What are the different methods of ranking of projects?


Ans.  Two approaches are available for determining which project to accept and which projects to reject : (i) the method of ranking, and (ii) the method of mathematical programming.This section discusses the method of ranking ; the following section discusses the method of mathematical programming.
The method of ranking consists of two steps : (i) Rank all projects in a decreasing order according to their individual NPV’s, IRR’s or BCR’s. (ii) Accept project in that order until the capital budget is exhausted. The method of ranking, originally proposed by Joel Dean is seriously impaired by two problems: (i) conflict in ranking as per discounted cash flow criteria, and (ii)project indivisibility.
Conflict in Ranking
In a given set of projects, preference ranking tends to differ from one criterion to another. For example, NPV and IRR criteria may yield different preference rankings. Likewise, there may be a discrepancy between the preference rankings of NPV and BCR (benefit cost ratio) criteria. When preference rankings differ, the set of projects selected as per one criterion tends to differ from the set of projects selected as per some other criterion. This may be illustrated by an example. Consider a set of five projects, A, B, C, D, and E, for which the investment
outlay, expected annual cash flow, and project life are as shown below:
Project                            Investment outlay                     Expected annual         Project life
                                                                                                cash flow
                                                     (Rs)                                       (Rs)                        (Years)
A                                                  10,000                                  4,000                           12
B                                                   25,000                                 10,000                          4
C                                                   30,000                                  6,000                           20
D                                                   38,000                                 12,000                          16
E                                                    35,000                                 12,000                          9

The NPV, IRR and BCR for the five projects and the ranking along these dimensions
are shown  below
 NPV, IRR and BCR for the Five Projects
Project                              NPV          NPV           IRR             IRR          BCR            BCR
(Rs)                                                  Ranking  (Per cent)     Ranking                   Ranking
A                                        14,776       4              39                 1             2.48            1
B                                      5,370        5                          22              4           1.21            5
C                                            14,814       3             19                5             1.49            4
D                                            45,688       1             30                2              2.20           2
E                                             28,936      2             29                3              1.83           3
It is clear that in the above case the three criteria rank the projects differently. If there is no capital rationing, all the projects would be accepted under all the three criteria though internal ranking may differ across criteria. However, if the funds available are limited, the set of projects accepted would depend on the criterion adopted. What causes ranking conflicts? Ranking conflicts are traceable to differing assumptions made about the rate of return at which intermediate cash flows are re-invested.

Project Indivisibility
A problem in choosing the capital budget on the basis of individual ranking arises because of indivisibility of capital expenditure projects. To illustrate, consider the following set of projects (ranked according to their NPV) being evaluated by a firm which has a capital budget constraint of Rs. 2,500, 000.
Project                                                           Outlay                           NPV
                                                                          Rs.                               Rs.
A                                                                   1,500,000                    400,000
B                                                                   1,000,000                    350,000
C                                                                    800,000                      300,000
D                                                                   700,000                       300,000
E                                                                    600,000                       250,000

If the selection is based on individual NPV ranking, projects A and B would be included in the capital budget- these projects exhaust the capital budget. A cursory examination, however, would suggest that it is more desirable to select projectsB, C, and D. These three projects can be accommodated within the capital budget of Rs. 2,500,000, and have a combined  NPV of Rs. 850,000, which is greater than the combined NPV of projects A and B.
Feasible Combinations Approach
The above example suggests that the following procedure may be used for selecting the set of investments under capital rationing. 1. Define all combinations of projects which are feasible, given the capital budget restriction and project interdependencies.
2. Choose the feasible combination that has the highest NPV. To illustrate this procedure, consider the following projects that are being evaluated by a firm which has a capital budget constraint of Rs. 3,000,000.
Project Outlay NPV
                         Rs.                               Rs.
A                  1,800,000                   750,000
B                  1,500,000                   600,000
C                  1,200,000                   500,000
D                  750,000                      360,000
E                  600,000                      300,000
Projects B and C are mutually exclusive. Other projects are independent Given the above information the feasible combinations and their NPV are shown below:
Feasible Outlay NPV combination
                           Rs.                                   Rs.
A                   1,800,000                        750,000
B                   1,500,000                        600,000
C                   1,200,000                        500,000
D                   750,000                           360,000
E                    600,000                          300,000
A and C        3,000,000                       1,250,000
A and D        2,550,000                      1,110,000
A and E         2,400,000                      1,050,000
B and D        2,250,000                       960,000
B and E         2,100,000                      900,000
C and D         1,950,000                     860,000
C and E         1,800,000                     800,000
B,D and E     2,850,000                     1,260,000
C, D and E    2,550,000                     1,160,000

The most desirable feasible combination consists of projects B, D and E as it has the highest NPV.

Comments

Post a Comment

Popular posts from this blog

Discuss the UNIDO approach of social-cost benefit analysis

Ans. Towards the end of the sixties and in the early seventies two principal approaches for SCBA emerged: the UNIDO approach and the Little- Mirrlees approach. This section discusses the UNIDO approach; the following discusses the Little-Mirrlees approach. The UNIDO method of project appraisal involves five stages: 1. Calculation of financial profitability of the project measured at market prices. 2. Obtaining the net benefit of project measured in terms of economic (efficiency) prices. 3. Adjustment for the impact of the project on savings and investment. 4. Adjustment for the impact of the project on income distribution. 5. Adjustment for the impact of project on merit goods and demerit goods whose social values differ from their economic values. Each stage of appraisal measures the desirability of the project from a different angle. The measurement of financial profitability of the project in the first stage is similar to the financial evaluation. So, sk
Read more

Discuss the Little-Mirrlees approach and point out the differences from UNIDO approach to social-cost benefit analysis.

Ans. I.M.D. Little and J.A. Mirrlees have  developed an approach (hereafter referred to as the L-M approach) to social cost benefit analysis. The LM technique assumes that a country can buy and sell any quantity of a particular good at a given world price. Hence, all traded inputs and outputs are valued at their international prices (CIF for importables and FOB for exportables) which is the opportunity cost/value of the particular good to the country. Every input is treated as a forex outgo and every output is treated as a forex inflow. All non-tradable inputs are valued at accounting prices. These costs are broken up into tradable goods and other non-traded goods. Following this chain of production, commodities that are either exported or imported are determined for application of accounting prices. The theory assumes that non-tradable form an insignificant part of operating costs Despite considerable similarities there are certain differences between the two approaches
Read more

Discuss the type of information required for market and demand analysis.

Ans. The exercise of project appraisal often begins with an estimation of the size of the market. Before a detailed study of a project is undertaken, it is necessary to know, at least roughly, the size of the market because the viability of the project depends critically on whether the anticipated level of sales exceeds a certain volume. Many a project has been abandoned because preliminary appraisal revealed a market of inadequate size. This chapter is divided into the following five sections dealing with various aspects of market and demand analysis. 1. Information required for market and demand analysis 2. Secondary sources of information 3. Market survey 4. Demand forecasting 5. Uncertainties in demand forecasting Information required for market and demand analysis The principal types of information required for market and demand analysis relate to- (i) Effective demand in the past and present To guage the effective demand in the past and present, the s
Read more