The Project Selection Criteria

Once the project preparation activity is

completed the next step will be to select the
project on the basis of different criteria
There are several criteria that can be employed
to judge the worthiness of the project
Some are general and applicable to a wide range
of investments, where as others are specialized
and suitable for certain types of investments
and industries.
The important selection criteria are classified into
two broad categories. These are
 Non-discounting criteria
 Discounting criteria
1
 Non-discounting methods
The non-discounted criteria will not in general take
into account the time value of money.
That is inter-temporal variations of costs and
benefits and its influence on cash flow is largely
ignored.
As a result a time dimension is not included in
the evaluation.
There are different methods under this
category

1. Ranking by Inspection
By simple inspection it is possible to determine
which of the two or more investment projects
is more desirable. 2
 1. Ranking by Inspection
There are two cases under consideration
(i) When two projects have identical cash flows but
different project life, i.e.,
One has shorter life
while the other has longer project life
then, the project with the longer life would be
more desirable.
(ii) When two projects have the same initial outlay the
same earning life and earn the same total proceeds
(profits), but one project has more of the flow
earlier in the time sequence,
Then we choose the project having higher proceeds
in the earlier period than later.
3
 Ranking by Inspection (cont…)

Consider the following example

Net cash proceeds per
Investment year
(project) Initial cost
Year I Year II

A 10,000 10,000 ---

B 10,000 10,000 1,100
C 10,000 3,762 7,762
D 10,000 5,762 5,762
4
 Ranking by Inspection (cont…)

From the above table, comparison of project A

and B
Investment B is better than investment A,
since all things are equal except that B
continues to earn proceeds after A has been
retired.
More analysis is required to decide between C
and D.
Investment D is more profitable than
investment C, since D earns 2000 more in
year 1 than investment C, which does not
make up the difference until year two.
5
 2. The Payback Period
What is payback Period?

The pay – back period is defined as the period

required to recover the original investment
outlay through the accumulated net cash flow
earned by the project
Or payback period is defined as the number of
years it is expected to take from the
beginning of the project until the sum of its
net earnings (receipts minus operating costs)
equals the projects initial capital investment

6
 The Payback Period (Cont…)
If a project involves cash outlay of Birr 600,000
and generates cash inflows of
 Birr 100,000,
 Birr 150,000,

 Birr 150,000 and Birr 200,000

in the first, second, third and fourth years
respectively
Its payback period is four years, because the sum
of cash inflows during four years is equal to the
initial outlay.
When the annual cash inflow is a constant sum, the
pay back period is simply the initial outlay divided
by the annual cash inflow.
7
 The Payback Period (Cont…)
A project, which has an initial cash outlay of
Birr 1,000,000 and a constant annual cash
inflow of Birr 300,000, has a payable period
of 3 1/3 years.

The table below shows payback period

determination using cash flow of a
hypothetical project.

It indicated that the original investment costs

would be recovered after a little less than
6.5 years, including the construction period.
8
 The Payback Period (Cont…)
Amount paid Balance at the
back “profit” end of year
Year 1 and 2 - 10,300
(construction
period)
Year 3 870 -9,430
Year 4 2,030 -7,400
Year 5 2,330 -5,070
Year 6 3,500 -1,570
Year 7 3,500 1930
9
 The Payback Period (Cont…)
A single project proposal may be accepted
If the payback period is smaller than or equal to
an acceptable time period – a firms maximum
desired payback period

