Problem Statement
In 2005, Nu-hot resources had a budget of N800,000 for investment projects. The company had identified six (6) competing projects with a total initial investment cost of N1,500,000. Due to limited funds, the company had to make a decision on which of the projects to invest its fund that will maximize shareholders value. Companies and individuals are constantly faced with this challenge of choosing between several good projects competing for limited funds.
Alternatives
| Project | Initial Investment (Io) |
| A | |
| B | |
| C | |
| D | |
| E | |
| F | |
Outcome of the Alternatives
Net Present Value (NPV) and Benefit Cost Ratio or Profitability Index (PI) was calculated for each of the projects based on their cash flow as follows:
NPV = -Io + C1 / (1+r) + C2 / (1+r)2 + ………….+ Cn / (1+r)n
PI = (NPV+Io) / Io
Where:
Io is the initial investment cost of the project
Ci is the cash flow in the period “i”
r is interest rate
| Project | Initial Investment (Io) | Net Present Value (NPV) | Profitability Index (PI) |
| A | | | 1.5 |
| B | | | 1.24 |
| C | | | 1.75 |
| D | | | 1.38 |
| E | | | 1.30 |
| F | | | 1.40 |
Selection Criteria
The company applied the following principles in selecting between the alternatives:
· For mutually exclusive projects, accept the project with the highest NPV, where NPV>0
· Select the project with the highest Profitability Index, where PI>1
Analysis of Alternatives
The projects were ranked based on their PI as follows:
| Project | Initial Investment Io | Net Present Value (NPV) | Profitability Index (PI) |
| C | | | 1.75 |
| A | | | 1.5 |
| F | | | 1.40 |
| D | | | 1.38 |
| E | | | 1.30 |
| B | | | 1.24 |
Alternative Selected
Based on the project outcomes, all the projects are good because they all have NPV>0 and PI>1. However, based on the PI ranking, projects C, A, & D were selected.
Performance Monitoring
1. Actual project execution cost shall be closely tracked and controlled to complete within investment estimate if the NPV’s and PI’s is to be realized for the selected projects.
2. NPV & PI shall be re-calculated based on actual delivery cost at completion of the project.
References
1. Engineering Economy, 14th Edition. William G. Sullivan, Elin M. Wicks, C. Patrick Koelling, Chapter 1, Page 27 & Chapter 5, Page 91-102
2. Skills & Knowledge of Cost Engineering, AACE International, 5th Edition Revised, Chapter 28
Good posting, Biola!! But not WOW!! or AWESOME!! Why not?
ReplyDeleteGIVEN that I am looking for a minimum of three references, why didn't you also try the External Rate of Return Method (ERR) as shown on pages 237-239? Or the Internal Rate of Return Method (IRR) shown on pages 226-237?
Another question. Why didn't you talk about the relative RISKINESS of these projects in calculating your MARR? Surely not all these projects are equally risky? (See Engineering Economy, pages 575 to 580)
And I know you alluded to the fact that these were mutually independent projects, but are they REALLY? Very few projects in an oil field are mutually independent. Nearly all of them share some degree of dependency.
While I am willing to accept this for a W6 posting, by the time you get to W15 onwards, I will be expecting to see more sophisticated, complete analysis, using more than one tool/technique and citing at least 3 sources. (Can be 3 different chapters of the same book or even 3 different tools/techniques from the SAME book)
But the bottom line remains, you are on the right track and now we need to focus on building your competency in applying what you are learning.
BR,
Dr. PDG, Jakarta