Project Management Framework: Project Selection Method

Overall

• Mathematical Approach (Constrained Optimization Methods)
• Linear Programming
• Integer Programming
• Dynamic Programming
• Multi-Objective Programming
• Cooperative Approach (Benefit Measurement Method)
• Peer review
• Murder Boards (panel that tries to poke holes in your argument)
• Economic models
• Scoring Models
• Benefit-Cost Analysis
• Payback period
• Discounted cash flows
• Net Present Value
• Internal Rate of Return (IRR)

Definition and Sample

1. Benefit-Cost Analysis 

Compares the project benefit to the costs to derive a ratio from which a decision can be made.Ex: If a project generates $125,000 in profits and costs $50,000, the benefit-cost ratio would be 2.5 (also written as 5:2)

2. Payback Period 

Number of periods to pay back a project’s cost.Ex: if a project cost $1 million and will generate revenue of $100,000 per year, then the payback period would be 10 years.

3. Discounted Cash Flows 

Calculates in today’s (discounted) terms what the value of a project would be given cash inflows and/or outflows over a period of time. 

4. Net Present Value (NPV) 

A formula that calculates the value today of a future cash flow. Ex: If you receive a future cash flow in 3 years of $1,157.62, what would that be worth today if the interest rate is 5%?PV = FV / (1+i)ⁿPV = 1157.62 / (1+0.05)³PV = $1000Important: Always choose projects with the biggest positive NPV, reject negative NPV. 

5. Internal Rate of Return (IRR) 

The discounted interest rate when NPV equals zero. Always choose the project with the highest IRR.Assumes that cash flows are reinvested at the IRR value. 

Example / Case Scenario
A project costs $10,000 today and will return $2,500 per year for 5 years. Assume your required return on investment is 10%. Should you do the project? 

Benefit-Cost Ratio 

(5 x $2,500) / $10,000 = 1.25 or 5:4

Payback Period 

$10,000 / $2,500 = 4 years

Net Present Value 

NPV p = Sum of [Future Cash Flows / (1 + i) n]-$10,000 + [$2,500 / (1.10)¹] + [$2,500 / (1.10)²] + [$2,500 / (1.10)³] + [$2,500 / (1.10)⁴] + [$2,500 / (1.10)⁵] = -$523.03

IRR 

The value of I where NPV equals zero = 7.93%

Other Terminology

• Opportunity Costs: the opportunity given up by choosing another project
• Sunk Cost: costs spent to date, these costs are already spent
• Law of Diminishing Returns: adding more resources doesn’t proportionately increase productivity
• Working Capital: current assents minus current liabilities
• Depreciation: straight-line (same amount each year), accelerated (ex. Double-declining balance and sum of years digits)
• Assumptions: something that is believed to be true or something that is taken for granted. *Needs to be continually evaluated throughout the project
• Constraints: a factor that limits the project team’s options; any restriction placed on the project.