CAPITAL UNIVERSITY OF SCIENCE AND TECHNOLOGY

Name: Muhammad Arsalan

Reg no: Mba223004

Date: 10 November 2022

Assignment no: 02

Course: Advance Project Management

Submitted to: Dr. Khurrum Shahzad

NUMERIC PROJECT SELECTION MODELS
(PROFIT/PROFITABILITY)
The profitability is used as the only measure of acceptability by the majority of organizations
using different types of project selection models. The following are some of the numeric models
for project selection.

 Payback Period
 Average Rate of Return
 Discounted Cash Flow
 Internal Rate of Return (IRR)
 Profitability Index
 Other Profitability Models

Payback Period

The initial fixed investment in the project divided by the forecasted annual net cash inflows from
the project is referred to as the payback period for the project. The number of years needed by
the project to refund its initial fixed investment is reflected in the ratio of these quantities.

For example, suppose a project costs $200,000 to operate and has annual net cash inflows
of $40,000. Then

Payback Period = $200,000 / $40,000v = 5 Years

This method supposes that the cash inflows will die-hard to the minimum extent to pay back the
investment, and any cash inflows outside the payback period are ignored. This method also
functions as an inadequate representative for the risk. The company faces less risk when it
recovers the initial investment fast.

Average Rate of Return

The ratio of the average annual profit (either after or before taxes) to the average or initial
investment in the project is referred to as the average rate of return. It is mostly misunderstood as
the reciprocal of the payback period.

The average rate of return does not generally equal the reciprocal of the payback period because
average annual profits are generally not equivalent to the net cash inflows. In the above-
mentioned example, suppose the average annual profits are $30,000

Average Rate of Return = $30,000 / $200,000 = 0.15

None of the two above mentioned evaluation methods are effective for project selection, though
the payback period is frequently used and exhibits reasonable value for decisions related to cash
budgeting. These two models have a major advantage in the shape of simplicity, but none of
them cover the important concept of the time value of money.

Discounted Cash Flow

The discounted cash flow method is also called the Net Present Value (NPV) method. The net
present value of all cash flows is determined by discounting them by the required rate of return
in this method.

Where k = the required rate of return,

Ft = the net cash flow in period t and

Ao = the initial cash investment

In order to cover the effect of inflation in the equation

Where pt is the forecasted rate of inflation during the period t.

Net cash flow is likely to be negative in the early life of the project because of the potential
outflow in the form of the initial investment. However, cash flow will become positive when the
project acquires success. If the sum of the net present value of all forecasted cash flows
throughout the life of the project is positive, the project is acceptable.

A simple example will be adequate. Suppose a project has an initial investment of $100,000. It
has a net cash inflow of $25,000 per year for a period of eight years. The required rate of return
for the project is 15% with an inflation rate of 3% p.a. Now the NPV of this project is calculated
as below

The Net Present Value of the project is positive because the present value of the inflows is
higher than the present value of the outflows. So this should be acceptable.

Internal Rate of Return (IRR)

If there are two sets expected cash flows, one for expected cash inflows and other for expected
cash outflows then the Internal Rate of Return is the discount rate that equalizes the present
value of the two sets of flows. If Rt is the forecasted cash inflow for period t and A t is a
forecasted cash outflow in the period t, the internal rate of return is the value of k that satisfies
the following equation

The value of k is ascertained by trial & error.

Profitability Index

The net present value of all future expected cash flows divided by the initial investment is
referred to as the profitability index. The profitability index is also called the benefit-cost ratio.
The project may be accepted if this ratio is higher than 1.0.

Other Profitability Models

The models just explained have different variations that fall into the following three groups:

1. Those that further split the net cash flow into components that make up the net flow
2. Those that contain particular terms to acquaint risk (uncertainty) into the assessment
3. Those that widen the analysis to view impacts that the project can have on activities or
projects in the company

Numeric Models: Profit/Profitability

As noted earlier, a large majority of all firms using project evaluation and selection models use
profitability as the sole measure of acceptability. We will consider these models first, and then
discuss models that surpass the profit test for acceptance.

1. Payback Period:

The payback period for a project is the initial fixed investment in the project divided by the
estimated annual net cash inflows from the project. The ratio of these quantities is the number of
years required for the project to repay its initial fixed investment. For example, assume a project
costs $100,000 to implement and has annual net cash inflows of $25,000. Then This method
assumes that the cash inflows will persist at least long enough to pay back the investment, and it
ignores any cash inflows beyond the payback period. The method also serves as an (inadequate)
proxy for risk. The faster the investment is recovered, the less the risk to which the firm is
exposed.

