May 24, 2024

methods of ranking of project

Methods of Ranking of Project

There are several methods and techniques that organizations can use to rank projects based on specific criteria and priorities. The choice of method depends on the organization’s goals, available data, and the complexity of the projects being evaluated. Here are some common methods for ranking projects:

  1. Scoring Models:
    • Scoring models involve assigning scores or ratings to each project based on predefined criteria. The criteria can be quantitative or qualitative. Projects are then ranked based on their total scores.
    • Example: Each project is scored on a scale of 1 to 10 for criteria such as ROI, strategic alignment, and risk. The project with the highest total score is ranked first.
  2. Cost-Benefit Analysis (CBA):
    • Cost-Benefit Analysis involves comparing the expected costs of a project to its expected benefits in monetary terms. The project with the highest net benefit (benefits minus costs) is ranked highest.
    • Example: Calculate the net present value (NPV) or return on investment (ROI) for each project and rank them accordingly.
  3. Multi-Criteria Decision Analysis (MCDA):
    • MCDA methods consider multiple criteria simultaneously and provide a structured way to evaluate and rank projects based on weighted criteria.
    • Example: Use Analytic Hierarchy Process (AHP) or Technique for Order of Preference by Similarity to Ideal Solution (TOPSIS) to rank projects by considering criteria weights and performance scores.
  4. Benefit-Cost Ratio (BCR):
    • BCR is a variation of cost-benefit analysis where projects are ranked based on the ratio of total benefits to total costs. Projects with the highest BCRs are ranked higher.
    • Example: Calculate the BCR for each project and rank them from highest to lowest.
  5. Weighted Scoring Models:
    • Similar to scoring models, but with the added feature of assigning different weights to criteria to reflect their relative importance. The total weighted score determines the ranking.
    • Example: Assign weights to criteria such as strategic alignment (40%), ROI (30%), and risk (30%) and calculate the weighted scores for each project.
  6. Pareto Analysis:
    • Pareto analysis is a simple method where projects are ranked based on their cumulative impact. The projects that, when ranked in descending order, cumulatively account for a significant portion of the desired outcome are prioritized.
    • Example: Rank projects by their cumulative contribution to revenue, starting with the project that contributes the most.
  7. Eisenhower Matrix (Urgency-Importance Matrix):
    • This method classifies projects into four quadrants based on their urgency and importance. Projects are ranked according to their placement in the matrix.
    • Example: Quadrant 1 contains high-urgency, high-importance projects and is given the highest priority.
  8. Nominal Group Technique (NGT):
    • NGT is a structured group decision-making process where stakeholders collectively rank projects through discussions and consensus-building.
    • Example: Stakeholders meet to discuss and collectively rank projects based on their expertise and insights.
  9. Expert Judgment:
    • In cases where data is limited or subjective, expert judgment can be used to rank projects. Experts with relevant knowledge and experience assess and rank projects based on their judgment.
    • Example: A panel of experts evaluates and ranks research projects based on their potential scientific impact.
  10. Pairwise Comparison:
    • Projects are ranked through a series of pairwise comparisons, where each project is compared to every other project to determine their relative importance.
    • Example: Use a pairwise comparison matrix and the Analytic Hierarchy Process (AHP) to rank projects based on their comparative importance.

The choice of method should consider the organization’s specific needs, the availability of data, the complexity of the projects, and the importance of various criteria. It’s not uncommon for organizations to use a combination of methods to comprehensively evaluate and rank projects.

Ranking of project – payback method

Project ranking using the payback method is a straightforward approach that assesses projects based on how quickly they are expected to recoup the initial investment or pay back the upfront costs. The payback method is particularly useful for organizations that prioritize projects with shorter payback periods, emphasizing liquidity and risk reduction. Here’s how to rank projects using the payback method:
  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or initiatives that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Cash Flows:
    • Estimate the expected cash flows that each project will generate over time. Cash flows typically include revenue, cost savings, and other financial benefits.
  4. Calculate Cumulative Cash Flows:
    • Calculate the cumulative cash flows for each project by adding up the net cash inflows (cash benefits minus costs) for each period until the initial investment is fully recovered.
  5. Determine Payback Period:
    • Identify the point in time when the cumulative cash flows equal or exceed the initial investment. This is the payback period for each project.
  6. Rank Projects by Payback Period:
    • Rank the projects in ascending order of their payback periods. Projects with shorter payback periods are ranked higher, as they are expected to recoup the investment faster.
  7. Review and Consider Qualitative Factors:
    • While the payback method focuses primarily on the time it takes to recover costs, it’s essential to consider qualitative factors and strategic alignment as well. Some projects with longer payback periods may still be strategically important.
  8. Finalize the Ranked List:
    • Take into account the payback rankings along with qualitative considerations and any specific organizational goals. Finalize the ranked list of projects.
  9. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with shorter payback periods are typically prioritized if liquidity and risk reduction are high priorities for the organization.
  10. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual cash flows and payback periods. Adjust rankings if projects deviate significantly from initial projections.