Limitation of payback period

Payback period as widely used investment criterion
has got the following advantages.
It is simple both in concept and application.
It is rough and ready method for dealing with risk
 If favors projects which generate substantial
cash inflows in the earlier years but it
discriminates projects which brings cash inflows
in the later years. 10
 The Payback Period (Cont…)
Limitation of payback period
It over looks cash flows beyond the payback
period
 This leads to discrimination against projects,
which generate substantial cash inflows in
later years.
It does not measure the profitability of the
project but it measures only capital recovery.
It ignores the time value of money.
 Cash inflows, in the pay back calculation, are
simply added without suitable discounting.
11
 The Payback Period (Cont…)
Discounted payback period
A major deficiency of a conventional payback
period is that it does not take into account the
time value of money.
To overcome this limitation, the discount
payback has been suggested.
In this modified method,
 cash follows are first converted into their
present values
 and then added to determine the period of time
required to recover the initial outlay on the project.
12
3. Proceeds Per Unit of Outlay
In this method, investments are ranked
according to their total proceeds divided
by the amount of the corresponding
investments.
In other words, the total net value of
incremental proceed divided by the total
amount of investment gives us the
proceeds per unit of outlay.
Let us consider the previous example used
in the inspection criteria.

13
 Proceeds per Unit of Outlay (Cont…)

Alternative Total Investment Proceeds per

Investment proceeds outlay unit of Rankin
outlay g
A 10,000 10,000 1.00 4

B 11,100 10,000 1.11 3

C 11,524 10,000 1.15 1

D 11,524 10,000 1.15 1

14
 Proceeds per Unit of Outlay (Cont…)

Using the above method, since project

C and D are given the same rank both
are selected.
However, we know that project D is
superior because D generates Birr
2000 of proceeds in year 1.
The limitation of this method is thus, it
fails to consider the timing of
proceeds.
15
 4. The average annual proceeds
per unit of outlay

This is similar to the proceeds per unit

of outlay.
It is the ratio of the average
proceeds to the original investment
That is,
The total proceeds are first divided by
the number of years during which they
are received, and then expressed as a
ratio of the original outlay.
16
 The average annual proceeds per unit of
outlay (Cont…)

The limitation of this method

This method fails to consider the timing of
proceeds and
It exhibits a inbuilt bias for short lived
investment with high cash proceeds.
Let us consider the following example.

17
 The average annual proceeds per unit
of outlay (Cont…)

Projects Total Average Original Average annual Ranking

proceeds annual outlay proceeds per
proceeds unit of outlay

A 10,000 10,000 10,000 1.00 1

B 11,100 5,550 10,000 0.555 4

C 11,524 5,762 10,000 0.576 2

D 11,524 5,762 10,000 0.576 2

18
 The average annual proceeds per unit
of outlay (Cont…)

We know that project D is superior to C

although this method gives them equal ranks.
Investment A and B are also incorrectly
ranked.
This criteria ranked A above B in spite of the
fact that the latter is obviously superior.
No weight is given to the time distribution.
For instance, a project that earns 10000 Birr
for 10 years would also have an average proceed
of 10000 per year and it would be given the
same rank as project A
19
 Discounting methods of project
selection
The non-discounted criteria failed to take into
account adequately the timing of benefits.
We know that inter-temporal variations of
costs and benefits influence their values and a
time adjustment is necessary before
aggregation.
Therefore, a time dimension should be included
in our evaluation.
That means we need to express costs and
benefits by discounting all items in the cash
flows back to year 0.
The need for such a procedure will be apparent
if one considers the following simple argument.
20
 Discounting methods of project
selection (Cont…)
Suppose one is offered the choice between
receiving Birr 100 today and receiving the
same amount in a year’s time. It will be
rational to prefer to receive the money today
for several reasons.
1. One may expect inflation to reduce the real
value of Birr 100 in a year’s time.
2. If there is no inflationary effect it would
still be preferable to take the money today
and invest it at some rate of interest, r.
Hence, receiving a total of Birr 100 (1+r) at
the end of the year.
21
 Discounting methods of project
selection (Cont…)
3. Even if no investment opportunities are available,
Birr 100 today would still be preferable on the
grounds that there is a high risk of not being around
to collect the money next year.

