LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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MODULE TITLE: PROJECT APPRAISAL, PLANNING & CONTROL.
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS.
INTRODUCTION.
Projects, as you saw in lesson 1, are non-routine activities which are undertaken to
deliver a specific outcome. They normally have definite start and end dates and often
require scarce resources. In some cases several projects might compete for the same
scarce resources. Some projects can have positive implications for some people whilst
having negative implications for others.
Consider for example a project to construct a reservoir to provide a continuous supply
of drinking water. The benefits appear to be obvious. However, suppose the proposed
site for the reservoir is in an area of great historical significance or outstanding natural
beauty. Perhaps the finished reservoir would require the relocation of people from
land they have occupied for many generations. It may be that the resources required
are such that plans to build a much needed hospital have to be postponed. There might
even be some doubt about the real need for the reservoir or the suitability of the site.
Finally, there might be some doubt about the ability or willingness to finance the
project. It is easy to see that the implications of projects can be very far reaching
indeed!
Examples of projects such as the one outlined above are not uncommon. It is therefore
prudent to carry out an initial assessment to ensure that a project makes the best use of
resources and is likely to be successful in addressing a real need. The result of this
assessment will help to decide whether or not to proceed with the project. This lesson
will introduce you to techniques for carrying out the appraisal, comparison and
selection of projects.
YOUR AIMS.
On completion of this lesson you should be able to:
Understand and outline the importance and main stages of a project feasibility
study.
Understand and apply a range of financial models to the appraisal and
selection of projects.
Develop a scoring approach to the appraisal and selection of projects.
STUDY ADVICE.
This lesson requires extensive use of chapters 4 and 5 of the set book, Project
Management Planning and Control Techniques by Burke. The main advice is to read
the lesson outline in conjunction with the set book, following the suggested sequence.
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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You should be particularly careful to work through and understand the methodology
used in the numerical examples in the set book.
PROJECT FEASIBILITY.
The first phase of the project life cycle is the concept phase. It is in the concept phase
that the initial ideas about a need, and whether and how that need might be generated
or satisfied, have their origin. The free thinking and creativity that should characterise
the concept stage is likely to lead to a range of ideas, each being subject to some level
of uncertainty. It is also likely that some ideas will compete with one another for
scarce resources.
During the concept phase one or more definite ideas will emerge as being worthy of
detailed consideration. It is at this point that a feasibility study is likely to be formally
authorised. Some practitioners see the feasibility study as a separate phase of the
project life cycle. Burke however sees the feasibility study as an integral part of the
concept and initiation phase of the life cycle. In any event, the purpose of the
feasibility study is to check that the project can be successfully carried out and will
make the best use of resources. Care taken at this stage can lead to better decisions not
only about which projects to select, but also how best to avoid costly changes and
even abandonment later in the project life cycle.
At this point you should read Chapter 4: Feasibility Study, in the set book.
Burke identifies the following ten aspects of conducting a feasibility study.
1. Feasibility Study Initiation. Burke argues that the feasibility study should be
formalised in terms of requirements, boundaries and expected outcomes. It is
an activity which must be taken seriously and resourced appropriately.
2. Appointment of the Feasibility Study Team. Burke points to the benefits of
involving stakeholders in the project feasibility study team. He takes new
product development as an example and includes future operators as
stakeholders who should be involved in the feasibility study. If we extend the
concept of future operator to include all subsequent or end users, Burke’s
contention they should be involved applies to all types of project.
3. Plan the Feasibility Study. It is suggested that the feasibility study is best
conducted as a mini project which follows the project life cycle and requires
the use of normal project planning tools and techniques. The British Standards
Institution Guide to Project Management suggests that although the feasibility
study may be confined to paper assessment and evaluation; technical and
experimental work, including modelling, should be carried out where the
validation of basic concepts or consideration of technical problems is
necessary. Care is therefore needed to ensure that the members of the
feasibility study team have the necessary expertise.
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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4. Stakeholder Analysis. Stakeholders include any people or organisations that
are involved in or affected by the project. A key responsibility of the project
manager is to identify all stakeholders, and to take account of and to balance
their expectations. It is important to know which stakeholders will be affected
positively and which will be affected negatively by the project.
