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Unit 3: Strategic Management and Project Selection

subset of the projects that would most benefit the firm, but the projects do not seem to be Notes
easily comparable. For example, some projects concern potential new products, some
concern changes in production methods, others concern computerisation of certain records,
and still others cover a variety of subjects not easily categorised (e.g., a proposal to create
a daycare center for employees with small children).
The organisation has no formal method of selecting projects, but members of the selection
committee think that some projects will benefit the firm more than others, even if they
have no precise way to define or measure “benefit.”
The concept of comparative benefits, if not a formal model, is widely adopted for selection
decisions on all sorts of projects. Most United Way organisations use the concept to make
decisions about which of several social programs to fund. Senior management of the
funding organisation then examines all projects with positive recommendations and
attempts to construct a portfolio that best fits the organisation’s aims and its budget.

3.4.2 Numeric Models

As noted earlier, a large majority of all firms using project evaluation and selection models use
profitability as the sole measure of acceptability. We will consider these models first, and then
discuss models that surpass the profit test for acceptance. These include the following:
1. Payback Period: The payback period for a project is the initial fixed investment in the
project divided by the estimated annual net cash inflows from the project. The ratio of
these quantities is the number of years required for the project to repay its initial fixed
investment. For example, assume a project costs $100,000 to implement and has annual net
cash inflows of $25,000. Then

Payback period = $ 100,000 / $ 25,000 = 4 years
This method assumes that the cash inflows will persist at least long enough to pay back the
investment, and it ignores any cash inflows beyond the payback period. The method also
serves as an (inadequate) proxy for risk. The faster the investment is recovered, the less the
risk to which the firm is exposed.
2. Average Rate of Return: Often mistaken as the reciprocal of the payback period, the
average rate of return is the ratio of the average annual profit (either before or after taxes)
to the initial or average investment in the project. Because average annual profits are
usually not equivalent to net cash inflows, the average rate of return does not usually
equal the reciprocal of the payback period. Assume, in the example just given, that the
average annual profits are $15,000.

Neither of these evaluation method is recommended for project selection, though payback
period is widely used and does have a legitimate value for cash budgeting decisions. The
major advantage of these models is their simplicity, but neither takes into account the
time-value of money. Unless interest rates are extremely low and the rate of inflation is
nil, the failure to reduce future cash flows or profits to their present value will result in
serious evaluation errors.
3. Discounted Cash Flow: Also referred to as the Net Present Value (NPV) method, the
discounted cash flow method determines the net present value of all cash flows by
discounting them by the required rate of return (also known as the hurdle rate, cutoff rate,
and similar terms) as follows:
To include the impact of inflation (or deflation) where pt is the predicted rate of inflation
during period t, we have Early in the life of a project, net cash flow is likely to be negative,
the major outflow being the initial investment in the project, A0. If the project is successful,

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