Project Selection Methods, according to PMI, is outside the scope of the project manager's role since project selection is usually performed by the project's sponsor, customer, or subject matter experts.
However, it is important to note that these project selection methods can also aid the project manager in evaluating and choosing between alternative ways of performing the project. Therefore, we need to learn them and use them as necessary.
Project Selection Methods are categorized in two ways: benefits measurement (a.k.a. decision models) and mathematical measurement (a.k.a. calculation methods).
Benefits measurement or Decision models examine the different criteria that is used when deciding which project to choose. Mathematical measurement of Calculation methods calculates the value of the project when deciding which project to use.
This is the length of time before the initial costs of producing the product, service, or result is recouped. This is the least precise of all the cash flow techniques because it does not consider the time value of money (value of money in later years).
However, it is important to note that these project selection methods can also aid the project manager in evaluating and choosing between alternative ways of performing the project. Therefore, we need to learn them and use them as necessary.
Project Selection Methods are categorized in two ways: benefits measurement (a.k.a. decision models) and mathematical measurement (a.k.a. calculation methods).
Benefits measurement or Decision models examine the different criteria that is used when deciding which project to choose. Mathematical measurement of Calculation methods calculates the value of the project when deciding which project to use.
Benefits Measurement
Cost-Benefit Analysis
This method takes the cost of the project and its benefits and performs a comparative analysis. The resulting margin helps the project sponsor or whoever is performing the analysis to choose which project has the most benefit.Weighted-Scoring Models
In this method, relevant criteria are set and each project is rated against each of the given criteria. Each criteria is assigned a numeric value called weight within a scale, say 1 to 5, whose value is based on how important that criteria is to the project committee. Each project is rated against each criteria and each rating is multiplied by the weight giving us the actual score of the project for the given criteria. The resulting product is summed up with the rest of the weighted criteria and project with the highest sum wins.Cash Flow Analysis Techniques
Payback PeriodThis is the length of time before the initial costs of producing the product, service, or result is recouped. This is the least precise of all the cash flow techniques because it does not consider the time value of money (value of money in later years).
Discounted Cash Flows
Money received now is worth more than money received in the future. It's because money has a time value.
There are two formulas for this, FV and PV, that is Future Value and Present Value of money. In the formula below i means the interest rate and n means the time periods.
FV = 2000 (1.07)5
FV = 2000(1.4025517307)
FV = $2805.10
The discounted cash flow technique compares the value of the future cash flows in today's dollars, that is, we look for PV. If you would look closely at the formula it is the reverse of FV.
When asked what is the worth in today's dollars the value of $3750 that is to be gained five years from now with 7% interest? This is asking for the Present Value.
PV = 3750 / (1.07)5
PV = 3750 / (1.4025517307)
PV = $2673.69
The above is saying $3750 in five years is worth $2673.69 today.
In using the above formulas in choosing a project, we generally make use of PV.
Example:
Project A is expected to make $120000 in three years.
Project B is expected to make $150000 in four years.
If the interest rate is 15%, which project is more attractive?
Project A = $78901.95
Project B = $85762.99
Now there you have it, Project B is more attractive.
Net Present Value (NPV)
NPV works like discounted cash flows except that PV is computed for each time period. The PV for each time period is summed up after which the initial cost of investment is subtracted from it. The difference is our Net Present Value.
As a rule, if NPV is greater than zero, accept the project. If NPV is less than zero, reject the project.
Example:
Project A has invested $15700 at 12% cost of capital.
Project B has invested $25000 at 12% cost of capital.
Between Project A and Project B, we should choose Project A.
Note: But how about if both Project A and Project B have positive values? Which project should we chose then? In such a case, choose the one with higher NPV early in the project.
Internal Rate of Return (IRR)
This is the most difficult one to calculate and needs a financial calculator.
IRR is the discount rate when the present value of the cash inflows equals the original investment.
When choosing between projects or alternative methods of doing a project, projects with higher IRR values are generally considered better than those with lower IRR values.
Money received now is worth more than money received in the future. It's because money has a time value.
There are two formulas for this, FV and PV, that is Future Value and Present Value of money. In the formula below i means the interest rate and n means the time periods.
- FV = PV (1 + i)n
- PV = FV / (1 + i)n
FV = 2000 (1.07)5
FV = 2000(1.4025517307)
FV = $2805.10
The discounted cash flow technique compares the value of the future cash flows in today's dollars, that is, we look for PV. If you would look closely at the formula it is the reverse of FV.
When asked what is the worth in today's dollars the value of $3750 that is to be gained five years from now with 7% interest? This is asking for the Present Value.
PV = 3750 / (1.07)5
PV = 3750 / (1.4025517307)
PV = $2673.69
The above is saying $3750 in five years is worth $2673.69 today.
In using the above formulas in choosing a project, we generally make use of PV.
Example:
Project A is expected to make $120000 in three years.
Project B is expected to make $150000 in four years.
If the interest rate is 15%, which project is more attractive?
Project A = $78901.95
Project B = $85762.99
Now there you have it, Project B is more attractive.
Net Present Value (NPV)
NPV works like discounted cash flows except that PV is computed for each time period. The PV for each time period is summed up after which the initial cost of investment is subtracted from it. The difference is our Net Present Value.
As a rule, if NPV is greater than zero, accept the project. If NPV is less than zero, reject the project.
Example:
Project A has invested $15700 at 12% cost of capital.
Year
|
Inflows
|
PV
|
1
|
7,000
|
6,250.00
|
2
|
10,000
|
7,971.94
|
3
|
3,000
|
2,135.34
|
Total
|
20,000
|
16,357.28
|
Less Investment
|
15,700
|
|
NPV
|
657.28
|
Year
|
Inflows
|
PV
|
1
|
17,000
|
15,178.57
|
2
|
9,000
|
7,174.74
|
3
|
3,000
|
2,135.34
|
Total
|
29,000
|
24,488.65
|
Less Investment
|
25,000.00
|
|
NPV
|
(511.35)
|
Note: But how about if both Project A and Project B have positive values? Which project should we chose then? In such a case, choose the one with higher NPV early in the project.
Internal Rate of Return (IRR)
This is the most difficult one to calculate and needs a financial calculator.
IRR is the discount rate when the present value of the cash inflows equals the original investment.
When choosing between projects or alternative methods of doing a project, projects with higher IRR values are generally considered better than those with lower IRR values.
Mathematical Measurement
Selection methods under this perform linear, dynamic, integer, nonlinear computations. You would need to have a mathematical background to be able to perform the methods.