It’s important to note that the payback method has limitations. It does not consider the time value of money, risk factors, or the full lifecycle of projects. Therefore, organizations may use the payback method in conjunction with other project ranking methods to ensure a more comprehensive evaluation. Additionally, the payback method is most appropriate for relatively simple projects with straightforward cash flow projections. For more complex projects, other financial analysis methods like net present value (NPV) or internal rate of return (IRR) may provide a more accurate assessment of value.

Ranking of project – accounting rate of return method

The Accounting Rate of Return (ARR) method is a financial analysis technique used to rank and evaluate investment projects based on their expected accounting profits relative to the initial investment. ARR is expressed as a percentage and measures the average annual accounting profit generated by a project as a percentage of the initial investment cost. Here’s how to rank projects using the Accounting Rate of Return method:
  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or investments that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Annual Accounting Profits:
    • Estimate the expected annual accounting profits that each project will generate over its anticipated lifespan. Accounting profits typically include revenue, operating expenses, depreciation, and taxes.
  4. Calculate Average Annual Accounting Profit:
    • Calculate the average annual accounting profit for each project by dividing the total accounting profit over the project’s life span by the number of years.

    ARR = (Average Annual Accounting Profit/initial Investment )× 100%

  5. Rank Projects by ARR:
    • Rank the projects in descending order of their Accounting Rate of Return (ARR). Projects with higher ARR percentages are ranked higher, as they are expected to generate a higher average annual accounting profit relative to the initial investment.
  6. Review and Consider Qualitative Factors:
    • While the ARR method focuses primarily on accounting profits, it’s essential to consider qualitative factors, strategic alignment, and any specific organizational goals in the ranking process.
  7. Finalize the Ranked List:
    • Take into account the ARR rankings along with qualitative considerations. Finalize the ranked list of projects.
  8. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with higher ARR percentages are typically prioritized if maximizing accounting profits is a primary objective.
  9. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual accounting profits and ARR. Adjust rankings if projects deviate significantly from initial projections.

It’s important to note that the ARR method has limitations. It does not consider the time value of money, cash flow timing, or risk factors, which can be critical in assessing the true economic value of an investment. Therefore, organizations may use the ARR method in conjunction with other financial analysis methods, such as the Net Present Value (NPV) or Internal Rate of Return (IRR), for a more comprehensive evaluation of investment projects. ARR is most suitable for simple projects with stable and predictable accounting profits.

Ranking of project – Net present value method

The Net Present Value (NPV) method is a widely used financial analysis technique for ranking and evaluating investment projects. NPV measures the present value of a project’s expected cash flows, considering the time value of money. Projects with positive NPVs are generally considered desirable because they are expected to generate a return greater than the cost of capital. Here’s how to rank projects using the Net Present Value method:
  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or investments that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Future Cash Flows:
    • Estimate the expected future cash flows that each project will generate over its anticipated lifespan. Cash flows typically include revenue, operating expenses, taxes, and depreciation.
  4. Determine the Discount Rate:
    • Determine the appropriate discount rate, often referred to as the “cost of capital” or “required rate of return.” The discount rate reflects the opportunity cost of capital and risk associated with the investment.
  5. Calculate Present Value of Cash Flows:
    • Calculate the present value of each project’s expected cash flows by discounting them back to their present values using the chosen discount rate.
    • PV= CF1/ (1+r)1     +      CF2/ (1+r)2++CFn/(1+r)n

     

    Where:

    • = Present Value of Cash Flows
    • = Expected cash flows in each period (years)
    • = Discount rate
  6. Calculate Net Present Value (NPV):
    • Subtract the initial investment from the present value of expected cash flows to calculate the NPV for each project.

  7. Rank Projects by NPV:
    • Rank the projects in descending order of their Net Present Value (NPV). Projects with higher NPVs are ranked higher, as they are expected to generate a higher return compared to the cost of capital.
  8. Review and Consider Qualitative Factors:
    • While the NPV method is primarily based on financial metrics, it’s essential to consider qualitative factors, strategic alignment, and specific organizational goals in the ranking process.
  9. Finalize the Ranked List:
    • Take into account the NPV rankings along with qualitative considerations. Finalize the ranked list of projects.
  10. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with higher NPVs are typically prioritized if maximizing financial returns is a primary objective.
  11. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual cash flows and NPVs. Adjust rankings if projects deviate significantly from initial projections.