4.Even where inflation, investment opportunities,

and risk are ignored, there is pure time
preference, which would lead one to prefer the
immediate offer

Due to the above reasons, there is a positive

rate of discount, which leads us to place a
lower value on a given sum of money that will
be received some times in the future. 22
 Discounting methods of project
selection (Cont…)

The most important discounted cash flow

measures include
The Net Present Value (NPV)
The Internal Rate of Return (IRR)
and the Benefit Cost Ratio (BCR)
1. Net Present Value (NPV)
The net present value of a project is the sum of
the present values of all the net cash flows that
are expected to occur over the life of the
project
23
Net Present Value (NPV) (Cont…)
n
CF0 CF1 CFn CFt
NPV    ..  
(1  r ) (1  r )
0 1
(1  r ) t 0 (1  r ) t
n

NPV = Net present value

CFt = Cash flow occurring at time
period (year) t (t = 0 ….n)
n = Life of the project
r = discount rate

24
 Net Present Value (NPV) (Cont…)
The discounted rate should be either
 the actual rate of interest on long term loans in
the capital market
 or the interest rate paid by the borrower
Since capital markets do not function properly
in developing countries, the discount rate should
reflect the opportunity cost of capital
This is the minimum rate of return below which
it does not pay to invest (Cut off rate)

25
 Net Present Value (NPV) (Cont…)
The discounting period is normally equal to the
life of the project.
This period is the economic life of the project
and varies from project to project.
Having determined discount rate, The project is
acceptable if the discounted net benefits is
greater than or equals to zero.
The economic criterion of project appraisal is to
accept all projects that show positive or zero
NPV at the predetermined discount rate and
reject all projects that show negative NPV.
Thus, the decisions is to accept if NPV > 0.
26
 Net Present Value (NPV) (Cont…)

Year 0 1 2 3 4 5

Cash flow -1,000,000 200,000 200,000 300,000 300,000 550,000

Therefore,
 1,000,000 200,000 200,000 300,000 300,000 550,000
NPV  0
 1
 2
 3
 4
 5
 118,913
(1.10) (1.10) (1.10) (1.10) (1.10) (1.10)

27
 Net Present Value (NPV) (Cont…)
We can also use the discount factor (PVIF r, n) from
present value tables and compute the NPV as shown in
following table
Year Cash flow PV Discount PV
Factor
0 -1,000,000 1 (1,000,000)
1 200,000 .909091 181,818
2 200,000 .826446 165,259
3 300,000 .751315 225,395
4 300,000 .683013 204, 904
5 550,000 .620921 341,507
28
NPV 118,913
 Net Present Value (NPV) (Cont…)
Independent projects are projects that are
not in any way substitutes for each other.
In such cases the decision rule is to
accept the project having positive NPV
Which means, if two projects have
positive NPV and there is no budget
constraint both could be accepted and we
do not need to choose the one with higher
NPV.
29
 Net Present Value (NPV) (Cont…)

A mutually exclusive project is a project

that can only be implemented at the
expense of an alternative project as they
are in some sense substitutes for each
other.
Example of the mutually exclusive projects
includes two versions of the same project,
say with different technology, scale or
time.
The decision rule for such projects is to
accept the project with the highest NPV.
30
 Net Present Value (NPV) (Cont…)
NPV is on the basis of the following assumptions
Annual outlays and receipts from each investment are
known for the entire life of the project.
The project life span is known.
There should be a rate of discount, which can be
applied to every proposal and for every time period.
However, the information required above is not
always available for every project.
That means the NPV criterion may be applicable
only to a limited number of project proposals on
which relevant data as indicated are available.
31
 Net Present Value (NPV) (Cont…)
Advantages of NPV Approach
It is simple to use
It recognize the time value of money
It is consistent with the firm’s goal
In addition it is the only selection criteria that can
be used to choose between mutually exclusive
projects
Limitations of the Net Present Value
The selection of an appropriate discount rate is
one major limitation of this method
It require detailed long-term forecast of
incremental costs and benefits of the project
32
 Net Present Value (NPV) (Cont…)
The NPV is expressed in absolute term, hence does
not consider the scale of investment.
Example,
Consider two projects
 Project A may have NPV of birr 5000 with
initial investment of birr 50000
 Where as project B may have NPV of birr
2500 with initial investment of birr 10000.
 Project A would be selected regardless of its
initial capital requirement
33
 Net Present Value (NPV) (Cont…)

