Project Selection Methods
There are five economic models to select a project.
1. Internal rate of return (IRR)
2. Payback methods
3. Cost benefit analysis
4. Present value
5- Net present value
1. Internal rate of return (IRR)
Internal rate of return calculation is very complicated
It is a similar concept to a bank interest rate ,
The higher the IRR, the better the project is . So we choose projects with a higher rate of return.
Example. Your company will start three new projects. Which companies would you select if you were given
IRR for project A is 8%
IRR for project B is 10%
IRR for project C is 15%
The correct answer is project C with the highest IRR (15%)
2. Pay back period
Time required for the invested money to be recouped/returned/repaid.
Example : your company invested $90,000 for project A. If expected yearly revenue is $30,000, the payback period for the project A would be three years
$90.000/$30,000= 3 years
Your company is a hard time selecting among three projects with payback period 5 ,3,2 years respectively.
According to the payback period, a project with the shortest payback is the best project. In this case a project with two years payback period.
3. Cost benefit analysis
Comparing total cost with total benefits.
Benefit cost ratio
If the total benefit of the project is $30,000,000 and the total cost $15,000,000 then the benefit cost ratio is 2.
$30.000,000/$15,000,000=2
Benefit is twice of the cost. Great project. The bigger the benefit the better the project
4. Present Value.
The present value of $1 is better today than its value in the future. What is a present value.
Money loses value every year.
Example. You have $50 today and you can buy a bag of grocery. But the same amount of money may be not be enough to buy the same full of bag of grocery 5 years from now.
Present Value ( PV)= Present value of money today
Future Value ( FV) = Future value of money tomorrow/in the future
Formula to remember
PV= FV/( 1 + r)n
where r is interest rate and n is number of time period
Example : A project with interest rate of 8% what is the present value of a project value of $10,000 received in three years from now
The answer is :
PV= $10.000/(1+0.08)3= $7938.32
5. Net Present Value
Net present value equals the total present value of the revenue less the total present value of the cost
If the total present of the value of the revenue of project A is $20,000,000 and the total value of the cost of the same project is
$15,000,000, what is the net present value of the project?
Net present value= $20,000,000- $15,000,000=$5,000,000
Summary on which project to select
How to select projects?
The project having the highest IRR is the best project.
The project having the shortest pay back period is the best project.
The project having the highest benefit-cost ratio is the best project.
The project having the highest present value is the best project.
The project having the highest net present value is the best project.
