
t
 NPV

IRR: Enter NPV = 0, solve for IRR.

n
CFt

t  0 (1  IRR )
t
0

8-32
 NPV?
Internal Rate of Return: Calculation

Then solve for r..=IRR

•The value of r in the equation where the cash inflows and the
investment outlay is zero is known as the internal rate of return.

Example 1: Compute IRR

Period 0 1 2 3
CF -2000 2400 0 0
33
 Computing IRR For The Project
• If you do not have a financial calculator, then this becomes a
trial and error process
• Calculator
– Enter the cash flows as you did with NPV
– Press IRR and then CPT
– IRR = 16.13% > 12% required return
• Do we accept or reject the project?

34
 IRR - Example 1

0 1 2 3 4 5
?

-1,500 450 460 470 480 490

IRR = 16.82%

35
 IRR - Example 2

0 1 2 3 4 5
?

-3,000 755 855 955 1,054 1,150

IRR = 16.37%

36
 IRR Problems
• First, it assumes that all cash inflows will earn the IRR rate
instead of the much more likely discount rate.
• Second, depending on the cash flow streams there can be
more than one IRR.

37
 Decision Criteria Test - IRR
• Does the IRR rule account for the time value of money?
• Does the IRR rule account for the risk of the cash flows?
• Does the IRR rule provide an indication about the increase in
value?
• Should we consider the IRR rule for our primary decision
criteria?
Answer: The answer to all of these questions is yes, although it is
not always as obvious.
38
 Advantages of IRR
• Knowing a return is intuitively appealing
• It is a simple way to communicate the value of a project to
someone who doesn’t know all the estimation details
• If the IRR is high enough, you may not need to estimate a
required return, which is often a difficult task

39
 NPV vs. IRR
• NPV and IRR will generally give us the same decision
• Exceptions
– Non-conventional cash flows – cash flow signs change more than
once
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different

40
 Independent Projects
• If two projects are independent, then adopting one does not
affect the firm’s ability to adopt the other.
• If two projects are independent, all projects with positive NPV
and/or IRR greater than the discount rate should be adopted.

41
 Independent Projects
• All projects with positive NPV add value to the firm.
• All projects where IRR or MIRR are greater than the discount
rate will bring more return than their cost of capital.

42
 Mutually Exclusive Projects
• If two projects are mutually exclusive, then the firm can only
adopt one of the two projects.
• So which of the techniques should be used to decide which
project to adopt?

43
 Benefit-Cost Ratio (Profitability Index)
• The profitability index is calculated by dividing the
present value of the future net cash flows by the initial
cash outlay: PV of net cash flows
Benefit Cost Ratio 
Initial cash outlay

• Decision rule:
– Accept if benefit–cost ratio > 1
– Reject if benefit–cost ratio < 1

5-44
 Summary _Project appraisal In Practice
• Consider all project appraisal criteria when making
decisions

• NPV and IRR are the most commonly used primary

investment criteria

• Payback is a commonly used secondary investment

criteria

• All provide valuable information

8-45
 NPV Summary

Net present value =

– Difference between market value (PV of inflows) and cost
– Accept if NPV > 0
– No serious flaws
– Preferred decision criterion

8-46
 IRR Summary
Internal rate of return =
– Discount rate that makes NPV = 0
– Accept if IRR > required return
– Same decision as NPV with conventional
cash flows
– Unreliable with:
• Non-conventional cash flows
• Mutually exclusive projects

8-47
 Payback Summary
Payback period =Length of time until initial
investment is recovered
– Accept if payback < some specified target
– Doesn’t account for time value of money
– Ignores cash flows after payback
– Arbitrary cutoff period

 The best alternative: discounted payback

period

8-48
 4.3 Sources, measures, and perspectives on risk

• What is risk?
Risk: An uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s
objectives

VENTURE OUTCOME
(Project) (Products)

FAVORABLE
UNKNOWNS (Opportunity)
(Uncertainty)
UNFAVORABLE
(Risks)

49
 Project Risk Management
Risk Management Overview

Project Lifecycle
Risk vs. Amount at Stake

I
CONCEPT DEVELOPMENT IMPLEMENT CLOSE
N
PHASE PHASE PHASE PHASE
C
R $
OPPORTUNITY AND RISK
E
A V
S A
PERIOD WHEN
I HIGHEST RISKS L
N ARE INCURRED U
G E

PERIOD OF
R HIGHEST
I RISK IMPACT
AMOUNT AT STAKE
S
K
50
 Project Risk Management
Risk Management Overview

• What is risk management?