SAQ 1. Imagine you are a member of a team that is considering the feasibility
of building a new bride over a river. Identify three internal and three external
stakeholders.
Internal Stakeholders.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………
External Stakeholders.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………
5. Define the Client’s Needs. Projects often arise from having to address a client
need. For example, there might be a need to implement a change, develop a
new product, enter a new market, relocate a department etc. It is possible that
at the outset the project objectives, and perhaps even who the end client is,
might be stated in quite general terms. Some objectives might be speculative
and mutually exclusive. The project manager must work with the client to
produce an agreed and unambiguous statement of which needs will be
addressed by the project.
6. Evaluate the Constraints. Most projects are subject to a range of constraints
that restrict what or how things can be done. Some constraints might even be
such that a project should not be undertaken. Typical constraints include
deadlines, levels of funding, availability of resources, company policies,
statutory regulations, public opinion, etc. Burke classifies constraints under the
following three headings.
o Internal Project Constraints.
o Internal Corporate Constraints.
o External Constraints.
It is important to identify and assess all constraints in order that
proper decisions can be taken and appropriate plans set in
place.
1. Evaluate Alternatives and Options. In complex projects there are normally a
number of different options available to achieve the objective .
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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accommodating more traffic by widening an existing road or by building a
second road. Furthermore, it will often be possible to pursue each option in a
number of ways, . carrying out the work internally or by employing
sub-contractors. Each alternative should be identified and systematically
evaluated so that the best alternative can be chosen. A useful framework for
evaluation is to assess each alternative on its impact on the following criteria.
o Time.
o Cost.
o Quality.
o Resources.
o Technical.
1. Gather Information. Information is a pre-requisite for effective
decision-making and good project management. Burke lists a number of
sources of information. He draws particular attention to the value of reports
from previous projects which can often contain information of particular
relevance to the organisation carrying out the project. He also emphasise the
importance of learning from previous projects . mistakes to avoid and good
points on which to build. Project managers who conduct post project review
will be particularly well place to take advantage of such prior experience.
2. Value Management. Burke describes Value Management as a structured,
systematic and analytical process which seeks to achieve value for money by
providing all the necessary functions at the lowest total cost consistent with
required levels of quality and performance. Value management assumes that
there is always more than one way of achieving a function and that
examination of alternatives should produce the most acceptable option. Burke
suggests that value management looks at the project has a whole and considers
the relationship between function, cost and worth, its purpose being to ensure
value for money over the complete product life cycle.
3. Cost Benefit Analysis. Cost benefit analysis seeks to identify all the costs and
benefits associate with a project, and where possible to express them in
monetary terms. In general terms if the benefits exceed the costs the project is
considered to be worthwhile.
SAQ 2. Complete the following statements made by Burke
about three methods of assessing costs and benefits.
The Pareto improvement criterion is expressed
as ………………………………………………………………
…………..………………………………………………………
…………………..………………………………………………
………………………..............................
The Hicks-Kaldor test states
that………………………………………………………………
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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…………………………………………………………………
………………..…………………………………………………
………………………………………..
The Willingness-to-pay test is simply
to ………………………………………………………………
………….………………………………………………………
………………….………………………………………………
………………………………………….
Following the above ten point framework is likely to lead to an effective feasibility
study which can be the basis of decisions about the value of the project. Lockyer and
Gordon suggest that an effective feasibility study will, at the very least, result in a
determination of the following factors.
The capability of the organisation to provide the product in the time required.
The costs involved.
The price of any resultant product.
The budget required for the project.
The outline specification of the product, including the quality and reliability
requirements.
The ability of the organisation to support the capital outlay.
The availability of any items or services to be procured from outside the
organisation.
The acceptability of any geographical requirements on procurement or
ecology which are specified in the project enquiry.
The acceptability of any contract conditions which are specified in the
enquiry.
In many cases it will be only in the light of an effective feasibility study that decisions
can be made about whether, how and when to proceed with a project.
PROJECT SELECTION.
