Project manger is expected to select the the project which is benificiary to the organization. Cost benefit anlysis is done by the project manger. It is highly unlikely that project manger select the the project whose cost exceeds its benefits. Benefits can be measured either finacial or non-finacial. The puposuse of idetifying the financial benefits is called copital budgeting, which may be defined as decision making process by which organization evaluate the projects that include the purchase of major fixed assets such as machinary , building, and equipments. So there are two main catagories of selection of project,
2-Non- financila model
In financial maethod we determine the capital budget of the project. In capital budgeting following techniques are used, 1-Pay back period 2-Net present value
3-Internal rate of return4-Profitability index
These method are explained below,
1-PAY BACK PERIOD:
Payback period is the exect length of time needed to recover the intial investment of the firm as calculated from the cash inflows.
Payback period method is the least prices of all capital budgting methods because calculation is done in rupees and not adjusted from the time value of money. For examle the following table shows th cash flow streams of the project A. Initial investment| Expected cash inflow|
| year 1 | year 2| year3| year4| year5|
10,000 | 1000| 2000| 2000| 5000| 2000|
Upper table shows that the project A will continue to execly five years. And the payback period will exectly the four years. If the cash inflow in 4th year were 6000 intead of 5000, then the payback period would be three year and 10 months. Accepance Criterion:
If the payback period calculated is less than some maximum acceptable period, the proposal is accepted, and if not, it will be rejected. If the required payback period is 4 year then we accept the project. Disadvantges of method:
A major shortcoming of the method is that is ignores the cash flows after the expiration of payback period,consequently, it cannot be regarded as a measure of profitability. In addition to this shrtcoming this method also ignores the time vale of maoney. It simply adds the cash flows without regarding to the timing of these flows. 2-NET PRESENT VALUE:
The net present value (NPV) method is suphisticated capital budgeting technique that equates the dicouted cash flows against the initial investment . It is calculated from the follwing formula; NPV= P.V of all cash inflow- cash outflow
Project Selection, Example 1:
Investment project "Blue": development of a new version of product "Blue Dolphin". The cost for development is $100,000.-- this year. Next year, we will be able to sell the first batch for $70,000.--, in two years the second batch for $50,000.--. Given an interest rate of 10%, what is the net present value of that project?
Project Selection, Example 2:
Investment project "Red": development of a new version of product "Red Shark". The cost for development is $150,000.-- this year. Next year, we will be able to sell the first batch for $90,000.--, in two years the second batch for $85,000.--. Given an interest rate of 10%, what is the net present value of that project?
If we would have to choose between project "Blue" and project "Red" we would choose the one with the higher NPV, i.e. project "Blue" 3- INTERNAL RATE OF RETURN:
Because of the various shortcomings in the payback method, it is generally felt that discounted cash flow method provides a more objective basis for evaluating and selecting investment projects. Internal rate of return (IRR) is an average rate of return of all the cash flows over time resulting from a project. The internal rate of return is a rate such as, for example, 10% that reflects the return on investment discounted over the years in...