PROJECT SELECTION (CONTD.):Payback Period, Internal Rate of Return (IRR)

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LESSON 12

PROJECT SELECTION (CONTD.)

Broad Contents

Q-Sort Model

Pay-back Period

Average Rate of Return

Discounted Cash Flow

Internal Rate of Return (IRR)

12.1

Types of Project Selection Models (Continued):

Non-Numeric Models:

Q-Sort Model:

Of the several techniques for ordering projects, the Q-Sort (Helin and Souder,

1974) is one of the most straightforward. First, the projects are divided into

three groups--good, fair, and poor--according to their relative merits. If any

group has more than eight members, it is subdivided into two categories, such

as fair-plus and fair-minus. When all categories have eight or fewer members,

the projects within each category are ordered from best to worst. Again, the

order is determined on the basis of relative merit. The rater may use specific

criteria to rank each project, or may simply use general overall judgment. (See

Figure 12.1 below for an example of a Q-Sort.)

Figure 12.1: Example of a Q-Sort

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The process described may be carried out by one person who is responsible for

evaluation and selection, or it may be performed by a committee charged with

the responsibility. If a committee handles the task, the individual rankings can

be developed anonymously, and the set of anonymous rankings can be

examined by the committee itself for consensus. It is common for such rankings

to differ somewhat from rater to rater, but they do not often vary strikingly

because the individuals chosen for such committees rarely differ widely on

what they feel to be appropriate for the parent organization.

Projects can then be selected in the order of preference, though they are usually

evaluated financially before final selection.

There are other, similar nonnumeric models for accepting or rejecting projects.

Although it is easy to dismiss such models as unscientific, they should not be

discounted casually. These models are clearly goal-oriented and directly reflect

the primary concerns of the organization.

The sacred cow model, in particular, has an added feature; sacred cow projects

are visibly supported by "the powers that be." Full support by top management

is certainly an important contributor to project success (Meredith, 1981).

Without such support, the probability of project success is sharply lowered.

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.

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.

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

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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.

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.

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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 up-

to-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 shown in the table

12.1 below.

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 project as shown in

the table 12.1 below.

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.

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Table 12.1: Net Present Value (NPV) Analysis

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.

Profitability Index:

Also known as the benefitcost 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.

Other Profitability Models:

There are a great many variations of the models just described. These variations

fall into three general categories. These are:

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

net flow.

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

which is treated as risk) into the evaluation.

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.

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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

timevalue 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

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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).

PROJECT PROPOSAL

12.2

Introduction:

Project Proposal is the initial document that converts an idea or policy into details of a potential

project, including the outcomes, outputs, major risks, costs, stakeholders and an estimate of the

resource and time required.

To begin planning a proposal, remember the basic definition: a proposal is an offer or bid to do

a certain project for someone. Proposals may contain other elements technical background,

recommendations, results of surveys, information about feasibility, and so on. But what makes a

proposal a proposal is, that it asks the audience to approve, fund, or grant permission to do the

proposed project.

If you plan to be a consultant or run your own business, written proposals may be one of your

most important tools for bringing in business. And, if you work for a government agency, non-

profit organization, or a large corporation, the proposal can be a valuable tool for initiating

projects that benefit the organization or you the employee proposed (and usually both).

A proposal should contain information that would enable the audience of that proposal to decide

whether to approve the project, to approve or hire you to do the work, or both. To write a

successful proposal, put yourself in the place of your audience the recipient of the proposal,

and think about what sorts of information that person would need to feel confident having you

do the project.

It is easy to get confused about proposals. Imagine that you have a terrific idea for installing

some new technology where you work and you write up a document explaining how it works

and why it is so great, showing the benefits, and then end by urging management to go for it. Is

that a proposal? The answer is "No", at least not in this context. It is more like a feasibility

report, which studies the merits of a project and then recommends for or against it. Now, all it

would take to make this document a proposal would be to add elements that ask management

for approval for you to go ahead with the project. Certainly, some proposals must sell the

projects they offer to do, but in all cases proposals must sell the writer (or the writer's

organization) as the one to do the project.

12.3

Types of Project Proposals:

Consider the situations in which proposals occur. A company may send out a public

announcement requesting proposals for a specific project. This public announcement, called a

Request for Proposal (RFP), could be issued through newspapers, trade journals, Chamber of

Commerce channels, or individual letters. Firms or individuals interested in the project would

then write proposals in which they summarize their qualifications, project schedules and costs,

and discuss their approach to the project. The recipient of all these proposals would then

evaluate them, select the best candidate, and then work up a contract.