2. Average Rate of Return:

Often mistaken as the reciprocal of the payback period, the average rate of return is the ratio of
the average annual profit (either before or after taxes) to the initial or average investment in the
project. Because average annual profits are usually not equivalent to net cash inflows, the
average rate of return does not usually equal the reciprocal of the payback period. Assume, in the
example just given, that the average annual profits are $15,000 Neither of these evaluation
methods is recommended for project selection, though payback period is widely used and does
have a legitimate value for cash budgeting decisions. The major advantage of these models is
their simplicity,but neither takes into account the time-value of money. Unless interest rates are
extremely low and the rate of inflation is nil, the failure to reduce future cash flows or profits to
their present value will result in serious evaluation errors.

3. Discounted Cash Flow:

Also referred to as the Net Present Value (NPV) method, the discounted cash flow method
determines the net present value of all cash flows by discounting them by the required rate of
return (also known as the hurdle rate, cutoff rate, and similar terms) as follows: To include the
impact of inflation (or deflation) where pt is the predicted rate of inflation during period t, we
have Early in the life of a project, net cash flow is likely to be negative, the major outflow being
the initial investment in the project, A0. If the project is successful, however, cash flows will
become positive. The project is acceptable if the sum of the net present values of all estimated
cash flows over the life of the project is positive. A simple example will suffice. Using our
$100,000 investment with a net cash inflow of $25,000 per year for a period of eight years, a
required rate of return of 15 percent, and an inflation rate of 3 percent per year, we have Because
the present value of the inflows is greater than the present value of the outflow— that is, the net
present value is positive—the project is deemed acceptable.

For example: PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked pots and other

cracked items, is considering the installation of a new marketing software package that will, it is
hoped, allow more accurate sales information concerning the inventory, sales, and deliveries of
its pots as well as its vases designed to hold artificial flowers. The information systems (IS)
department has submitted a project proposal that estimates the investment requirements as
follows: an initial investment of $125,000 to be paid up-front to the Pottery Software.
Corporation; an additional investment of $100,000 to modify and install the software; and
another $90,000 to integrate the new software into the overall information system. Delivery and
installation is estimated to take one year; integrating the entire system should require an
additional year. Thereafter, the IS department predicts that scheduled software updates will
require further expenditures of about $15,000 every second year, beginning in the fourth year.
They will not, however, update the software in the last year of its expected useful life. The
project schedule calls for benefits to begin in the third year, and to be upto- speed by the end of
that year. Projected additional profits resulting from better and more timely sales information are
estimated to be $50,000 in the first year of operation and are expected to peak at $120,000 in the
second year of operation, and then to follow the gradually declining pattern . Project life is
expected to be 10 years from project inception, at which time the proposed system will be
obsolete for this division and will have to be replaced. It is estimated, however, that the software
can be sold to a smaller division of PsychoCeramic Sciences, Inc. (PSI) and will thus, have a
salvage value of $35,000. The Company has a 12 percent hurdle rate for capital investments and
expects the rate of inflation to be about 3 percent over the life of the project. Assuming that the
initial expenditure occurs at the beginning of the year and that all other receipts and expenditures
occur as lump sums at the end of the year, we can prepare the Net Present Value analysis for the .
The Net Present Value of the project is positive and, thus, the project can be accepted. (The
project would have been rejected if the hurdle rate were 14 percent.) Just for the intellectual
exercise, note that the total inflow for the project is $759,000, or $75,900 per year on average for
the 10 year project. The required investment is $315,000 (ignoring the biennial overhaul
charges). Assuming 10 year, straight line depreciation, or $31,500 per year, the payback period
would be ;A project with this payback period would probably be considered quite desirable.101

4. Internal Rate of Return (IRR):

If we have a set of expected cash inflows and cash outflows, the internal rate of return is the
discount rate that equates the present values of the two sets of flows. If At is an expected cash
outflow in the period t and Rt is the expected inflow for the period t , the internal rate of return is
the value of k that satisfies the following equation (note that the A 0 will be positive in this
formulation of the problem): The value of k is found by trial and error.