Sometimes there will be only one project under consideration. In such cases the
decision of whether or not to proceed can be made entirely in the light of the
conclusions and recommendations of the feasibility study. In other circumstances
there may be several feasible projects that might be pursued. It is unlikely that there
will be sufficient resources to pursue all feasible projects and so it will be necessary to
select those that make the best use of resources and are likely to make the greatest
contribution to the achievement of long term goals. This section of the lesson will
consider a framework for evaluation and ranking projects using numeric methods.
Numeric project selection methods are normally financially focused and based on an
attempt to compare the potential financial rewards with the estimated costs of carrying
out a project. The amount and timing of the rewards and costs is crucial to the
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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evaluation and comparison of projects. This inward and outward movement of money
is referred to as cash-flow analysis which involves knowledge of the amount and
timing of the following.
Cash Outflow which includes all items of expenditure for, or resulting from
the project. This might include salaries, materials, fuel etc.
Cash Inflows which include all items of income or cost saving resulting from
the project. This might include sales revenue, royalties, proceeds from
disposal of equipment etc.
Net Cash Flow which is the difference between cash outflows and cash
inflows during a specified period or for the whole project. This is often
referred to simply as cash-flow.
Where the comparison of financial rewards and cost is possible, the normal minimum
justification for proceeding with a project is that the rewards, . the financial return,
will at least exceed the cost of carrying out the project.
At this point you should read pages 49 to 52 of chapter 5 of the set book.
SAQ 3. Burke divides numeric selection models into financial and scoring models.
What are the four financial models he identifies? List you answers in the space below.
………………………………………………………………………………………….
………………………………………………………………………………………….
………………………………………………………………………………………….
………………………………………………………………………………………….
PAYBACK PERIOD.
This is the time taken to generate a cumulative income equal to the original
investment. The convention is to express the period in years and months.
You should now read section 3 of chapter 5 in the set book.
In Table 1 on page 53 of the set book, Burke gives an example of two project options,
each involving an initial investment of $35000. You should note that accounting
conventions often show an outflow of cash as a figure in brackets. The income from
options A and B is such that the payback periods are respectively 2 years and 3 years.
Under the payback selection method, option A would be preferred.
Burke provides an excellent summary of the advantages and disadvantages of the
payback selection method. You should pay particular to Figure 1 however which
illustrates that options with very different cash-flow profiles can have the same
payback period. Even though options C and D have the same payback period, option
C generates an earlier inflow and may be preferable on those grounds. Figure 2
LESSON 2: THE APPRAISAL AND SELECTION OF PROJECTS
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illustrates the point that although option E has the shorter payback period, option F
goes on generating larger cash inflows and may be the better option.
The failure to take account of the timing of cash-flow is a weakness of the payback
method. Never-the-less, the payback period is probably the most widely used project
selection method, primarily because it is simple and quick.
RETURN ON INVESTMENT.
The return on investment (ROI) selection method expresses the average annual profit
as a percentage of the original investment.
Average Annual Profit = (Total Gains) – (Total Outlay)
Number of years.
Return on Investment (ROI) = Average Annual Profit x 100
Original Investment
You should now read section 4 of chapter 5 in the set book, paying particular attention
to Table 2.
Like the payback method, return on investment is also a simple project selection
method. Return on investment is an improvement on the payback period in that it
considers cash-flow over the whole life of the project. Burke however uses Table 2 to
illustrate that the return on investment method averages out the profit over the life of
the project. This could lead to a project with high initial profits being ranked equally
with a project having high profits later in the project life. This is the case in Table 2
where it is estimated that by the end of year 2 Machine A will have generated $35000
profit, and incidentally achieved payback, whilst Machine A will have generated only
$20000 profit. Despite this, both options have the same initial outlay, the same total
gains and the same return on investment of 14%. This is one of the main criticisms of
the return on investment method because, if inflation is taken into account, the project
with high initial profits would be likely to be preferred.
DISCOUNTED CASH-FLOW (DCF).
Unlike payback period and return on investment, discounted cash-flow takes account
of the time value of money and recognises that the purchasing power of a given
amount of money declines over time. This is particularly important where a project
and the associated rewards and costs are spread over several years. The two
discounted cash-flow techniques are as follows.
Net Present Value.
Internal Rate of Return.
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NET PRESENT VALUE.
