Selection of Projects

Transcription

1 Selection of Projects M A H Sazzad Shikder Chapter objective: To know about several project selection techniques to help project managers for selecting proper projects Project selection: Project selection is the process of evaluating individual projects or group of projects and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. Project selection process is applied when a project or set of projects to be selected from competing alternatives. Say for example, a manufacturing organization can use project selection technique to choose a machine for producing its product. Every project involves cost, risk and benefit. All should be estimated and evaluated properly. In evaluation, projects should be evaluated from the following points of views- Production factors Financial factors Marketing factors Personnel factors Administrative factors Environmental or ecological factors Project selection is a part of project life cycle. Project manager is responsible for project selection. The goal achievement of an organization depends on selection and implementation of proper project. Criteria for project selection models:. Realism: The model should reflect the reality of the manager s decision situation including the multiple objectives of both the firm and its managers. The model should take into account the realities of the firm s limitations on facilities, capital, personnel, etc. The model should also include factors that reflect project risks, including the technical risks of performance, cost, and time as well as the market risks of customer rejection and other implementation risks. Capability: The model should be sophisticated enough to deal with multiple time periods, simulate various situations both internal and external to the project ( e.g. strikes, interest rate changes, etc.) and optimize the decision. An optimizing model will make the comparisons that management deems important, consider major risks and constraints on the projects and them select the best overall project or set of projects. Flexibility: The model should give valid results within the range of conditions that the firm might experience. IT should have the ability to be easily modified or to be self adjusting in response to changes in the firm s environment. e.g. tax laws change, goals change etc. Ease to use: the model should be reasonably convenient, not take a long time to execute and be easy to use and understand. Cost: Data gathering and modeling costs should be low relative to the cost of the project and must surely be less than the potential benefits of the project. Easy computerization: It must be easy and convenient to gather and store the information in a computer data base and to manipulate data in the model through use of widely available, standard computer package Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 1

2 M A H Sazzad Shikder Project Selection Models There are basically two categories of project selection model. These are Numeric and Nonnumeric. Numerical Models: Under Profitability 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) 3. Pay Back Period (PBP) 4. Benefit Cost Ratio (BCR) or Profitability Index(PI) 5. Accounting rate of return(arr) 6. Discounted Pay Back Period(DPBP) Numerical Models: Scoring 1. Un-weighted 0-1 factor model 2. Un-weighted factor scoring model 3. Weighted factor scoring model 4. Constrained weighted factor scoring model Non numerical models: 1. Sacred cow 2. Operating Necessity 3. Competitive necessity 4. Product line extension 5. Comparative Benefit. Pls. visit text book for the details of the above project selection models. Capital Budgeting Problem: 1 You are considering a project costing Tk with estimated useful life of 5 years (using the straight line depreciation method). Expected cash flows before depreciation and Tax (EBDT) over next five years are as follows: Year EBDT 1 Tk Assuming 50% tax rate. Calculate i) Pay back Period (PBP) ii) Net Present value (NPV) of project and comment on it (when interest rate is 12%) the Problem: 2 Tranter, Inc. is considering a project that would have a ten-year life and would require a $1,500,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows: Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 2

3 M A H Sazzad Shikder Sales... $2,000,000 Less variable expenses... 1,100,000 Contribution margin ,000 Less fixed expenses: Fixed out-of-pocket cash expenses... $500,000 Depreciation , ,000 Net operating income... $ 250,000 All of the above items, except for depreciation, represent cash flows. The company's required rate of return is 12%. Requirement: a. Compute the project's net present value. b. Compute the project's internal rate of return to the nearest whole percent. c. Compute the project's payback period. Problem: 3 Jamuna Company is considering to purchase one of the two machines. Particular for the both machines are given below: Particulars Machine- A Machine-B Purchase price $ $ Freight and carriage Installation charge Working capital requirement Estimated life 5 years 5 years Salvage value Nil Annual EBDT of the two machines are given below: Year Machine-A Machine-B 1 $ $ The company pays 50% and expects 7% return on its investment. The first Machine should be depreciated on sum of the year digit method and Machine B on straight line basis. Apply capital budgeting techniques and advise Jamuna Company which machine should be purchased? Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 3

