PROJECT SELECTION METHODS

Viability/Profitability of Investment

 Benefit Measurement Methods (Comparative Approach)

Scoring Models

Economic Models

Constrained Optimization Methods (Mathematical Approach)

Linear Programming

Integer Programming
Dynamic Programming

Multi-Objective Programming

BENEFIT MEASUREMENT METHODS

Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Return on Investment (ROI) Benefit to Cost Ratio (BCR) Payback Period (PP) Opportunity Cost (OC)

Net Present Value

DEFINITION:

The total value of future amounts in todays terms less costs. PV = FV PV = Present Value FV = Future Value (1+r)n
r = Interest Rate n = Number of time period

NPV

= Present Value Cost of Investment

CRITERIA:

Accept projects with positive NPV Consider other projects if NPV is zero For multiple options, Select project with the highest NPV The greater the NPV the better

Internal Rate of Return

DEFINITION:
The rate at which an Investment earns money for itself.

CRITERIA:

Accept project if IRR is greater than cost of capital or hurdle rate.

The greater the IRR the better.

E.g. IRR of 28% is greater than 19%

Profitability Index
DEFINITION:

Ratio of returns or cash flows to investments.

CRITERIA:

Pursue project if PI is higher. Reject project if PI is less than 1. Consider other projects if PI is 1;project breaks even.

Return on Investment
DEFINITION:

Ratio of net earnings to the value of the investment. It is calculated by taking out Investment cost from gross earnings.

CRITERIA:

Pursue project if ROI is higher.

For several projects, choose the one with the highest ROI.

Benefit-to-Cost Ratio
DEFINITION:

BCR is the ratio of the projects benefits (revenues) to the costs (investment).

CRITERIA:

Pursue project if BCR is greater than 1.

Reject project if BCR is less than 1

Consider other projects if BCR is 1; project breaks even

Payback Period
DEFINITION:

Length of Time within which project investment cost is recovered before it starts collecting profit.

Measure of viability/risk/liquidity.

CRITERIA:

The shorter the payback period the better.

Does not consider the time value of money

Opportunity Cost
DEFINITION:

The cost of the alternative foregone in order to pursue the selected option.

CRITERIA:

The smaller the opportunity cost the better.

For a number of options, the opportunity cost of an option is the cost of the next best option.

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