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Project Selection Methods: NPV, IRR, & Payback Period

Project Selection Methods NPV, IRR, & Payback Period

With the level of development in our country, organizations may get numerous projects. However, some of these projects may be not be suitable. A goods project should involve minimal risks but have high profits as well as recognition. In their work, Ahmad and Haq (2016) point out that benefit measurement methods are the most common.

Benefit/Cost Ratio

This is the ratio between the present value cash inflows and the cash outflows of a given project. The cost of completing a project is compared to the present value of the expected future benefits. The project with the highest cost benefit ratio is selected.

Benefit/Cost Ratio Advantages

  1. This project selection method is very simple to apply and thus simplifies complex business decisions.
  2. This method provides an objective way of comparing projects thus eliminating the emotionally made decisions.
  3. This project selection method also helps companies estimate the net benefits of a project.
  4. Finally, it helps make accurate decisions because it is based on facts.

project selection method

Benefit/Cost Ratio Disadvantages

  1. It is inaccurate in that it uses the approximated costs and benefits.
  2. It increases the subjectivity of non- monetary costs which at times are quite substantial.
  3. The present values may be wrong especially when the wrong discounting tare is applied.

Payback analysis

Here, the objective is finding out how long it would take a project to return the amount invested. We find ratio of cash out with an average per period of cash in. The project with the shortest payback period is selected.

Payback Analysis Advantages

  1. It is simple to calculate.
  2. This project selection method is risk focused as it helps find out how quickly money invested in a given project can be recovered.

Payback Analysis Disadvantages

  1. This project selection method does not take into account the time value of money.
  2. It also does not take into account that cash inflows continue beyond the payback period

The Net Present Value (NPV)

This is the difference between the present value of cash inflow and the present value of the cash outflow of a project. Only the projects with a positive NPV are viable. In case the several have positive NPVs, the one with the highest value of is selected. Chrisman (2008) say that this project selection method measures the magnitude of returns of a given project.

NPV Advantages

  1. This project selection method puts into consideration the concept of time value of money.
  2. Using this project selection method, one can tell whether a n investment will create value for the investor
  3. It also puts into consideration the cost of capital and the risk involved in a given project

The Internal Rate of Return (IRR)

This is the rate of return at which the present value of cash outflows equal that of cash inflows. In other words it is that interest rate at which the net present value of a project is equal to zero.

IRR Advantages

  1. It is simple and easy to understand.
  2. It also recognizes the time value of money.
  3. It is an indicator of the efficiency of a given project.

project selection method

IRR Disadvantages

  1. It cannot be used to choose between mutually exclusive projects.
  2. It also assumes that reinvestment of cash flows in projects with equal interest rate which is not true.
  3. Finally it does not consider the cost of capital thus cannot be used to compare projects of different durations.

Opportunity Cost

Spiller (2011) said term opportunity cost as the cost of foregoing other project when a give project is chosen. The project with the least opportunity cost should be picked.

Opportunity Cost Advantages

  1. It causes one to be aware of lost an opportunity which is the reality in project selection.
  2. It allows one to compare the relative prices and benefits of various projects.

Opportunity Cost Disadvantages

  • This project selection method is time consuming. It takes managers a lot of time to compare the opportunity cost of different projects.
  • Despite its usefulness this method is not accounted for by company accounts.

The Project Selection Method I Choose

In selecting the planed upgrade to electrical equipment project, I used the Net Present Value method. I estimated the future value of the cash inflows of various project and compared them to the present value of costs. Quite a number of my options had a positive NPV so I picked the one with the highest NPV.

My Strengths and Suitability for the Project I Selected

As Flannes (2003) says in his work, there are various attributes that are common evident in successful managers. In myself reflection I realized that I too have them. This will help in the success of the planed electrical equipment project. They include:

  1. I have successful created an inclusive vision of the project at hand. Therefore, I lead competently and within the stipulated period of time.
  2. I am a good communicator and can easily connect with people. With this ability I will lead my subordinates easily as well as ask for direction s from my superiors easily too.
  3. I am capable in that am competent in the area that my project is based. This will help me solve any problem that comes my way in the course of the project.
  4. I stay calm under stress. Bearing in mind the fact that my project is quite demanding and may require long working hours, I can work efficiently and remain focused for as long as am required.
  5. I am a team player. It is obvious that my project will require a team in its implementation. I can play well along with my teammates and together we will achieve the objectives set.

My Weaknesses and How I Plan to Improve on Them

Despite my numerous strengths, just like all other human beings I too have weaknesses. They include:

  1. I at times make unrealistic estimations of resources, cost and timeframes. In their work Essay (2013) they say that this is quite common among a number of project managers. I adjust my estimations, I will ask for help from my colleagues on how realistic my estimations are.
  2. I cannot handle bureaucracy in work places. In my opinion it is the biggest hindrance to progress. However this is the reality in most if not all big organizations. I therefore will work on my diplomatic skill.
  3. My project lacks international experience. None of my teammates have worked for a time before. This is making our point of view quite narrow. This problem can be solved by creating a vacancy for someone with international experience.

project selection method

References

  • Ahmad, B., & Haq, I. (2016). Project Selection Techniques, Relevance & Applications: ResearchGate. Islamabad, Pakistan.
  • Chrisman, J. (2008), Net Present Value: Methods of Project Selection. New York USA.
  • Essays, UK. (November 2013). The Strengths And Weaknesses Of Project Management Management Essay.
  • Flannes, S. (2003). Effective People Skills for the Project Manager: Planning, Development and Support. Aokland, USA.
  • Spiller, S. (2011). Opportunity Cost Consideration: Chicago Journal. Chicago, USA.

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