5. Profitability Index:

Also known as the benefit–cost ratio, the profitability index is the net present value of all future
expected cash flows divided by the initial cash investment. (Some firms do not discount the cash
flows in making this calculation.) If this ratio is greater than 1.0, the project may be accepted.

6. Other Profitability Models:

There are a great many variations of the models just described. These variations fall into three
general categories. These are:

a) Those that subdivide net cash flow into the elements that comprises the

net flow.

b) Those that include specific terms to introduce risk (or uncertainty,

which is treated as risk) into the evaluation.

c) Those that extend the analysis to consider effects that the project might

have on other projects or activities in the organization.

12.1.1 Advantages of Profit-Profitability Numeric Models:

Several comments are in order about all the profit-profitability numeric models. First,

let us consider their advantages:

 The undiscounted models are simple to use and understand.

 All use readily available accounting data to determine the cash flows.
 Model output is in terms familiar to business decision makers.
 With a few exceptions, model output is on an “absolute” profit/profitability scale and
allows “absolute” go/no-go decisions.
 Some profit models account for project risk.
12.1.2 Disadvantages of Profit-Profitability Numeric Models:

The disadvantages of these models are the following:

 These models ignore all non-monetary factors except risk.

 Models that do not include discounting ignore the timing of the cash flows and the time–
value of money.
 Models that reduce cash flows to their present value are strongly biased toward the short
run.
 Payback-type models ignore cash flows beyond the payback period.
 The internal rate of return model can result in multiple solutions.
 All are sensitive to errors in the input data for the early years of the project.
 All discounting models are nonlinear, and the effects of changes (or errors) in the
variables or parameters are generally not obvious to most decision makers.
 All these models depend for input on a determination of cash flows, but it is not clear
exactly how the concept of cash flow is properly defined for the purpose of evaluating
projects.

12.1.3 Profit-Profitability Numeric Models – An Overview:

A complete discussion of profit/profitability models can be found in any standard work on

financial management see Ross, Westerfield, and Jordan (1995), for example. In general, the net
present value models are preferred to the internal rate of return models. Despite wide use,
financial models rarely include non-financial outcomes in their benefits and costs. In a discussion
of the financial value of adopting project management (that is, selecting as a project the use of
project management) in a firm, Githens (1998) notes that traditional financial models “simply
cannot capture the complexity and value-added of today’s process-oriented firm.” The
commonly seen phrase “Return on Investment,” or ROI, does not denote any specific method of
calculation. It usually involves Net Present Value (NPV) or Internal Rate of Return (IRR)
calculations, but we have seen it used in reference to undiscounted average rate of return models
and (incorrectly) payback period models. In our experience, the payback period model,
occasionally using discounted cash flows, is one of the most commonly used models for
evaluating projects and other investment opportunities. Managers generally feel that insistence
on short payout periods tends to minimize the risks associated with outstanding monies over the
passage of time. While this is certainly logical, we prefer evaluation methods that discount cash
flows and deal with uncertainty more directly by considering specific risks. Using the payout
period as a cash-budgeting tool aside, its primary virtue is its simplicity.

Real Options: Recently, a project selection model was developed based on a notion well known
in financial markets. When one invests, one foregoes the value of alternative future investments.
Economists refer to the value of an opportunity foregone as the “opportunity cost” of the
investment made. The argument is that a project may have greater net present value if delayed to
the future. If the investment can be delayed, its cost is discounted compared to a present
investment of the same amount. Further, if the investment in a project is delayed, its value may
increase (or decrease) with the passage of time because some of the uncertainties will be
reduced. If the value of the project drops, it may fail the selection process. If the value increases,
the investor gets a higher payoff. The real options approach acts to reduce both technological and
commercial risk. For a full explanation of the method and its use as a strategic selection tool, see
Luehrman (1998a and 1998b). An interesting application of real options as a project selection
tool for pharmaceutical Research and Development (R and D) projects is described by Jacob and
Kwak (2003). Real options combined with Monte Carlo simulation is compared with alternative
selection/assessment methods by Doctor, Newton, and Pearson (2001).

Numeric Models Scoring

In an attempt to overcome some of the disadvantages of profitability models, particularly their
focus on a single decision criterion, 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 examples discussed illustrate some of the different types.
Unweighted 0-1 Factor Model :
A set of relevant factors is selected by management. These are usually listed in a preprinted
form, and one or more raters score the project on each factor depending on whether or not it
qualifies for that individual criterion. The raters are chosen by senior managers, for the most part
from the rolls of senior management. The criteria for choice are a clear understanding of
organizational goals and a good knowledge of the firm's potential project portfolio. Figure 2-2
shows an example of the rating sheet for an unweighted, 0-1 factor model.