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But proposals come about much less formally. Imagine that you are interested in doing a project

at work (for example, investigating the merits of bringing in some new technology to increase

productivity). Imagine that you visited with your supervisor and tried to convince her of this.

She might respond by saying, "Write me a proposal and I will present it to upper management."

As you can see from these examples, proposals can be divided into several categories:

Internal Proposal:

If you write a proposal to someone within your organization (a business, a government

agency, etc.), it is an internal proposal. With internal proposals, you may not have to

include certain sections (such as qualifications), or you may not have to include as

much information in them.

External Proposal:

An external proposal is one written by a separate, independent consultant proposing to

do a project for another firm. It can be a proposal from organization or individual to

another such entity.

Solicited Proposal:

If a proposal is solicited, the recipient of the proposal in some way requested the

proposal. Typically, a company will send out requests for proposals (RFPs) through the

mail or publish them in some news source. But proposals can be solicited on a very

local level. For example, you could be explaining to your boss what a great thing it

would be to install a new technology in the office; your boss might get interested and

ask you to write up a proposal that offered to do a formal study of the idea.

Unsolicited Proposal:

Unsolicited proposals are those in which the recipient has not requested proposals.

With unsolicited proposals, you sometimes must convince the recipient that a problem

or need exists before you can begin the main part of the proposal.

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Table 12.2: Solicited Versus Unsolicited Proposals

12.3.1 Request for Proposal:

A Request for Proposal (referred to as RFP) is an invitation for suppliers, through a

bidding process, to submit a proposal on a specific product or service.

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A Request for Proposal (RFP) typically involves more than the price. Other requested

information may include basic corporate information and history, financial information

(can the company deliver without risk of bankruptcy), technical capability (used on

major procurements of services, where the item has not previously been made or where

the requirement could be met by varying technical means), product information such as

stock availability and estimated completion period, and customer references that can be

checked to determine a company's suitability.

In the military, Request for Proposal (RFP) is often raised to fulfill an Operational

Requirement (OR), after which the military procurement authority will normally issue a

detailed technical specification against which tenders will be made by potential

contractors. In the civilian use, Request for Proposal (RFP) is usually part of a complex

sales process, also known as enterprise sales.

Request for Proposals (RFPs) often include specifications of the item, project or service

for which a proposal is requested. The more detailed the specifications, the better the

chances that the proposal provided will be accurate. Generally Request for Proposals

(RFPs) are sent to an approved supplier or vendor list.

The bidders return a proposal by a set date and time. Late proposals may or may not be

considered, depending on the terms of the initial Request for Proposal. The proposals

are used to evaluate the suitability as a supplier, vendor, or institutional partner.

Discussions may be held on the proposals (often to clarify technical capabilities or to

note errors in a proposal). In some instances, all or only selected bidders may be invited

to participate in subsequent bids, or may be asked to submit their best technical and

financial proposal, commonly referred to as a Best and Final Offer (BAFO).

12.3.2 Request for Proposal (RFP) Variation:

The Request for Quotation (RFQ) is used where discussions are not required with

bidders (mainly when the specifications of a product or service are already known), and

price is the main or only factor in selecting the successful bidder. Request for Quotation

(RFQ) may also be used as a step prior to going to a full-blown Request for Proposal

(RFP) to determine general price ranges. In this scenario, products, services or suppliers

may be selected from the Request for Quotation (RFQ) results to bring in to further

research in order to write a more fully fleshed out Request for Proposal (RFP).

Request for Proposal (RFP) is sometimes used for a Request for Pricing.

12.3.3 Request for Information (RFI):

Request for Information (RFI) is a proposal requested from a potential seller or a

service provider to determine what products and services are potentially available in the

marketplace to meet a buyer's needs and to know the capability of a seller in terms of

offerings and strengths of the seller. Request for Information (RFIs) are commonly used

on major procurements, where a requirement could potentially be met through several

alternate means. A Request for Information (RFI), however, is not an invitation to bid,

is not binding on either the buyer or sellers, and may or may not lead to a Request for

Proposal (RFP) or Request for Quotation (RFQ).

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