Non-Numerical Project Selection Models

Memo

To: The Director and Research Associates of Te Au Rangahau

From: Student

Date: 4th April 2011

Re: Analysis of investment proposals

Message

The purpose of this memo is to advise on two investment proposals currently under discussion. Two financial models will be used to evaluate the projects followed by a discussion of non-numerical methods that may be relevant.

There are basic criteria that can be used when deciding which selection models to use when evaluating projects (Souder & Helin, 1974). Various selection models, both numeric and otherwise will be discussed in this memo.

The first proposal (known as Proposal A) requires an initial investment of $25,000 and it is expected to generate inflows of $5,500 per year.

The second proposal (known as Proposal B) also requires an initial investment of $25,000 and it is expected to have the following earnings.

Year Earnings $

1 -2000

2 5000

3 7000

4 9000

5 1000

6 12000

7 12000

For the purposes of comparison both projects will be evaluated over a seven year life period.

Net Present Value

Net Present Value (NPV) is one of the most popular financial methods for evaluating a project's value in monetary terms (Pinto, 2007, p. 93). The method predicts the value of the project in today's dollars taking into account the future worth of money over the lifetime of the project. It explicitly calculates inflation as well as expected or desired profits that the money invested could have made had it been invested elsewhere (Taylor, 1998, p. 143).

If the purpose of a project is to create profit then a positive NPV would be expected to make the project worthwhile. There may be other motivations for instigating a project than profit which should also be taken into consideration when deciding between two projects.

Given the financial information provided for Project A, Table 1 can be created to calculate the NPV.

Table 1 : NPV of project A

Year Inflows Outflows Net Flow Discount Factor Net Present Value(NPV)

0 $25,000.00 ($25,000.00) 1 ($25,000.00)

1 $5,500.00 $5,500.00 0.884955752 $4,867.26

2 $5,500.00 $5,500.00 0.783146683 $4,307.31

3 $5,500.00 $5,500.00 0.693050162 $3,811.78

4 $5,500.00 $5,500.00 0.613318728 $3,373.25

5 $5,500.00 $5,500.00 0.542759936 $2,985.18

6 $5,500.00 $5,500.00 0.480318527 $2,641.75

7 $5,500.00 $5,500.00 0.425060644 $2,337.83

Total ($675.64)

Giving Project A a Total Net Present Value of -$675.64 over a seven year project life.

Given the financial information provided for Project B, Table 2 can be created.

Table 2 : NPV of project B

Year Inflows Outflows Net Flow Discount Factor Net Present Value(NPV)

0 $25,000.00 ($25,000.00) 1 ($25,000.00)

1 $2,000.00 ($2,000.00) 0.884955752 ($1,769.91)

2 $5,000.00 $5,000.00 0.783146683 $3,915.73

3 $7,000.00 $7,000.00 0.693050162 $4,851.35

4 $9,000.00 $9,000.00 0.613318728 $5,519.87

5 $10,000.00 $10,000.00 0.542759936 $5,427.60

6 $12,000.00 $12,000.00 0.480318527 $5,763.82

7 $12,000.00 $12,000.00 0.425060644 $5,100.73

Total $3,809.19

Giving Project B a Total Net Present Value of $3,809.19 over a seven year project life.

In purely financial terms Project B would appear to be the better investment as it has a positive Net Present Value over the life of the project. Project A would have to run a further year with the same Inflow figures to achieve a positive NPV. Due to the exponential nature of the discount factor used to calculate NPV a longer time period leads to excessive deterioration of the value of the invested money (Gollier, 2008, p. 142), so the shorter time period required would be preferable. There is also risk in being able to accurately forecast future interest or inflation rates over longer periods of time (Pinto, 2007, p. 95). Financially it would be logical to minimize the project duration to reduce risk. This would also reduce the discounted payback period.

Discounted Payback Period

The payback period of any project is the length of time required to pay back the initial expenditure. Over a short period of time this is a very easy calculation, however over longer time periods the impacts of inflation and the possible gains that money could have made elsewhere need to be taken into account (Taylor, 1998, p. 143). The discount factor used to calculate the Net Present Value over a period of time can be used to calculate a discounted Payback Period to accurately predict how long a project will take to become profitable.

The Discounted Payback Period for project A has been calculated in Table 3.

Table 3 : Discounted Payback Period for Project A.

Year Inflows Outflows Net Flow Discount Factor Net Present Value(NPV) Cum. Cash Flow

0 ($25,000.00) ($25,000.00) 1 ($25,000.00) ($25,000.00)

1 $5,500.00 $5,500.00 0.884955752 $4,867.26 ($20,132.74)

2 $5,500.00 $5,500.00 0.783146683 $4,307.31 ($15,825.44)