Introduction

Feasibility of the projects in the context of the business, technology,

operations should be assessed before talking any decisions.

The Strategic Management requires every project to be clearly linked to the

strategy. The strategic objectives are

S Be specific in targeting an objective

M Establish a measurable indicator(s) of progress
A Make the objective assignable to one person for completion
R State what can realistically be done with available resources
T State when the objective can be achieved

Various models are used to select the projects. These models are
categorized as non-numerical and numerical models. As a part of the
previous topic, we discussed non-numerical models such as
• Sacred Cow
• Operating Necessity
• Competitive Necessity
• Product Line Extension
• Comparative Benefit Model

We also discussed one numerical model i.e. Net Present Value. In today’s
session, we would be discussing rest of the Numerical models (Heading),
such as

• Benefit/Cost Ratio (Profitability Index)

• Payback Period (PB)
• Internal Rate of Return

Benefit/Cost Ratio (Profitability Index)

What do you mean by a benefit? What do you mean by cost?

Do we have to be a financial expert to understand these terms?

Everybody thinks about the benefits when one has to incur a cost. Right?

For example, what benefit I would accrue if I pay INR 10,000 to do a

particular course?

So Benefit is an advantage or profit gained from something and the Cost is

an amount that has to be paid or spent to buy or obtain something.

Then what benefit cost ratio or cost benefit ratio means?

A ratio representing the benefits of a project or investment compared to its

cost.

It is interesting to know when exactly these terms were used in the theories
of management. Jules Dupuit, an engineer from France, first introduced the
concept of benefit cost ratio in 1848.

Alfred Marshall, a British economist further enhanced the formula that

became the basis for benefit cost ratio.

Then United States of America introduced the Federal Navigation Act of

1936. This act required that projects that were carried out by the U.S.
Corps of Engineers have a higher benefit to the general public than the
total investment in the projects.

Let us take some examples and understand how it is calculated.

You have to decide whether to go out with your friends for a dinner or not.

Going out will have associated benefits and costs. The benefits include
spending time with your friends and watching the final of the foot ball match
with them at the big screen at the restaurant. The costs include commuting
charges, cost of the food and going late to the office or missing class the
next day :). The costs could run higher.

Let us consider another example.

Due to the increase in the population, there is a short of the space for
constructing new apartments in the tier one and tier 2 cities in India.
The proposal is submitted to the local authority for opening-up an old-
growth forest for logging. Logging would provide a variety of benefits, but
will also entail costs. The products and employment generated by logging
are benefits. Some of the costs of cutting the old-growth forest include the
cost of cutting, the loss of wildlife habitat, damages to local streams due to
runoff, and the loss of an opportunity to cut the forest sometime in the
future.

So the point that I want to tell is that explicitly or implicitly, nearly every
public and private decision involves some comparison of benefits and
costs. Although a formal Benefit Cost Analysis is not used for all decision
making, the principles are applied in many settings.

Now let us concentrate on the business scenario

An organizations’ top executive has an idea for a new product that will
revolutionize the food industry. The total cost to plan, develop and produce
the widget is INR 55,000. Once the production line has been set up, the
product sells like hotcakes and produces record net profits for the
organization of INR 500,000 for the year.

What is the benefit cost ratio?

The formula to find out the benefit cost ratio is

= Present value of Cash inflows/Present value of Cash outflows

= 500,000/55,000 = 9.09

The ratio 9.09 implies that the organization would get INR 9.09 for the
investment of INR 1.

After one year of sales, the product would pay for itself almost ten times.

So the benefit cost ratio also called as a profitability index is the net present
value of all future expected cash flows divided by the initial cash
investment. If this ratio is greater than 1.0, the project may be accepted.
Now imagine a situation where the top management has to select one
project from the various options.

In this example, both the ratios are more than one. So you select the
project which has maximum ratio.

Cost-benefit analysis

Using the benefit cost ratio allows businesses and governments to make
decisions on the negatives and positives of investing in different projects.

In other words, using benefit cost ratio analysis allows an entity to decide
whether or not the benefits of a given project or proposal outweighs the
actual costs that go into the creation of the project or proposal.

Businesses and governments can benefit greatly by figuring out the cost of
a project versus its returns. For this reason alone, the benefit cost ratio is
an important formula to be used in the decision making process for any
project that might be presented.

Advantages and disadvantages of using benefit-cost analysis

Advantages–

1. It provides a starting point from which to begin evaluation of a project.

2. It is based on the quantitative data.

3. It also helps in comparing the various projects.

Payback period

Let me share my experience with you. You might have experienced the
same in your personal or professional life.