The columns of Figure 2-2 are summed and those projects with a sufficient number of qualifying
factors may be selected. The main advantage of such a model is that it uses several criteria in the
decision process. The major disadvantages are that it assumes all criteria are of equal importance
and it allows for no gradation of the degree to which a specific project meets the various criteria.

Unweighted Factor Scoring Model:

The second disadvantage of the 0-1 factor model can be dealt with by constructing a simple
linear measure of the degree to which the project being evaluated meets each of the criteria
contained in the list.

Project Does Not Qualifies Qualify No increase in energy requirements x Potential market size,
dollars x Potential market share, percent x No new facility required x No new technical expertise
required x No decrease in quality of final product X Ability to manage project with current
personnel x No requirement for reorganization x Impact on work force safety x Impact on
environmental standards x Profitability Rate of return more than 15% after tax x Estimated
annual profits more than $250,000 x Time to break-even less than 3 years x Need for external
consultants x Consistency with current lines of business x Impact on company image With
customers x With our industry x Totals 12

The x marks in Figure 2-2 would be replaced by numbers. Often a five-point scale is used, where
5 is very good, 4 is good, 3 is fair, 2 is poor, I is very poor. (Three-, seven-, and 10-point scales
are also common.) The second column of Figure 2-2 would not be needed. The column of scores
is summed, and those projects with a total score exceeding some critical value are selected. A
variant of this selection process might select the highest-scoring projects (still assuming they are
all above some critical score) until the estimated costs of the set of projects equaled the resource
limit. The criticism that the criteria are all assumed to be of equal importance still holds.
The use of a discrete numeric scale to represent the degree to which a criterion is satisfied is
widely accepted. To construct such measures for project evaluation, we proceed in the following
manner. Select a criterion, say, "estimated annual profits in dollars." For this criterion, determine
five ranges of performance so that a typical project, chosen at random, would have a roughly
equal chance of being in any one of the five performance ranges. (Another way of describing this
condition is: Take a large number of projects that were selected for support in the past, regardless
of whether they were actually successful or not, and create five levels of predicted performance
so that about one-fifth of the projects fall into each level.) This procedure will usually create
unequal ranges, which may offend our sense of symmetry but need not concern us otherwise. It
ensures that each criterion performance measure utilizes the full scale of possible values, a
desirable characteristic for performance measures.

Consider the following two simple examples. Using the criterion just mentioned, "estimated
annual profits in dollars," we might construct the following scale:

Score Performance Level

5 Above $1,100,000

3 $500,001 to $750,000

2 $200,000 to $500,000

1 Less than $200,000

As suggested, these ranges might have been chosen so that about 20 percent of the projects
considered for funding would fall into each of the five ranges.

The criterion "no decrease in quality of the final product" would have to be restated to be scored
on a five-point scale, perhaps as follows:

Score Performance Level

The quality of the final product is:

 5 significantly and visibly improved

 4 significantly improved, but not visible to buyer

 3 not significantly changed

 2 significantly lowered, but not visible to buyer

 1 significantly and visibly lowered

This scale is an example of scoring cells that represent opinion rather than objective (even if
"estimated") fact, as was the case in the profit scale.
Weighted Factor Scoring Model:
When numeric weights reflecting the relative importance of each individual factor are added, we
have a weighted factor scoring model. In general, it takes the form

Si = the total score of the ith project,

Si,- = the score of the ith project on the j'th criterion, and

Wj - the weight of the jth criterion.

The weights, wmay be generated by any technique that is acceptable to the organization's policy
makers. There are several techniques available to generate such numbers, but the most effective
and most widely used is the Delphi technique. The Delphi technique was developed by Brown
and Dalkey of the Rand Corporation during the 1950s and 1960s. It is a technique for developing
numeric values that are equivalent to subjective, verbal measures of relative value. (The method
is also useful for developing technological forecasts. The method of successive comparisons (or
pairwise comparisons) may also be used for the same purpose. Originally described by
Churchman, Ackoff, and Arnoff in their classic text on operations research , this technique asks
the decision maker to make a series of choices between several different sets of alternatives. A
set of numbers is then found that is consistent with the choices. These numbers can serve as
weights in the scoring model.