PMP_Economic Selection Criteria

EECONOMICCONOMIC PPROJECTROJECT
SSELECTIONELECTION CCRITRIARITRIA
Hisham Haridy, PMP, PMI-RMPFebruary 2016

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

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
2) Net present value
3) Internal rate of return
4) Payback period
5) Benefit-cost ratio.

1. Present Value (PV):
The value today of future cash flows.
This is the method of determining today’s value of future money.
PV =
FV
(1+i)n
Where:
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

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)
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

Time
Period
Income /
Revenue
Present Value of Income at
10% Interest Rate
Costs
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

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.
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

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.
are in dollars and not adjusted for the time value of money.
Payback Period=
Initial Investment
(Annual cash inflows)

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,
Payback Period=
100,000
= 4 years
25,000
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

Example
Example
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

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.
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

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

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

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.
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 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
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.

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.
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.

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

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 advanceIn 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.

PMP_Economic Selection Criteria

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