One of my friends Shalaka and her husband Shashankwant to start a

restaurant in the newly developed suburbs of the city.
Shalaka is very excited about this new venture and is ready to work
wholeheartedly in this project. It was her dream to start her own restaurant.
However her husband is more concerned about the investments.

He said it would take INR15,00,000 to start the restaurant and it would

generate net annual cash inflows of INR3,00,000. How many years it would
take to get back the invested amount?

It is simple to find out right? It would be 5 years. This is called as a payback

period.

So what is the formula for calculating the payback period?

Payback period = Initial cash outlay / Annual net cash inflow

It is the length of time required for an investment to recover its initial outlay
in terms of profits or savings.

If the calculated payback period is less than some maximum value

acceptable to the company, the proposal is accepted.

So in our example, if five years of payback period is acceptable to Shalaka

and Shashank then it is suggested that they should accept the project. If
they think that the payback period should not be more than 2 years then
they should better look for some other projects 

Let us now discuss complex example

The initial investment is INR100,000

Cash flow is as shown in the slide. How much is the payback period?

The investor would get back the INR100000 by the end of 3rd year so the
payback period is 3 years.

This method looks pretty simple isn’t it?

And that is one of the major advantages of payback period.

1. It serves as a risk indicator.

2. Sometimes OK for screening the projects.
Though it is simple to understand, the criticism about payback period model
is that

• No consideration is given to cash flows after the payback period.

• The cash flows are not discounted thus ignoring the time value of
money.

• The payback period is greater than the project life cycle.

• Assumes cash inflows for the investment period and not beyond.

• Does not consider profitability.

Internal Rate of Return

Let us discuss now a bit complex model i.e. Internal Rate of Return

Internal rate of return (IRR) is the interest rate at which the net present
value of all the cash flows (both positive and negative) from a project or
investment equal zero.

If the IRR of a new project exceeds a company’s required rate of return,

that project is desirable. If IRR falls below the required rate of return, the
project should be rejected.

Ohoh sounds difficult? Let us consider this example to understand these

jargons.

Example 1

Sushil wants to start a medical store in his colony. The colony is located in
the outskirts of the city but not very far from the city. He estimates all the
costs such as investment, operational costs and earnings for the next 2
years, and calculates the Net Present Value.

We know how to calculate the net present value; we studied this model in
the previous module.
The formula to calculate present value is

PV = FV / (1+r)n

 where PV is Present Value

 FV is Future Value
 r is the interest rate (as a decimal, so 0.10, not 10%)
 n is the number of years

Sushil uses above formula and for 6% discount rate he gets a Net Present
Value of INR 2000

If the discount rate is 8% then he gets a Net Present Value of −INR 1600

But as per the definition of internal rate of return, we have to find a discount
rate where the net present value is zero.

SoSushil tries once more with 7% interest rate and he gets a Net Present
Value of INR 15.

Close enough to zero, so he doesn't want to calculate any more.

The Internal Rate of Return (IRR) is about 7%

So the rule is that

• If IRR > cost of capital = accept project

• IRR < cost of capital = reject project

You must be wondering how we find the internal rate of return. Do we have
to keep guessing and calculating?

So the key to the whole thing is ... calculating the Net Present Value!

Since NPV of a project is inversely correlated with the discount rate, if the
discount rate increases future cash flows become more uncertain and thus
become worth less
An investment has money going out (invested or spent), and money
coming in (profits, dividends etc). You hope more comes in than goes out,
and you make a profit!

Money now is more valuable than money later on.

Let us see how it works

Assume Company XYZ must decide whether to purchase a piece of factory

equipment for INR 300,000.

The equipment would only last five years, but it is expected to generate
INR 150,000 of additional annual profit during those years.

Company XYZ also thinks it can sell the equipment for scrap afterward for
about INR 10,000.

Using IRR, Company XYZ can determine whether the equipment purchase
is a better use of its cash than its other investment options, which should
return about 10%.

The formula for IRR is:

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n,

respectively; and
IRR equals the project's internal rate of return.

In our example

P0 = Initial investment which 3, 00,000 rupees. So it is negative

P1 = is the present value at year one, cash flow for the 1st year i.e. 1, 50,000
rupees, which the company is expecting

P1 = (INR 150,000)/(1+IRR)
P2 = (INR 150,000)/(1+IRR)^2

P3 = (INR 150,000)/(1+IRR)^3

P4 = (INR 150,000)/(1+IRR)^4

We try to find out an IRR where net present value is zero

So our equation is

0 = P0+P1+P2+P3+P4

0 = -INR 300,000 +(INR 150,000)/(1+IRR)+ (INR 150,000)/(1+IRR)^2+(INR

150,000)/(1+IRR)^3+(INR 150,000)/(1+IRR)^4

If we solve this equation we will get IRR as 24.31% which is much more
than expected 10%

So it is suggested that the company should buy the equipment.