The NPV rule does not consider the life

of the project.
As a result when mutually exclusive
projects with different lives are
considered, the NPV rule is biased in
favour of the long term project
It does not show the exact profitability
rate of the project
34
 Net Present Value (NPV) (Cont…)
Net – Present – Value Ratio
One of the limitation of NPV is that it does not
consider the scale of the initial investment.
If one among a number of project alternatives
has to be chosen, the project with the largest
NPV is selected.
This process needs some refinement
The Net Present Value Ratio (NPVR) is an
attempt to improve this limitation.
When there are two or more alternatives, it is
advisable to know how much investment will be
required to generate these positive NPV.
35
 Net Present Value (NPV) (Cont…)
The ratio of the NPV and the present value of
initial investment (PVI) is called the net-present-
value ratio (NPVR)
This should be used for comparing alternative
projects.
NPV
NPVR 
PVI
Given alternative projects, the one with the
highest NPVR should be chosen.
However, when comparing alternative projects,
care should be taken to use the same discount rate
for all projects.
36
 Net Present Value (NPV) (Cont…)
If the construction period does not exceed one
year, the value of investment will not have to be
discounted.

In summary, the NPV has great advantages as a

discriminatory method as compared with
 the pay back period
 annual rate of return, and
 Other non discount methods
since it takes into account the entire project life
and the timing of the cash flows.
.
37
 2. The Internal Rate of Return of
a Project (IRR)
The Internal Rate of Return (IRR): is the
discount rate at which the present value of all
cash flows is equal to the present value of the
initial cash outflows.
In other words, it is the discount rate for which
the present value of the net receipts from the
project is equal to the present value of the
investment,
Here an attempt is made to find the discount
rate which just makes the net present value of
the cash flow equal to zero
38
 The Internal Rate of Return (Cont…)
The IRR of a project is probably the most
commonly used assessment criterion in project
appraisal.
This is because the concept of IRR is in some
way comparable to the profit rate of a project.
The method utilizes present value concept but
will avoid the arbitrary choice of a discount
rate.
The procedure used to determine the IRR is
the same as the one used to calculate the NPV.
39
 The Internal Rate of Return (Cont…)
Instead of using a predetermined cut-off rate,
several discount will be tried until the
appropriate rate is found.
And this (IRR) represents the exact
profitability of the project

In the NPV calculation, we assume that the

discount rate is known and used to determine the
net present value of the project.
But in the IRR calculation, we set the net
present value equal to zero and determine the
discount rate which satisfies this condition.
40
 The Internal Rate of Return (Cont…)
If the net cash flow of the project is a
constant amount throughout the project life,
then the determination of the IRR is some how
easier.
Take for example, a hypothetical project with the
initial cash outlay of birr 10,000 and has a net cash
flow after tax birr 3000 each year up to five years
where the project will be retired.

3,000 3,000 3,000 3,000 3,000

10,000     
(1  r ) (1  r ) (1  r ) (1  r ) (1  r )
1 2 3 4 5

41
 The Internal Rate of Return (Cont…)
This can be written as,
 1 1 1 1 1 
10,000  3,000     
5 
 (1  r ) (1  r ) (1  r ) (1  r ) (1  r ) 
1 2 3 4

This is a present value of annuity which can

be solved as 5
10,000 1

3000 (1  r ) t 1
t

From the table value in the year’s row (5th row)