Net Present Value takes account of the fact that the value, or purchasing power of
money, reduces with time. To illustrate how this works, let us take a very simple
example. Assume that the purchasing power of our income reduces at say 10% per
year. Obviously, for our purchasing power to remain constant, our income would need
to increase by 10% per year. If we receive £1000 this year, (year 0), then in order for
our purchasing power to remain the same next year, (year 1), we would need to
receive £1100. In other words, £1100 received one year from now would have the
same value as £1000 received today. Therefore, £1100 received one year from now
would have a present value of £1000.
This can be simply stated as follows.
For purchasing power to remain constant;
Cash in Year n = (Cash in Year 0) x (1+i)n where i = rate of inflation/interest.
The above example would then be as follows.
Cash in Year 1 = 1000(1+)1 = 1000 x = £1100.
In normal circumstances however we have a forecast of the cash we expect to receive
in future years and wish to calculate its present value. In order to do this, all we have
to do is transpose the above expression .
Cash in year 0 = (Cash in year n) x 1/(1+i)n
Or Present Value = (Cash in year n) x D Where D = Discount Factor = 1/(1+i)
So provided we know the interest/inflation rate, we can calculate a discount factor for
any future year of interest. We can then multiply the cash-flow for that year by the
discount factor for that year to work out the present value of the cash-flow. The sum
of the present value of cash inflows and out-flows for a series of years is known as the
Net Present Value or NPV. The higher the NPV the better. Projects that generate a
negative NPV are likely to be discarded.
So the value of a given quantity of cash tends to reduce over time. The implications of
this for project selection are that projects that generate early cash in-flows are better
than those that generate later cash in-flows. Conversely, projects in which cash
out-flows can be delayed are better than those where payments have to be made early.
At this point you should read Sections 5 and 6 of chapter 5 in the set book. You
should pay particular attention to the tables. You are strongly advised to follow the
suggestion at the top of page 57 . that you calculate some of the discount factors
yourself.
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The essence of Net Present Value is well illustrated in Tables5 and 6 on page 58 of
the set book. These show that Machine A generates more cash in earlier years than
Machine B. The NPV for Machines A and B are respectively $2692 and ($1396).
Having a negative NPV, Project B would be likely to be discarded.
The calculation of discount factors could of course be quite tedious. This however is
unnecessary because published tables are readily available which give discount
factors for a whole range of interest rates and years. For the purpose of demonstration
however, we will calculate the discount factor for 12% and year 5.
Discount factor = 1/(1+i)n = 1/(1+.12)5 = (1/)5 = =
The main advantage of NPV is that it takes account of the value of money over time.
Its accuracy is however dependent on the quality of the forecasts of cash flow and
interest rates. Furthermore, NPV assumes that interest rates remain constant
throughout the project.
SAQ 4 Assume an interest rate of 10% and that in year 6 of a project there is a net
cash inflow of £10000.
a. Calculate the discount factor.
b. Calculate the present value of the cash inflow.
INTERNAL RATE OF RETURN.
At this point you should carefully read Section 7 of chapter 5 of the set book by Burke.
As you do so, please note that Tables 10 and 11 on page 60 have been incorrectly
completed. The discount factors have been entered in the Cash-flow column and
Cash-flow figures have been entered in the discount column.
If financial return is the main selection criterion, a project can be considered to be
financially viable if the NPV is positive . greater than zero. If the NPV is negative,
. less than zero, the project would not be considered financially viable. The Internal
Return Rate, (IRR), is the value of the discount factor which leads to the NPV being
zero. Burke makes the point that many managers have a preference for financial
selection models which express profitability as a percentage. Being expressed as a
percentage, the Internal Return Rate does this.
On page 59 Burke continues with the example of the two machines and demonstrates
the trial and error method by which the Internal Rate of Return is identified. As the
Discount Factor increases, the NPV reduces. In the case of Machine A, (Tables 7 to 9),
when the Discount Factor is set at 22% and 24%, the NPV is positive . $1494 and
$361 respectively. When the Discount Factor is set at 25% the NPV is negative .
($184). The IRR is therefore somewhere between 24 and 25%.