Rule of Thumb

A general rule of thumb is that the IRR value cannot be derived

analytically. Instead, IRR must be found by using mathematical trial-and-
error to derive the appropriate rate. However, most business calculators
and spreadsheet programs will automatically perform this function.

Apart from its application in the project selection, IRR can also be used by
an individual to calculate expected returns on stocks or investments,
including the yield to maturity on bonds. IRR calculates the yield on an
investment and is thus different than net present value (NPV) value of an
investment.

Why it Matters:
IRR allows managers to rank projects by their overall rates of return rather
than their net present values, and the investment with the highest IRR is
usually preferred. Ease of comparison makes IRR attractive, but there are
limits to its usefulness. For example, IRR works only for investments that
have an initial cash outflow (the purchase of the investment) followed by
one or more cash inflows.

So you can think of IRR as the rate of growth a project is expected to

generate. The Internal Rate of Return is a good way of judging an
investment. The bigger the better!

Scoring Model

Now discuss the last numerical model that is called Scoring model

Till now we have discussed the models such as benefit cash ratio, net
present value and Internal rate of return.

These methods focus on a single decision criterion. However the projects

are not selected considering only one parameter or by applying only a
single method.

A number of evaluation/selection models that use multiple criteria to

evaluate a project have been developed. Such models vary widely in their
complexity and information requirements.

The scoring models are generally categorized as

• Un Weighted Factor Scoring Model

• Weighted Factor Scoring Model
• Constrained Weighted Factor Scoring Model

We will discuss the concept behind these models.

The scoring model is a method of scoring options or solutions against a
prioritize requirements list to determine which option best fits the selection
criteria.

The unweighted Scoring model

Imagine a situation where you are a program manager in a product

company and you have to select one project among the three projects A, B
and C

The unweighted scoring model suggests that you consider various

parameters such as Profitability, Time to Development Commercial Market,
risks, and probability of the success.

For all the projects consider above parameters and give score either 0 or 1,
then add the scores and select the one with maximum score

Advantage of this method is that it is a multiple criteria for the decision

process.

However the disadvantage is that it assumes all criteria are of equal

importance; the second disadvantage is that it allows for no gradation of
the degree to which a specific project meets the various criteria

So discuss another category of the scoring model that is called Weighted

Scoring Method.

The Weighted Scoring Method

Let me take an example that is close to our hearts 

Suppose you want to purchase a car. When purchasing a new car, how do
you pick the one you want? You might make a list of items the car must
definitely have to be considered. Then you write down additional options
you’d like to have. And you leave a few spaces to note features one car
has the others don’t.
After trips to the various dealers, you tally up the list of matches and buy
the one which meets the list the best. You may not do all these formally
with paper and pencil, but you do it mentally. You are simply weighting
some features and functions of the car of higher importance than others
and if a car does not meet one of those important criteria, it is thrown out of
the running.

This Weighted Scoring Method can be use when selecting projects or

anything where we must compare one item to another.
Using a consistent list of criteria, weighted according to the importance or
priority of the criteria to the organization, a comparison of similar “solutions”
can be completed. If numerical values are assigned to the criteria priorities
and the ability of the product to meet a specific criterion, a “weighted” value
can be derived. By summing the weighted values, the product most closely
meeting the criteria can be determined.

Benefits of Scoring Models

These models are structurally simple and apply multiple decision criteria.
They are easy to modify and easy to do “what if” or sensitivity analysis.
Also the Weights provide flexibility. However there are certain drawbacks of
Scoring Models

• It is a “ranking” method, but does NOT necessarily represent “true”

value
• Quantitative value may cause decisions without “judgment”
• Assigning values sometimes is haphazard
• Input value changes (assumptions) may cause large swings in results

Drawbacks of Scoring Models

• It is a “ranking” method, but does NOT necessarily represent “true”

value
• Quantitative value may cause decisions without “judgment”
• Assigning values sometimes is haphazard
• Input value changes (assumptions) may cause large swings in results
Conclusion

Here is the recap of today’s discussion. The net present value models are
preferred to the internal rate of return models. Despite wide use, financial
models rarely include nonfinancial outcomes in their benefits and costs.

Although the NPV method is considered the favorable one among analysts,
the IRR and PB are often used as well under certain circumstances.
Managers can have the most confidence in their analysis when all three
approaches indicate the same course of action.

The scoring models are used when the decision are based on multiple
criteria. They allow the multiple objectives of all organizations to be
reflected in the important decision about which projects will be supported
and which will be rejected.

Now we conclude the second session on Project Selection Models.

Hope you enjoyed the session.

Thank you!!!!