we find the value closer to 3.333 and we read the
interest rate which is the IRR. The interest rate
is 15%
42
 The Internal Rate of Return (Cont…)
In many cases the cash flow of the project
is not the same amount throughout the
project life. As a result the IRR is
determined through iterative process.
The IRR calculation procedure includes
Preparation of a cash flow table
An estimation of any discount rate to discount
the net cash flow to the present value
If the NPV is positive, a higher discount rate is
applied
If the NPV is negative at this higher rate, the
IRR must be between these two rates.
43
 The Internal Rate of Return (Cont…)
But, if the higher discount rate still
gives a positive NPV, the discount rate
must be increased until the NPV
becomes negative
If the positive and negative NPVs are
close to zero, a good approximation of
the IRR can be obtained, using the linear
interpolation formula.
To illustrate the calculation of internal
rate of return, consider the cash flows
of the following hypothetical project
44
 The Internal Rate of Return (Cont…)
Year Cash flow
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
The IRR is the value of r, which satisfies the said
condition
Let us, begin with, say, r = 12 percent. The right –
hand side of the above equation becomes:
30,000 + 30,000 + 40,000 + 45,000 = 107,773
(1.12) (1.12)2 (1.12)3 (1.12)4
45
 The Internal Rate of Return (Cont…)
Since this value is higher than the target value of
100,000, we have to try a still higher value of r.
Now let us try r = 15 percent. This makes the right –
hand side equal to:
30,000 + 30,000 + 40,000 + 45,000 =100,806.5
(1.15) (1.15)2 (1.15)3 (1.15)4
This value is still higher than our target value,
100,000. So we increase the value of r from 15
percent to 16 percent
30,000 + 30,000 + 40,000 + 45,000 = 98,637.5
(1.16) (1.16)2 (1.16)3 (1.15)4
46
 The Internal Rate of Return (Cont…)
Now this value is less than 100,000, we conclude
that the value of r lies between 15 percent and
16 percent.
For most of the purposes this information is
sufficient.
However, if a single value is required, we have to
resort to interpolation
For that purpose we can use the following
procedures
(High value – Initial investment)/(High value –
Lower value) = (Lower interest rate – X) /
(Lower interest rate – Higher interest rate)
47
 The Internal Rate of Return (Cont…)

100806.5  100,000 15  X
   X  15.3718
(100,806.5  98637.5) (15  16)
Thus, the IRR would be 15.3711

Another approximate solution to the IRR is to plot the

NPVs corresponding to several discount rates to give
what we call the NPV curve
The present values are plotted on the y-axis and the
discount rates on the X-axis.
A curve is then drawn to connect the various points on
the graph. The point at which the curve cuts the X-
axis represents the rate at which the present value
of the investment is equal to 0.
48
Graphical presentation of IRR
Present value
3000 3000 @ 0 %

2000
1671 at 5%
1000
91 @ at 13%

Discount rate
1 5 10 15 20
IRR -221 @ 15%
49
 The Internal Rate of Return (Cont…)
Once the IRR is identified, the decision rule is
‘accept the project if the IRR is greater than
the cost of capital, say r (cost of borrowing).
That is, all projects with an internal rate of
return greater than some target rate of return,
should be accepted.
The target rate is usually the same rate used as
the discount rate employed in the computation of
the projects net present value.
Note that the use of IRR does not preclude the
need for discount rate, as sometimes claimed,
but merely delays the need to use it until the
IRR has been computed
50
 The Internal Rate of Return (Cont…)
From our discussions it is clear that both the
NPV and the IRR methods can and do rank
investment projects in more rational manner
than the other methods previously considered.
In general, it can be said that the NPV method
is simpler, easier, and more direct and more
reliable.
In some situations, both the NPV and the IRR
criteria give the same accept or reject
decision.
51
 The Internal Rate of Return (Cont…)

Advantages of the IRR

 Useful for international institutions like the
WB since they are dealing with different
discount rate for different countries.
 It is a measure that could be understood
easily by non-economists since it is closely
related to the concept of the return on
investment.
 It is a pure number and hence allows projects
of different size to be directly compared
52
 The Internal Rate of Return (Cont…)

Disadvantages of IRR
The IRR is inappropriate to use for
mutually exclusive projects
It assumes that cash flows over the life
of the project are reinvested at the IRR
Requires detailed long term forecasts of
the projects incremental costs and
benefits
53
 Modified Internal Rate of Return
The major drawback of the IRR relative to the
NPV is the reinvestment rate assumption made
by the IRR.
The IRR assumes that all cash inflows over the
life of the project are reinvested at IRR until
the termination of the project.
The MIRR will correct this shortcoming by
making alternative assumption that,
all cash inflows over the life of the project are
reinvested at the required rate of return.
The MIRR, will take all the annual after cash
inflows (ATCI) and find their future value at the
end of the projects life, compounded at the
required rate of return. 54
 Modified Internal Rate of Return (Cont…)

We call this the Projects Terminal Value (TV).