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At the top of page 60, Burke begins to consider Machine B. He points out that at 20%
the NPV is negative. This information is derived from Table 6 on page 58 where the
NPV is shown as negative . ($1396). Remember that the cash-flow and discount
factors have been entered in the wrong columns in Tables 10 and 11. The present
value columns are however correct and the IRR is shown to be between 18% and
19%.
It is sometimes helpful to show the results of the IRR analysis for several projects on
the same graph and Burke demonstrates how this is very easily done.
The IRR is a measure of return on investment. The higher the IRR the more likely it is
that the project will generate a positive NPV, even if interest or inflation rates rise. If
there is capital rationing and choices have to be made between projects, those with the
higher IRR will be preferred.
NET PRESENTA VALUE USING VARIABLE INTEREST RATES.
We have seen that the standard NPV model assumes that interest rates are fixed over
the life of a project. Interest rates can fluctuate and this can be accommodated by a
modification of the NPV method.
You should now read section 8 of chapter 5 of the set book by Burke. You will find it
helpful to examine table 13 on page 61 in conjunction with table 4 on page 57.
Burke shows in Table 13 how it is possible to vary the interest rate from year to year.
In year 1 the rate is 10%. The discount factor is found in the year 1 row for 10% in
Table 4 and is .9091. This is entered in both the discount factor and total discount
factor columns in Table 13.
In the second year of Table 13 the interest is shown as 20%. The discount factor for a
single year at 20% is found in the year 1 row for 20% in Table 4 and is .8333. This is
entered in the discount column of the year 2 row of Table13 and is multiplied
by .9091 to give the total discount factor for year 2 of .7576.
In the third year of Table 13 the interest is shown as 15%. The discount factor for a
single year at 15% is found in the year 1 row for 15% in Table 4 and is .8696. This is
entered in the discount column of the year 3 row of Table13 and is multiplied
by .7576 to give the total discount factor for year 3 of .6588.
This is a useful modification of the NPV model. However it depends on the quality of
the estimates that can be made of interest rates in future years.
The following SAQ will help to bring out some of the issues arising from financial
selection models.
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SAQ 5. According to Burke, which of the following statements are true and which are
false?
a. The payback method does not consider the time value of money.
True/False.
b. The return on investment method does not consider cash-flow over the
whole project. True/False.
c. The standard NPV method assumes interest rates are constant over the
life of the project. True/False.
d. The Internal Rate of Return is the discount factor which maximises the
NPV. True/False.
e. The payback method considers cash-flow over the whole life of a
project. True/False.
SCORING MODELS.
The numeric models considered thus far have focused on the financial
appraisal of projects. However, at the beginning of chapter 5 in the set
book, Burke makes the point that when choosing a selection model the
points to consider are;
Realism,
Capability,
Ease of use,
Flexibility,
Low costs.
Some of these considerations are essentially financial in nature whilst
others are not. The important point is to assess projects according to
the extent they support and help to achieve an organisation’s goals.
Burke draws on the work of Meredith and suggests an appraisal
framework which takes account of the following headings.
Production.
Marketing.
Financial.
Personnel.
Administration.
Burke then goes on to proposes a ten point checklist for each of the
above headings.
Although financial selection models are extremely useful, if used in
isolation they do not help us to address all the issues in checklists such
as those above. Scoring or factor models can help us to do so.
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At this point you should read section 9 of chapter 5 in the set book by
Burke.
Burke presents the rudiments of a scoring model in a rather speculative
and undeveloped way. The essential point however is that the scoring
model can be used to develop a comprehensive project appraisal
framework that can include financial and non-financial criteria. Indeed
the framework can include the results of financial appraisal carried
using the financial models considered earlier. The approach to rating
projects against the criteria can be similarly customised.
The following is just one way in which a scoring approach might be
used to develop a project appraisal framework. Each criterion has been
identified, weighted and rated in the way suggested by Burke. Table 14
on page 63 has been modified to show the results of the appraisal of
several projects. The table has then been presented in the form of a
rating matrix as follows.
Criterion Weight Project A Project B Project C
Criterion 1 Mandatory Yes Yes No
Criterion 2 10 (10x10)= 100 (7x10)= 70 (9x10)= 90
Criterion 3 8 (9x8)= 72 (8x8)= 64 (8x8)= 64
Criterion 4 8 (9x8)= 72 (6x8)= 48 (9x8)= 72
Criterion 5 5 (6x5)= 30 (8x5)= 40 (10x5)= 50
Total Score 274 222 276
Project Rating Matrix.