4 M A H Sazzad Shikder Problem: 4 SAF Builders, a real estate developer in Chittagong, contemplating to avail one of the two projects, project Karnafuli and Project Shangu. You are a financial analyst and you are given the following information relating to project Karnafuli - NPV PBP IRR BCR $ years 9 % 1.1% You are also given the following information of project Shangu - Year Capital Operating cost(other Revenue than depreciation) 0 $ $6,000 $47, The useful life of project Shangu is 4 years and the fixed assets be depreciated as per straight line method. At the end of the project Shangu the fixed assets of the project be sold for $ The corporate tax rate is 40% in the Bangladesh. SAF calculated its overall cost of capital is 10%. As a financial analyst you are requested to advice SAF regarding one project selection between Project Karnafuli and Project Shangu Problem: 5 SCL limited is engaged in the manufacture of power intensive products. As part of its diversification plans, the company proposes to put up a windmill to generate electricity. The details of the scheme are as follows: 1. Cost of the wind mill, TK. 300 lakhs 2. Cost of land. TK. 15 lakhs 3. Subsidy from Government of Bangladesh to be received at the end of first year of installation, TK. 15 lakhs 4. Cost of electricity will be TK per unit in year 1. This will be increased by TK per unit every year till year 7. After that it will increase every year by TK per year until year Maintenance cost will be TK. 4 lakhs in year 1 and the same will be increased by TK. 2 lakhs every year. 6. Estimated life, 10 years 7. Cost of capital, 15 percent 8. Residual value, nil. However, land value will go up to TK.60 lakhs, at the end of year Depreciation will be 100 percent of the cost of the windmill in year 1 and the same will be allowed for tax purposes. 10. As windmills are expected to work based on wind velocity, the efficiency is expected to be on an average 30 per cent. The gross electricity generated at this level will be 25 lakh units per annum; 4 percent of which will be contributed to the national power grid as per agreement. 11. Tax rate, 35 percent. From the above information, you are requested to calculate the Net Present Value. Ignore tax on capital profit. Use present value up to two digits. Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 4

5 M A H Sazzad Shikder Problem: 6 Tabin Enterprise is considering a project. The total outlay of the project will be Tk. 2,50,000. It includes Tk. 50,000 for net working capital and rest for fixed investment cost. The entire outlay will require 3 years (beginning (beginning from zero year) in a ratio of 40: 40:20. That is total investment will cover 3 investment phases. To finance this project, Tabin Enterprise has submitted a loan proposal to a bank where the project is situated. The bank will provide Tk. 1, 50,000 at 10% interest and Tk. 1, 00,000 will be sponsor s contribution (cost of equity capital 15%). The firm follows straight-line depreciation on fixed assets. The project will provide revenues of Tk. 1,00, 000 over its economic life of 5 years but it will require operating expenses Tk. 30,000 per year (other than interest on loans, depreciation on fixed assets and tax). The effective tax rate is 40% There is a salvage value of Tk. 20, 000 at the end of the life of the project. Determine the NPV, BCR, IRR, PBP. Problem: 7 Below are the cash flows information related to two investment projects. Project X Project Y a Investment cost Tk. 50, 000 Tk. 50, 000 b Net cash Inflows Year 1 Tk Tk Year 2 Tk Tk Year 3 Tk Tk Year 4 Tk Tk Compute PBP, NPV BCR and IRR(using 10% discount rate). Problem: 8 Assume a project of 5 years life with the following cost and benefit characteristics Year Capital cost Operating cost ( Other Revenue(Tk) (Tk) than depreciation (Tk) 0 Tk. 1,00, The fixed asset would have a 5 year useful life and be depreciated using 20% straight line rate. At the end of the project the fixed assets of the project could be sold Tk. 20, 000. The tax rate is 40% and cost of fund is 10%. Calculate the PBP, NPV, BCR and IRR. Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 5

6 M A H Sazzad Shikder Problem:9 Preet Ltd., is considering the purchase of a machine which will have a working life of five years. The machine is expected to earn Tk p.a. the company considers a yield of 20% necessary before investment is made in a project. How much could be spent in purchasing the machine? Problem: 10 A company is considering the possibility of manufacturing a particular component which at present is being bought from outside. The manufacture of the component would call for an investment of Tk. 7,50,000 in a new machine besides an additional investment of Tk. 50,000 in working capital. The life of the machine would be 10 years with a salvage value of Tk. 50,000. The estimated saving (before tax) would be Tk. 1,80,000 p.a. the income tax rate is 50%. The company s required rate of return is 10%. Depreciation is considered on straight line method. Problem: 11 The management of a firm is considering an investment project costing Tk. 1,50,000 that will have a scrap value of Tk. 10,000 at the end of its 5-year life. Transportation cost are expected to be Tk and installation charges are expected to be Tk. 25,000. The project is accepted, a spare parts inventory of Tk. 10,000 must also be acquired. It is estimated that the spare parts will have and estimated scarp value after 5 of their initial costs. The annual revenue from the project is expected to be Tk. 1,70,000 and annual labour, material and maintenance expenses are estimated to be Tk , Tk. 50,000 and Tk. 5,000 respectively. The depreciation and taxes for each of the five years will be: Year Depreciation( Taka) Taxes (Taka) 1 72,000 11, ,200 22, ,400 27, ,600 31, ,680 Calculate net cash flows for each year, NPV and cost of the project.(cut of rate 12%). Lecturer in Finance; DBA; IIUC; sazzad.amzad@yahoo.com 6