We then calculate the present value of the
projects cash outflows.
The MIRR is then the discount rate that equate
the present value of the cash outflows with the
present value of the projects Terminal Value
(TV).
This can be shown mathematically,
n
ACOFt
(1  r ) t
 
t 0
ACIF t (1  k ) t
/(1  MIRR ) t

55
 Modified Internal Rate of Return (Cont…)

TV
PVoutflows 
(1  MIRR ) t

Where,
ACOFt = all cash outflow in time period t
ACIFt = the annual after tax cash inflows in time
period t
TV = terminal value of the project
n = Project’s expected value
MIRR = Modified IRR
56
Modified Internal Rate of Return (Cont…)

Consider a project with a three years

life and a required rate of return 10
percent assuming the following cash flows
are associated with it.
After tax cash flows
Initial outlays (6000)
Year one 2000
Year two 3000
Year Three 4000
57
 Modified Internal Rate of Return (Cont…)

To determine the MIRR we can follows the

following steps
 Determine the FV of the cash outflows
 Determine the terminal value (TV) of the
project’s cash inflow.
 Determine the discount rate that equate the
present value of the terminal value and the
present value of the project’s cash outflows.
 And the determined discount rate is MIRR

58
 Modified Internal Rate of Return (Cont…)

0 1 2 3
-6000 2000 3000 4000

4000

3300

2420

9720 = TV
-6000
MIRR = 17.45%

59
 Modified Internal Rate of Return (Cont…)

6000= 9720/(1+MIRR)3
MIRR= 17.45%

In summery the MIRR for this project is 17.446

percent.
And this value is less than the IRR which is
20.614.

If the project MIRR is greater than or equal to

the projects required rate of return, then the
project will be accepted if not rejected.
60
 3. The Benefit Cost Ratio (BCR)
The Benefit Cost Ratio is also called
Profitability Index (PI)
It is defined as the ratio of the sum of the
project’s present value of benefits to the sum
of present value of its initial investment.
This is given as
n
Bt
 (1  r ) t
t 0
BCR  n
Ct
 (1  r ) t
t 0
61
 The Benefit Cost Ratio (BCR) (Cont…)
We can define the benefit – cost ratio (BCR) in
two different ways.
a) The first definition relates the present value
of all benefits to the initial investment.
This is given by
PVB
BCR 
Where: I
BCR = benefit – cost ratio
PVB = present value of benefits
I = initial investment
62
 The Benefit Cost Ratio (BCR) (Cont…)

b) The second definition relates net

present value to initial investment
PVB  I
NBCR   BCR  1
I
Where:
NCBR = net benefit – cost ratio
NPV = net present value
PVB = present value of benefits
I= initial investment
63
 The Benefit Cost Ratio (BCR) (Cont…)
Consider a project, which has a cost of
capital 12 percent annually and the initial
investment Birr 100,000
Year Benefit
1 25,000
2 40,000
3 40,000
4 50,000
64
 The Benefit Cost Ratio (BCR) (Cont…)

The benefit – cost ratio measures for this

project are:
 25000 40000 40000 50000 
BCR    2
 3
  / 1000,000  1.145
4 
 (1.12) (1.12) (1.12) (1.12) 
NBCR = 1.145 - 1 = 0.145
The two benefits – cost ratio measures give
the same signals because the difference
between them is simply unity.
65
 The Benefit Cost Ratio (BCR) (Cont…)
Since benefit – cost ratio measures net
present value per Birr of outlay, it can
discriminate better between large and
small investments.
The Decision rule for BCR
A project is accepted if its BCR is greater
than or equal to 1 (i.e. if its discounted
benefits exceed its discounted costs).
But if BCR is less than 1, the project is
rejected.
66
 The Benefit Cost Ratio (BCR) (Cont…)

The following decision rules can be taken as

a summary for the two criteria.