The above table is a simplified example in which three projects are
being appraised. The steps in carrying out such an appraisal can be
summarised as follows.
11. Brainstorm all the important criteria on which to evaluate
the projects. In this case five criteria were identified. In a
real-life project appraisal many more might be identified.
12. Identify any criteria that are mandatory . the project must
meet that criterion otherwise it will not be considered to be
viable. In the above example Criterion 1 was deemed to be
mandatory.
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13. Identify the most important of the non-mandatory criteria
and assign it a weight of 10. Then compare the remaining
criteria with the most important and assign them a relative
weighting. In the above example, Criterion 2 was considered
most important and assigned a weight of 10. Criteria 3 and 4
were deemed to be 80% as important as Criteria 2 and were
each assigned a weight of 8. Criteria 5 was deemed to be half as
important as Criteria 2 and assigned a weight of 5.
14. Rate each project against each criterion on a numeric scale.
In the above example a scale of 1 to 10 was used.
15. For each project, multiply the criteria weight by the rating
to arrive at a weighted score. For the purpose of this example
the weights are shown in italics and the rates in bold type. On
Criteria 2, Project A is rated at 10, which when multiplied by
the weighting of 10 gives a maximum weighted score of 100.
Project B is rated as 7 which when multiplied by the weighting
of 10 gives a weighted score of 70 on Criteria 2.
16. When all projects have been rated and scored on all criteria,
add the scores to give an overall score for the projects.
In the above example, although Project C has the highest overall score,
it fails to meet a mandatory criterion and would therefore be discarded.
Indeed, not having met a mandatory criterion, Project C would
probably have been eliminated before rating the remaining criteria. In a
resource limited situation, Project A would be the preferred one.
LESSON SUMMARY.
During the course of this lesson extensive use was made of Chapters 4
& 5 of the set book by Burke. The importance of assessing the
feasibility of projects was considered and a feasibility study framework
outlined. Numerical methods of making selections between alternative
projects were reviewed and practiced.
Excellent summaries are to be found at the end of Chapters 4 & 5 in
the set book, the main points being as follows.
Feasibility Study.
The feasibility study is a crucial part of the concept phase of projects.
It is the basis on which decisions about whether, how and when to
proceed with the project are taken. The feasibility study involves the
following.
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Stakeholder Analysis to identify who they are and to assess,
quantify and prioritise their needs and expectations.
Identification of all constraints, both internal and external.
Consideration of alternatives that might lead to a better project
outcome.
Project Selection.
In many cases there might be several feasible projects that could be
carried out. It is often the case that resources are insufficient to carry
out all feasible projects, it is therefore necessary to appraise projects
and select the most appropriate.
Financial appraisal models examine the timing and level of
return on the original investment. The models include payback,
return on investment, net present value and internal rate of
return.
The Scoring Model can be customised to provide a project
appraisal framework that can consider a wide range of criteria
including both financial and non-financial.
As a final activity in this lesson you may wish to read sections 10, 11
& 12 of chapter 5 in the set book. The issues raised there are taken up
elsewhere in the module.
In the next lesson the focus will be on Project Planning and Control.
ANSWERS TO SAQS.
SAQ 1. Internal Stakeholders might include;
project team members, the project champion,
any employee affected by the completed project.
External Stakeholders might include; the client,
contractors, and suppliers.
SAQ 2. The Pareto improvement criterion is
expressed as, "The project should make some
people better off without making anyone worse
off.
The Hicks-Kaldor test states that, "The
aggregate gains should exceed aggregate losses.
The Willingness-to-pay test is simply to
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determine how much your clients are prepared
to pay for your product.
SAQ 3. The four financial selection models
identified by Burke are
Payback period.
Return on investment.
Net present value.
Internal rate of return.
SAQ 4. a) Discount factor = 1/(1+)6 =
=
b) Present Value = £10000 x = £5645
SAQ 5 a) True.
b) False.
c) True.
d) False.
e) False.
