Financial Modeling : to
select the project
Project selection: Financial Modeling By: Temesgen Belayneh (PhD)
Introduction
There are four methods of project
selection in a firm. The methods
are:
1.Return of Investment (ROI)
2.Payback Method
3.Net Present Value (NPV)
4.The Internal Rate of Return (IRR).
Good Decision Criteria
All cash flows considered?
TVM considered?
Risk-adjusted?
Ability to rank projects?
Indicates added value to the firm?
Independent versus Mutually
Exclusive Projects
Independent
The cash flows of one project are
unaffected by the acceptance of the
other.
Mutually Exclusive
The acceptance of one project
precludes accepting the other.
1. Net Present Value Method
How much value is created from
undertaking an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of this risk
level.
Step 3: Find the present value of the cash flows and subtract
the initial investment to arrive at the Net Present Value.
Net Present Value
Sum of the PVs of all cash flows
n CFt
NPV = ∑
(1 + R)t
t=0 NOTE: t=0
Initial cost often is CF0 and is an outflow.
n CFt
NPV = ∑ - CF 0
(1 + R) t
t=1
NPV – Decision Rule
If NPV is positive, accept the project
NPV > 0 means:
Project is expected to add value to the firm
Will increase the wealth of the owners
NPV is a direct measure of how well this
project will meet the goal of increasing
shareholder wealth.
Sample Project Data
You are looking at a new project and have
estimated the following cash flows:
Year 0:CF = -165,000
Year 1:CF = 63,120
Year 2:CF = 70,800
Year 3:CF = 91,080
Your required return for assets of this risk is 12%.
This project will be the example for all problem
exhibits in this chapter.
Computing NPV for the Project
n
Using the formula: CFt
NPV t
t 0 (1 R )
NPV = -165,000/(1.12)0 + 63,120/(1.12)1 +
70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41
Capital Budgeting Project NPV
Required Return = 12%
Year CF Formula Disc CFs
0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00)
1 63,120.00 =(63120)/(1.12)^1 = 56,357.14
2 70,800.00 =(70800)/(1.12)^2 = 56,441.33
3 91,080.00 =(91080)/(1.12)^3 = 64,828.94
12,627.41
Rationale for the NPV Method
NPV = PV inflows – Cost
NPV=0 → Project’s inflows are
“exactly sufficient to repay the
invested capital and provide the
required rate of return”
NPV = net gain in shareholder wealth
Rule: Accept project if NPV >
0
NPV Method
Meets all desirable criteria
Considers all CFs
Considers TVM
Adjusts for risk
Can rank mutually exclusive projects
Directly related to increase in V F
Dominant method; always prevails
2. Payback Period Method
How long does it take to recover the initial cost of
a project?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until
initial investment is recovered
A “break-even” type measure
Decision Rule – Accept if the payback period
is less than some preset limit
Cont’d..
If an investment project is implemented, then the
time or the number of years within which the
summation of the flow of undiscounted net
revenues becomes equal to the total cost of the
project is called the payback period.
According to this method, if one of a number of
projects is to be selected, then the project for which
the payback period is minimum, should be
implemented.
Calculate Payback Period
If investment cost $100 and receive $50 a year for 3
years, what is payback period?
What if investment cost $75?
Same project as before
Year 0:CF = -165,000
Year 1:CF = 63,120
Year 2:CF = 70,800
Year 3:CF = 91,080
Computing Payback for the
Project
Capital Budgeting Project
Year CF Cum. CFs
0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000
Payback = year 2 +
+ (31080/91080)
Do we accept or reject the project?
Payback = 2.34 years
Advantages and Disadvantages of
Payback
Disadvantages
Advantages
Ignores the time value of
Easy to understand
money
Biased towards liquidity
Requires an arbitrary cutoff
point
Ignores cash flows beyond the
cutoff date
Example for ignoring cash flow
beyond PBP (pay back period)
Cont’d..
From the data given above we see that in the case
of project I, the sum total of the net revenue flow in
the first two years has been equal to the project
cost and, in the case of project II, the sum total of
the net revenue flow in the first three years has
been equal to the project cost.
In other words, the payback period for the two
projects are 2 and 3 years, respectively. According
to the payback method, if one of the two projects
are to be implemented then the project I should be
selected for implementation, for the payback period
of this project is shorter than project II.