When BCR When NBCR Decision

>1 >0 Accept

=1 =0 Indifferent
?

<1 <0 Reject

67
 The Benefit Cost Ratio (BCR) (Cont…)

This criterion is especially important

for ranking independent projects
since it shows the benefit per unit
of investment
One possible advantage of the BCR,
on top of being easy is that it is easy
to show the impact of a percentage
change in cost or benefits on the
projects viability.
68
 Problem with Project Ranking
In our previous discussion we have proposed
that all projects
with a positive NPV,
with IRR greater than the required rate of
return, or
BCR (profitability index) greater than one be
accepted.
However, accepting all projects is not always
possible
In many cases it may be necessary to select
only one of them.
69
 Problem with Project Ranking (Cont…)
This is true particularly for mutually exclusive
projects
Projects are mutually exclusive if the acceptance
of one project means the rejection of the other.
In other words it is a project that can only be
implemented at the expense of an alternative
project as they are substitutes for each other.
The decision rule for mutually exclusive projects is,
therefore, to accept the project with the highest
NPV
In general the NPV method is the preferred
decision making tool as it leads to the selection of
the project that increase the shareholders wealth.
70
 Problem with Project Ranking (Cont…)

However, problems of conflict in ranking of

projects may arise
There are two major types of ranking problems.
These are,
 The size disparity problem
 Unequal lives problem.
Each involves the possibility of conflicting in
the ranks given by different criteria.

71
 Problem with Project Ranking (Cont…)
1. Size Disparity Problem
The size disparity problem occurs when mutually
exclusive projects of unequal size are compared.

This problem is easily clarified with the help of

example.
Suppose a firm is considering two mutually exclusive
projects A and B.
both with the required rate of return of 10%.
Project A involves 200 initial cash outflow and cash
inflow of 300 at the end of the year.
Where as project B involves 1500 initial cash
outflow and cash inflow of 1900 at the end of the
year.
72
 Problem with Project Ranking (Cont…)
The NPV, the IRR, and BCR for each of them is
presented below

Project A Project B

300 inflow
1900 inflow
Year 1 1 year
200 outflow 1500 outflow

NPV= 72.70 NPV= 227.10

IRR = 50% IRR = 27 %
BCR = 1.36 BCR = 1.15
73
 Problem with Project Ranking (Cont…)
In this example if the NPV criterion is used
project B would be selected.
But if the IRR and BCR are used project A would
be the preferred one.
The question is which project is better?
The answer depends up on whether capital
rationing exists.
Without capital rationing project B is better
because it provides the largest increase in the
shareholders wealth.

74
 Problem with Project Ranking (Cont…)
If there is capital constraint,
 then focuses is on what can be done with
the additional 1300 (1500-200=1300) that
is freed if project A is chosen?

If the firm can earn more on project A plus the

project financed with the additional money of
1300 than on project B
 then project A and the marginal project
will be selected.
In effect we are attempting to select the set
of projects that maximize the firm’s NPV.
75
 Problem with Project Ranking (Cont…)
If the marginal project has the NPV greater than
154.4 ( 227.10-72.70) we select this new project
plus project A.
In summery, whenever the size disparity
problem result in conflicting ranking
between mutually exclusive projects, the
project with the largest NPV will be
selected, provided that there is no capital
rationing.
When there is capital rationing the firm
should select the set of projects with the
largest NPV.

76
 Problem with Project Ranking (Cont…)
2. Unequal Projects’ life
The other problem of project ranking of
mutually exclusive projects is problem
associated with unequal life.
Is it appropriate to compare two projects
having different life span?