– Identifying, analyzing, prioritizing, and responding to risk events
– Integration of risk management activities into your other project
management functions
– Developing responses to risk to meet your project objectives
– Project risk management is PROACTIVE

51
 Project Risk Management
Risk Management Overview

INTEGRATING RISK WITH OTHER PROJECT MANAGEMENT FUNCTIONS

PROJECT
MANAGEMENT
INTEGRATION
INFORMATION /
SCOPE
COMMUNICATIONS
Life Cycle and Environment
Expectations Variables
Ideas, Directives, Data Exchange
Feasibility
Accuracy

QUALITY
Requirements PROJECT RISK Availability HUMAN
Standards Productivity
RESOURCE

Services, Plant, Materials:

Time Objectives, Performance
Cost Objectives,
Constraints Restraints

CONTRACT /
TIME
COST PROCUREMENT

52
 Project Risk Management
Risk Management Overview

• Components of the Risk Management Plan

 Methodology
 Roles and responsibilities
 Budgeting
 Timing
 Risk categories
 Definitions of risk probability and impact
 Probability and impact matrix
 Stakeholder’s tolerances
 Reports
 Tracking

53
 Project Risk Management
Risk Identification

• Risk in corporate business is typically divided into 2 basic types

 Business Risk: Chances of profit or loss associated with a business endeavor
 Business employs a staff of qualified workers to increase profit and reduce chances of loss

 Pure or Insurable Risk: Divided into 4 categories

 Direct property: Destruction of property by fire, etc.
 Indirect property: Extra expenses associated with rental property or loss due to a business interruption
 Liability: Chance of a lawsuit of bodily injury, damages, etc.
 Personnel: Injuries to workers (Worker’s Comp)

54
 Project Risk Management
Risk Identification

• Risk in project management

– Usually not enough attention is paid to risk on projects
– All risks are not independent and frequently the greatest risk on a project comes from a
series of related/integrated events
– Ultimate responsibility of risk management resides with the project sponsor
– As the project manager representing the sponsor, risk management becomes a large
responsibility for you

55
 Project Risk Management
Risk Identification

• The process for identifying risk

– Understand the project

– Identify the risk event

– Document the results and take appropriate actions

56
 Project Risk Management
Risk Identification

• Types of risk
– Technical
– External
– Organizational
– Project Management
Note: These are example types of risk and this list can be modified to meet the needs of your
project

• Developing a project RBS (Risk Breakdown Structure) is an excellent tool to

help identify risks
57
 Project Risk Management
Risk Identification

PROJECT
RBS

PROJECT
TECHNICAL EXTERNAL ORGANIZATIONAL
MANAGEMENT

SUBCONTRACTORS PROJECT
REQUIREMENTS ESTIMATING
& SUPPLIERS DEPENDENCIES

TECHNOLOGY REGULATORY RESOURCES PLANNING

COMPLEXITY &
MARKET FUNDING CONTROLLING
INTERFACES

PERFORMANCES
& RELIABILITY CUSTOMER PRIORITIZATION COMMUNICATIONS

QUALITY WEATHER

The Risk Breakdown Structure (RBS) lists categories and sub-categories

for project risk. The actual categories will vary across different types of
projects. 58
 Project Risk Management
Risk Quantification
• What are the right risks to manage
– Analyzing risks for probability and impact
– Developing a risk profile for your project
– Prioritizing your risks
• When to quantify risks
– Whenever a new risk is created
– An existing risk changes
– Influential factors change
– New information surfaces
– A change is proposed by the sponsor
– Market conditions change
– Significant personnel leave the project

59
 Project Risk Management
Risk Quantification

• Quantitative Analysis • Qualitative Analysis

– Relies on a numeric value – Uses subjective values: Green, Amber,
– Uses objective data Red
– Requires understanding of probability – Requires common understanding of
theory ordinal ranking system
– Removes some uncertainty – May be less precise than quantitative
– Should be based on historical data analysis
– Some examples are: sensitivity analysis, – Should be defined in terms of the
expected monetary analysis, and parameters of the project
modeling and simulation

60
 Project Risk Management
Risk Quantification
• Probability
– Can be done in a basic approach by developing a simple estimate of the probability that an event will be late in delivery
• Ed says it is 50% likely this task will be late
• Probability of Event 1 x Probability of Event 2 = Probability
– Can be done in a more complex manner by using weighted averages
• Joe says 35% chance of being late
• Mary says 40% chance of being late
• Ed says 50% chance of being late
• Joe gets twice as much credit because he knows more about the situation
• The probability is: ((2 x 35) + (40) + (50)) / 4 = 40%
– Quantifying risk probability can become quite complex, there are many resources to assist you with more detailed approaches (books,
internet research, multi-day training, consultants).

