Project Selection - Internal Rate of Return



Definition
Internal rate of return (IRR) is the interest rate at which the cash inflow and cash outflow of the project equals zero.

You don't have to understand that!

Sample Question
There are three projects for you to choose from: Project A has an internal rate of return of 15%, Project B 20% while Project C -20%. Based on the information provided, which is the best project?

A. Project A
B. Project B
C. Project C
D. Not enough information provided

Solution: B

Higher the better
The larger the IRR, the more favorable the project financially is to the organization.

Project Selection - Benefit-Cost Ratio



Definition
Benefit-Cost ratio is the ratio of the benefits of a project compared to the costs calculated in terms of Present Value (PV).

BCR > 1 - the project is profitable, and the higher the BCR the better

BCR = 1 - the project will break even
BCR < 1 - the project will cause the organization to lose money and is generally considered as not a good investment

Sample Question

The total cost of a project being undertaken is $1,000,000 (NPV). It is expected that an increase in revenue of $2,000,000 (NPV) would be realized once the project is complete. What is the Benefit-Cost Ratio (BCR) of the project?

A. 0.5

B. 20
C. 2
D. Not enough information to calculation

Solution: C


Benefits = $2,000,000 and Costs = $1,000,000. Since BCR = Benefits / Costs = $2,000,000 / $1,000,000 = 2


Ideally speaking, you will not be required to calculate BCR in the PMP exam. Expect the value of BCR to be given in the question where you can select the highest as being most favorable.

Larger the better
The larger the Benefit-Cost Ratio (BCR), the more favorable the project financially is to the organization.

Project Selection - Opportunity Cost



Definition
Opportunity Cost is the highest value a person needs to give up for the selected choice.

For example, if you have US $10, you can either buy a coffee or an apple pie. When you buy the apple pie, your opportunity cost is coffee.

There is no calculation required for getting the opportunity cost.

Sample Question
You need to select one of the three proposed projects. However, owing to the limitation of capital, only one project can be chosen. Project A would have a NPV of US$100,000, Project B would have a NPV of US$120,000 while Project C would have a NPV of US$50,000. What is the opportunity cost of choosing the project with the highest NPV?

A. US$120,000
B. US$50,000
C. US$100,000
D. US$150,000

Solution: C

Note
Do note that Opportunity Cost is simply the highest value of the project not being selected. No addition, subtraction required!

Project Selection - Return on Investment



Definition
Return on investment (ROI) is the benefit an investment bring about, by comparing profits in relation to capital invested.

Sample Question
An organization is considering several projects with the following ROIs:
ROI of Project A = 1.1
ROI of Project B = 0.4
ROI of Project C = 1.8
ROI of Project D = 1.0
Based on this information, which is the best project to undertake?

A. Project A
B. Project B
C. Project C
D. Project D

Solution: C

Higher the better
The higher the ROI, the more favorable the project financially is to the organization.

PMBOK Guide 6th Edition - Buy Now

Project Selection - Payback Period




Definition

Payback Period is the time it takes for the organization to earn back the initial investment (in terms of monetary cost) to the project and begin making profits.

Sample Question

As a PM, you are given the responsibility of selecting a project from two proposals A and B based on the information on hand: Project A has a payback period of 20 months while Project B has a payback period of 30 months. Which one would you recommend?

A. Project A

B. Project B
C. Neither one is beneficial to the organization.
D. Ask the project sponsor to choose.

Solution: A


Lesser the better

The shorter the Payback Period, the more favorable the project financially is to the organization.

Project Selection - Net Present Value (NPV)



Definition
Net Present Value (NPV) of the sum of all cash inflows (in Present Value) of the project minus the initial cost, i.e.  PV (benefits) – PV (costs). Read more

NPV is an effective tool to help determining whether a project will be profitable,

NPV > 0 - the project is profitable
NPV = 0 - the project will break even
NPV < 0 - the project will lose money

Sample Question
For the software project, $100,000 would be needed which is expected to generate a total of $200,000 (in present value) over 5 years. What is the Net Present Value (NPV) of the project?

A. $100,000
B. $200,000
C. $300,000
D. -$100,000

Solution: A

Since the Net Present Value (NPV) is the present value of all benefits minus all costs, i.e. NPV = $200,000 – $100,000 = $100,000.

Higher the better
The larger the Net Present Value (NPV), the more profitable the project is to the organization.

Present Value (PV) and Net Present Value (NPV)


Let's get the formula for PV out of the way first as it will pave the way for a better understanding of the concept.

PV = FV / (1+r)n

Here,
PV = Present Value
FV = Future Value
r = rate of interest
n = number of years

This concept basically means that money in present is more valuable than the same amount of money in the future. For example, the stuff that you can get for $100 today is much more than what you would get for $100 five years down the line.

Let's take another example. If you receive $10,000 today and deposit it into a bank earning 4% interest per year. One year from now, you would have $10,400.

So Present Value (PV) of $10400 when r is 4% (or 0.04 for calculation) and n is 1 year is $10000. $10400 is the Future Value (FV) here.

Now, the important question, why should you learn the formula of PV from PMP perspective?

In the exam, you could be asked to calculate PV. At the same time, you can also come across a question or two based on NPV or Net Present Value. NPV is used as a project selection technique to make sure the project is worth doing. 

The initial investment on the project is subtracted by the total present value to arrive at NPV. Ideally, you won't be asked to calculate NPV so don't worry if the previous sentence was a bit too much to digest but the thumb rule is to select the project with the highest NPV.

Let's look into a sample question for more clarity,

There are 4 projects to be chosen from, Project A has NPV of $32500, Project B has NPV of $35000, Project C has NPV of $45000 and Project D has NPV of $10000, which project should be chosen?
A. Project A
B. Project B
C. Project C
D. Project D

The answer is Project C as it has the highest NPV.