Cont’d...
Payback method is not very suitable for evaluation of
investment projects. This is because, as we see in the above
example, that it is project II—not project I—that is more
profitable to the firm. For, in the fourth and fifth years, the
flow of net revenue from project II is much more than that
from project I.
In fact, if we use any acceptable discount rate to estimate the
present value of the revenue flows of the two projects, we
would see that the present value of project II is greater than
that of project I. Therefore, implementation of project II is
more profitable for the firm than that of project I.
Yet the payback method would prescribe the implementation
of project I. Actually, the payback method may quite often
lead the firm to take a wrong decision, because the method
does not consider the expected revenues of all the years.
3. Internal Rate of Return Method
Most important alternative to NPV
Widely used in practice
Intuitively appealing
Based entirely on the estimated cash flows
Independent of interest rates
IRR
Definition and Decision Rule
Definition:
IRR = discount rate that makes the NPV = 0
Decision Rule:
Accept the project if the IRR is greater than
the required return
NPV vs. IRR
NPV: Enter R (rate of return), then
solve for NPV
n
CFt
t 0 (1 R )
t
NPV
IRR: NPV = 0, solve for IRR.
n
CFt
t 0 (1 IRR )
t
0
Computing IRR For The Project
Calculator
Enter the cash flows as for NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return
Do we accept or reject the project?
Computing IRR for the Project
Using the TI BAII+ CF Worksheet
Cash Flows:
CF0 = -165000
CF1 = 63120
CF2 = 70800
CF3 = 91080
Computing IRR for the Project
Using the TI BAII+ CF Worksheet
Cash Flows: Display You Enter
CF, 2nd, CLR WORK
CF0 = -165000 C00 165000 Enter, Down
C01 63120 Enter, Down
CF1 = 63120
F01 1 Enter, Down
CF2 = 70800 C02 70800 Enter, Down
F02 1 Enter, Down
CF3 = 91080 C03 91080 Enter, Down
F03 1 Enter, IRR
IRR CPT
16.13%
IRR - Advantages
Preferred by executives
Intuitively appealing
Easy to communicate the value of a project
Considers all cash flows
Considers time value of money
IRR - Disadvantages
Can produce multiple answers
Cannot rank mutually exclusive projects
Example of Mutually Exclusive
Projects
Period Project A Project B The required
return for both
0 -500 -400
projects is 10%.
1 325 325
2 325 200
Which project
IRR 19.43% 22.17% should you accept
NPV 64.05 60.74 and why?
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the
firm
Whenever there is a conflict between NPV and
another decision rule, always use NPV
IRR is unreliable in the following situations:
Non-conventional cash flows
Mutually exclusive projects
4. Profitability Index
Measures the benefit per unit cost, based on the
time value of money
A profitability index of 1.1 implies that for every $1 of
investment, we create an additional $0.10 in value
Can be very useful in situations of capital rationing
Decision Rule: If PI > 1.0 Accept
Profitability Index
Example of Conflict with NPV
A B
CF(0) $ (10,000) $ (100,000)
PV(CF) $ 15,000 $ 125,000
PI $ 1.50 $ 1.25
NPV $ 5,000 $ 25,000
Capital Budgeting In Practice
Consider all investment 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
Summary
Calculate ALL -- each has value
Method What it measures Metric
NPV $ increase in Firm Value $$
Payback Liquidity Years
IRR E(R), risk %
PI If rationed Ratio
NPV Summary
Net present value =
Difference between market value (PV
of inflows) and cost
Accept if NPV > 0
No serious flaws
Preferred decision criterion
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
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
Profitability Index Summary
Profitability Index =
Benefit-cost ratio
Accept investment if PI > 1
Cannot be used to rank mutually
exclusive projects
Weighted Scoring Model
Weighted scoring model: provides systematic process for
selecting projects based on multiple criteria
First identify criteria important to project selection process
Then assign weights (percentages) to each criterion so they add up
to 100%
Then assign scores to each criterion for each project
Multiply the scores by weights and get total weighted scores
The higher the weighted score, the better
Schwalbe: Sample Weighted Scoring
Model for Project Selection
Excel file