61
 Project Risk Management
Risk Quantification

• Assessing Impact (cont.)

– Quality
• Ask yourself the question “What if the project fails to perform as expected
during its operational life?”
• Of all the project objectives, conforming to quality objectives is the one most
remembered
• Therefore, this is one of the most important dimensions impacting your
project
• You can use financial analysis to identify risk for poor quality by quantifying
long term activities that will impact the product lifecycle for your analysis
62
 Project Risk Management
Risk Response
• Risk response is:
– Defining steps for responses to opportunities and threats
– Assigning responsibility
– Developing responses for negative risks:
• Avoiding: Changing the project mgt plan to eliminate the risk. Could involve
changing the objective, modifying the schedule, or reduction in scope.
• Mitigating: A reduction in the probability or impact to the project. Taking early
action to reduce the probability, adopting less complex processes, or conducting
more tests.
• Transferring: Shifting the risk to a third party for the management of the risk.
Does not eliminate the risk, could involve insurance, warranties, bonds.
• Insurance: Purchase insurance to reduce/eliminate risk – an athlete may
purchase insurance against injury to guarantee their income.

63
 Project Risk Management
Risk Control

• Actively work your risk register/log

• Update risks as needed (data, new resources, new/changing requirements)
• Review the log in status calls, set and use due dates for active contingency plans
• Hold assigned resources accountable for their action items
• Engage sponsor when invoking contingency plans to ensure they know a risk has
happened and the team is actively working the response plan

64
4.4.Sensitivity and Breakeven Analysis
• Analyzing the risks of investment projects, by changing the
values of forecasted variables.

• Finding the values of particular variables which give the

project a Breakeven NPV of zero.

65
Process of Analysis

• Identification of those variables which will have significant

impacts on the NPV, if their future values vary around the
forecast values.
• The variables having significant impacts on the NPV are
known as ‘sensitive variables’.
• The variables are ranked in the order of their monetary
impact on the NPV.
• The most sensitive variables are further investigated by
management.
66
Management Use of Sensitivity and Breakeven Analysis
Using Sensitivity:
Sensitive variables are investigated and managed in two ways:
• (1) Ex ante; in the planning phase; more effort is used to
create better forecasts of future values. If management
decides the project is too risky, it is abandoned at this stage.

67
Management Use of Sensitivity and Breakeven Analysis

Using Sensitivity:
Sensitive variables are investigated and managed in two
ways:
•(2) Ex post; in the project execution phase; management
monitors the forecasted values. If the project is performing poorly,
it is abandoned or sold off prior to its planned termination.

68
Management Use of Sensitivity and Breakeven
Analysis
Using Breakeven:

• Forecasted calculated Breakeven values of variables are continuously

compared against actual outcomes during the execution phase.

69
 Terminology Within the Analysis

• Sensitivity and Breakeven analyses are also known as: ‘scenario

analysis’, and ‘what-if analysis’.
• Point values of forecasts are known as: ‘optimistic’, ‘most likely’, and
‘pessimistic’.
• Respective calculated NPVs are known as: ‘best case’, ‘base case’ and
‘worst case’.
• Variables giving a ‘breakeven’ value, return an NPV of zero for the
project.

70
Selection Criteria For Variables in the Analysis

• Degree of management control.

• Management's confidence in the forecasts.
• Amount of management experience in assessing projects.
• Extrinsic variables more problematic than intrinsic
variables.
• Time and cost of analysis.

71
Developing Optimistic and Pessimistic Forecasts

• (a) Use forecasting –error information from the forecasting

methods: eg - upper and lower bounds; prediction interval;
expert opinion; physical constraints, are applied to the
variables.
This method is formalized, but arguable, slow and
expensive.

72
Developing Optimistic and Pessimistic Forecasts

•(b) Use ad hoc percentage changes: a fixed percentage, such

as 20%,or 30%, is added to and subtracted from the most likely
forecast value.

This method is vague and informal, but fast, popular, and

cheap.
+20%

?
-20% 73
Outputs and Uses

• Each forecast value is entered into the model,and one

solution is given.
• Solutions can be summarized automatically, or individually
by hand.
• Variables are ranked in order of the monetary range of
calculated NPVs.
• Management investigates the sensitive variables.
• More forecasting is done, or the project is accepted or
rejected as is.
74
Strengths and Weaknesses of Analysis
• Easy to understand.
• Forces planning discipline.
• Helps to highlight risky variables.
• Relatively cheap.
• --------- --------- ---------
• Relatively unsophisticated.
• May not capture all information.
• Limited to one variable at a time.
• Ignores interdependencies.

75