E CONOMIC P ROJECT

S ELECTION C RITRIA

September 2015

Hisham Haridy,

PMP, PMI-RMP

ECONOMIC PROJECT SELECTION CRITERIA

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.
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.

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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.

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

1. Present Value (PV):

The value today of future cash flows.

This is the method of determining todays value of future money.

PV =
Where:

FV
(1+i)n

PV:

Present Value

FV:

Future Value

i :

Interest rate

n:

number of time periods

Example

What is the present value of $300,000 received three years from now if we expect the interest
rate to be 10 percent?

PV =
PROJECT COST MANAGEMENT

300000
(1+0.1)3

= $225,394
September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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=
Where:
k:

FV
(1+k+i)n

Initial investment

Annual inflation rate

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?

Project B
Key selection: Maximum NPV

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

Example
Cash flow as follow with interest 10%.
NPV?

Time

Income /

Present Value of Income at

Period

Revenue

10% Interest Rate

200

200

50

45

100

91

100

83

300

225

Total

Costs

353

NPV=

PROJECT COST MANAGEMENT

353 - 291

Present Value of Cost at

10% Interest Rate

291

= $ 62

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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=

Where:
i:

Example

FV
(1+k+i)n

Initial investment

Rate of return

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?

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
Key selection: Greatest IRR

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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.

Payback Period=

PROJECT COST MANAGEMENT

Initial Investment
(Annual cash inflows)

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

Example

A project costs $100,000 to implement and has annual net cash inflows of $25,000.
Payback Period=

100,000
25,000

4 years

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,
which project will you select?

Project A

Key selection: Lowest Payback period

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

Example
Years

Cash flow

-1000

500

400

300

100

Net Cash flow

-1000

-500

-100

200

300

Payback period = 2.33 years

Example

Years

Cash flow

-1000

100

300

400

600

Net Cash flow

-1000

-900

-600

-200

400

Payback period = 3.33 years

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

5. Benefit Cost Ratio (BCR)

A comparison of revenue to costs. Greater than 1 is good.

Benefits (or Payback or Revenue)
BCR=
Costs
BCR of > 1 means that benefits (i.e. expected revenue) is greater than the cost. Hence it
is beneficial to do the project.
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?

Project A

Although the project B has a smaller investment than project A will not impact the selection

Key selection: Greatest BCR

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

Exercise:
Time Period

Project A

Project B

Selection

NPV

$ 95,000

$ 75,000

IRR

13 %

17 %

16 months

21 months

2.79

1.3

Payback Period
Benefit : Cost ratio

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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

$ 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
Key selection: Ignore the sunk costs because they have already been incurred and cannot be avoided

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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

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?

Project $45,000

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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

The amount of money the company has available to invest, including investment in
projects.

Net Working Capital = Current assets - Current liabilities for an organization.

PROJECT COST MANAGEMENT

September 2015

ECONOMIC PROJECT SELECTION CRITERIA

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 Depreciation

The same amount of depreciation is taken

There are two forms:

each year.

1. Double Declining Balance

2. Sum of the Years Digits

Example: A $1,000 item with a 10-year

Example: A $1,000 item with a 10-year useful life

useful life and no salvage value (how much

and no salvage value (how much the item is worth at

the item is worth at the end of its life)

the end of its life)

Would be depreciated at $100 per year.

Would be depreciated at $180 the first year, $150 the

second, $130 the next, etc.

PROJECT COST MANAGEMENT

September 2015