Project Selection Criteria Question

Submitted by jagjitdhaliwal@... on Sun, 08/15/2010 - 02:35

Hi Team,

I came across two questions from two different exams and confused me:

Question from pm-abc:

There are multiple projects your organization is considering for the upcoming fiscal year. Project A has an NPV of $85,000. Project B is a $1 million project and has the benefit cost ratio of 1.6. Project C has an internal rate of return (IRR) of 15%. Project D has a payback period of two years. Based on this information which is the best project to select for execution?

a. Project B
b. Project C
c. Project D
d. Project A

They mentioned answer as D - Explanation: Did you pick BCR (B)? Without a documented breakdown of the benefits, you don’t know how much money you are making. Based on the information provided, the only project that has an identified, quantified return is project ‘A’. Answer a. is incorrect – we do not know the actual return based on the BCR. Answer b. is incorrect – a 15% IRR – fine… 15% of what? Answer c. is incorrect: payback of 2 years is nice, but what is the actual payback?

Then I came across another question from Rita's as follows:

You are PM for large consulting firm. Your superior has just asked for your input on a decision about which project your company should pursue. Project A has IRR of 12%. Project B has BCR of 1.3. Project C has a opportunity cost of $75000. Project D has a payback period of 6 months. if you had to choose based on this data, which project would you select?

a. Project B
b. Project C
c. Project D
d. Project A

They mentioned answer as Project A(option D) with explanation - A 12% IIR is more quantified benefit than a BCR of 1.3 You need more information to understand what the BCR of 1.3 will mean on the project. Thus it is impossible to determine whether BCR of 1.3 is better than an IRR of 12%. There is not enough information provided to support recomending or not recomending project C & D.

Can anyone help me understanding/approach to answer these type of questions and which explanation is correct?

Regards,

Jagjit

Forums:

General Discussion

pkukilla

Sun, 08/15/2010 - 04:08

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BCR , Payback and

BCR , Payback and Opportunity cost are not used as project selection methods.

NPV = Present Value of All Cash Inflows - Present Value of All Cash Outflows

IRR = Discount rate of an Investment which makes Present Value of All Cash Inflows=Present Value of All Cash Outflows

prashin

Sun, 08/15/2010 - 04:46

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NPV (total benefit - total

NPV (total benefit - total costs) is a quantifiable measurement of payback. So you know at the end of the project you'll get back 85000 more than your costs. Just with benefit cost ratio, you don't have enough info to know what you'll get back because you don't have the EBITDA info. A positive IRR is a good thing but just with that you can't say what your tangible payback will be. The projetc could have a cost of 10 dollars with a 150% IRR and i will still be nowhere near 85000 dollars. Payback period is not an exact measurement as well. It could again mean that you could've invested 10 dollars into the project and you'll make it back in two years. So, out of all these choices, the only one that is telling you that you are certain to make your money back to the amount of 85000 dollars is the first choice.

In the second question, the explanation is same for IRR and BCR, they mean nothing without knowing the incurred costs, again it could be 10 dollars. Opportunity cost is what you'll lose out on if you pick a project over another. So to pick a ridiculous example, I have two projects, one will give me a payback of 10 dollars and the other 75000 dollars. I decide to go for the one that is 10 dollars, then my opportunity costs is 75000 dollars. S0, opportunity cost doesn't tell me anything about my project either. The only choice left that gives me an assurance of payback is the payback period so I'll go with that.

Here is the basic approach,

When in doubt, go with NPV. More often than not you'll get it right. Always go for the higher one if multiple.

If just BCR or IRR, cancel out those choices right away. If multiple IRR or BCR and you have to for a chose, pick the higher one again.

Opportunity cost tells you nothing about your project, you cannot select based on them.

Payback period is least precise because it doesn't consider cash inflows. Your second best pick after NPV. When multiple to choose from, go for the shorter one. This should suffice.

Also sunk costs are never a consideration when picking projects.

Peace

jagjitdhaliwal@...

Sun, 08/15/2010 - 15:30

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First of all, thanks prashin

First of all, thanks prashin for detailed explanation,

Actually in 2nd question from Rita's, they mentioned project A with IRR as answer. Please read their explanation. So don't know which one to follow.

Regards,

Jagjit

pkukilla

Sun, 08/15/2010 - 16:25

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Second question

In the second question by elimination

a) BCR can never be used for project selection decision so Project B cannot be selected

b) Opportunity Cost can never be used for Project Selection Decision so Project C cannot be selected

c) Payback period can never be used for Project Selection Decision so Project D cannot be selected

d) IRR is one of the method used for Project Selection Decision so Project A can be selected.

jagjitdhaliwal@...

Sun, 08/15/2010 - 16:26

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Thanks pkukilla, Actually,

Thanks pkukilla,

Actually, your explanation works for question 2 whereas prashin explanation works for question 1. So, I am kinda confused what should be correct answer for both questions and thumb rule for these types of questions.

Regards,

Jagjit

pkukilla

Sun, 08/15/2010 - 16:44

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