Example
Suppose a firm with a 10% required rate of
return is faced with the problem of selecting
between two projects having different life
time.
77
 Project A Project B

500 500 500

300 300 300 300 300 300

1 2 3 years
1 2 3 4 5 6years

1000 outflow
1000 outflow

NPV= 243.5 NPV= 306.5

IRR = 23% IRR = 20 %
BCR = 1.2435 BCR = 1.306

78
 Problem with Project Ranking (Cont…)
When we examine these two projects we find
that the NPV, and BCR criteria indicate that
project B is better project.
But the IRR criteria favors project A.
In this case the decision is a difficult one as
the two projects are not comparable.
The problem of incomparability of projects with
different life time arises, because
 future profitable project proposals may be
rejected without being included in the analysis.
In our example, the comparison of the NPV
alone would be misleading. . 79
 Problem with Project Ranking (Cont…)
If the project A is taken, the firm could replace
it at its termination by another project and
receive additional benefits.
But acceptance of the project with longer life
span would exclude this probability.
As a result the key question here becomes,
Does today’s investment decision include all
future profitable investment proposals in its
analysis?

If not the two projects are not comparable

80
 Problem with Project Ranking (Cont…)
That is, if project B is selected, then the
project that could have been taken after three
years when a project A terminates is
automatically rejected.
How such projects are compared?
There are different methods to deal with such
problem.
i) The first approach is to assume that the cash
inflow from the shorter life project will be
reinvested at the required rate of interest until
the termination of the longer life project.
This approach is the simplest one. But when
calculating the NPV it ignore the problems at
hand. 81
 Problem with Project Ranking (Cont…)
That is, it ignores the possibility of
participating in other replacement projects

ii) Another option is the projection of

reinvestment opportunities into the future.
That is, making assumption about possible future
investment opportunity.
Unlike the first approach this is very difficult
and requires extensive cash flow forecast

82
 Problem with Project Ranking (Cont…)
iii) The final technique is to assume that
reinvestment opportunity in the future will be
similar to the current one.
Meaning creating a replacement chain to
equalized life span.
In the replacement chain, we can create two chain
cycle for project A.
That is, we can assume that project A can be
replaced with a similar investment at the end of
three years.
Thus, project A would be viewed as two A
projects occurring back to back as illustrated
below.
83
 Problem with Project Ranking (Cont…)

Project A

500 500 500 500 500 500

1 2 3 4 5 6 years

1000 Outflow 1000 Outflow

84
 Problem with Project Ranking (Cont…)
The present value on this replacement chain is
426.4 which is comparable with project B’s NPV.

Therefore, project A should be accepted as its

NPV is greater than NPV of project B.

One problem of replacement chain is that it can

be difficult to come up with equivalent life.
For example, if the two projects had 7 years
and 13 years life span, then we need a 91 years
replacement chain to establish equivalent lives.
In such cases we need to determine the
project’s Equivalent Annual Annuity (EAA). 85
 Problem with Project Ranking (Cont…)

A project EAA is an annuity cash flow ( a

stream of annual income) that yield the
same PV as the projects NPV
How do we calculate EAA?
Calculate first a project’s NPV and then
Divide the product by the Present Value
Interest Factor for Annuity (PVIFA i, n )
This will help us to determine the amount of n-
years annual cash receipts that would produce
the same NPV as the project.
86
 Problem with Project Ranking (Cont…)

This can be solved in two steps,

Step 1- Calculate project’s NPV. In our example
 Project A has NPV = 243.50
 Project B has NPV = 306.50
Step 2- Calculate EAA. This is done by dividing
each project’s NPV by the PVIFA
Where, i= required rate of return
n = Project’s life
The resulting EAA can be used to compare
projects.

87
 Problem with Project Ranking (Cont…)

For project A
The PVIFA10%, 3years = 2.4869
EAA = 243.5/2.487 = 97.91
For project B
The PVIFA10%, 6years = 4. 3553
EAA = 306.5/4.355 = 70.38
Since both EAA are annual annuity they
are now comparable
88
 Problem with Project Ranking (Cont…)

This can also be shown by calculating the PV of

an infinite stream.
This is done by using the PV of an infinite
annuity formula, i.e., simply dividing the EAA
by the approximate discount rate of 10%.
NPV , A = 97.91/0.1 =979.1 (9.96)
NPV , B = 70.38/0.1 =703.8
Thus, in all approach project A would be
preferable than B.
89