Any Organization has limited resources. They cannot execute all the Projects that come their way. They only take only those projects for execution, which makes financial sense for the Organization.
There are various parameters used in making such decisions. We will be looking at few such terms here.
Some of these terms are:
Present Value
Net Present Value
Internal Rate of Return
Payback Period
Benefit Cost Ratio
The first term, Present Value means value today of future cash flows. What this essentially means that, if a Project can give a return of say $100 per year, $200 next year and $250 the third year. What is the value of all these returns today $250 return in the 3rd year is not same as $250 today, because of inflation and other reasons.
Net Present Value(NPV) is basically Present value of the total benefits (income or revenue) less the costs over a time period. So, if there are multiple items involved, you add the present value of all of them to arrive at the Net Present Value.
Another term that is used in evaluating a Project is IRR, which stands for Internal Rate of Return. This method of working out the IRR is based on the financial accounting practices of the company for working out the annual profits. The net annual profits are derived after deducting depreciation and taxes. The average of annual profits thus derived is worked out on the basis of the period of the life of the project. For example, If doing project is like putting money in a bank account and earning interest, than you will put money in the Bank that gives maximum interest. Same is with the case of Project.
Payback Period isbasically the number of time periods it takes to recover your investment in the Project before your start making profit on the investment made in the Project. In simple terms it means the total period within which the total amount invested will be recovered throughout net cash flow (after tax).
Opportunity Cost is yet another term used in evaluating competing Projects. What it means is the Opportunity given up by selecting one project over another.
The last term that we are going to look at is Benefit Cost Ratio(BCR). In project selection, we usually account for an overall view of benefits and costs of proposed projects, trying to express all benefits and all costs in monetary terms of present values at given interest rates. This is the concept of BCR. BCR of more than 1 means that benefits are greater than the costs.