The NPV method is a powerful tool for evaluating project profitability, considering the time value of money. It helps organizations make informed decisions about investments by prioritizing projects that are expected to maximize shareholder value.

Ranking of project – net terminal value method

The Net Terminal Value (NTV) method is a financial analysis technique used to rank and evaluate investment projects, especially those with significant cash flows beyond the initial project period. NTV accounts for the value of future cash flows beyond the project’s explicit forecast period, often using a terminal growth rate. Here’s how to rank projects using the Net Terminal Value method:
  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or investments that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Future Cash Flows:
    • Estimate the expected future cash flows that each project will generate over its explicit forecast period. Cash flows typically include revenue, operating expenses, taxes, and depreciation.
  4. Determine the Discount Rate:
    • Determine the appropriate discount rate, often referred to as the “cost of capital” or “required rate of return.” This discount rate is used to calculate the present value of cash flows.
  5. Calculate Present Value of Cash Flows:
    • Calculate the present value of each project’s expected cash flows over the explicit forecast period by discounting them back to their present values using the chosen discount rate.

    • PV= CF1/ (1+r)1     +      CF2/ (1+r)2++CFn/(1+r)n

    Where:

    • = Present Value of Cash Flows
    • = Expected cash flows in each period (years)
    • = Discount rate
  6. Estimate Terminal Value:
    • Estimate the terminal value of each project, which represents the present value of all cash flows beyond the explicit forecast period. This can be calculated using various methods, with the most common being the perpetuity growth model (also known as the Gordon Growth Model):Where:
      • = Present Value of Terminal Cash Flows
      • = Cash flow in the first year beyond the explicit forecast period
      • = Discount rate
      • = Terminal growth rate (the rate at which cash flows are expected to grow perpetually)

     

  7. Calculate Net Terminal Value (NTV):
    • Add the present value of the explicit forecast period cash flows (calculated in step 5) to the terminal value (calculated in step 6) to determine the NTV for each project.

     

  8. Rank Projects by NTV:
    • Rank the projects in descending order of their Net Terminal Value (NTV). Projects with higher NTVs are ranked higher, as they are expected to generate a higher return, including the value of cash flows beyond the explicit forecast period.
  9. Review and Consider Qualitative Factors:
    • While the NTV method is primarily based on financial metrics, it’s essential to consider qualitative factors, strategic alignment, and specific organizational goals in the ranking process.
  10. Finalize the Ranked List:
    • Take into account the NTV rankings along with qualitative considerations. Finalize the ranked list of projects.
  11. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with higher NTVs are typically prioritized if maximizing financial returns is a primary objective.
  12. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual cash flows and NTVs. Adjust rankings if projects deviate significantly from initial projections.

The Net Terminal Value method is particularly useful when projects have significant long-term cash flows, and it accounts for the value of these future cash flows in the ranking process. It provides a more comprehensive view of project profitability by considering both the explicit forecast period and the cash flows beyond it.

Ranking of project – internal rate of return method

The Internal Rate of Return (IRR) method is a financial analysis technique used to rank and evaluate investment projects based on their expected rate of return. IRR is the discount rate at which the net present value (NPV) of a project’s cash flows equals zero. Projects with higher IRRs are generally considered more attractive because they offer a higher rate of return. Here’s how to rank projects using the Internal Rate of Return method:
  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or investments that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Future Cash Flows:
    • Estimate the expected future cash flows that each project will generate over its anticipated lifespan. Cash flows typically include revenue, operating expenses, taxes, and depreciation.
  4. Calculate NPV for Various Discount Rates:
    • Calculate the Net Present Value (NPV) of each project’s expected cash flows for a range of discount rates. Start with a conservative estimate of the discount rate (e.g., the cost of capital) and gradually increase it.

    Where:

    • = Net Present Value
    • = Expected cash flow in year
    • = Discount rate
    • = Year
  5. Find the IRR:
    • Identify the discount rate at which the NPV of the project’s cash flows equals zero. This is the Internal Rate of Return (IRR) for each project.
  6. Rank Projects by IRR:
    • Rank the projects in descending order of their Internal Rate of Return (IRR). Projects with higher IRRs are ranked higher, as they are expected to generate a higher rate of return on the initial investment.
  7. Review and Consider Qualitative Factors:
    • While the IRR method is primarily based on financial metrics, it’s essential to consider qualitative factors, strategic alignment, and specific organizational goals in the ranking process.
  8. Finalize the Ranked List:
    • Take into account the IRR rankings along with qualitative considerations. Finalize the ranked list of projects.
  9. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with higher IRRs are typically prioritized if maximizing the rate of return is a primary objective.
  10. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual cash flows and IRRs. Adjust rankings if projects deviate significantly from initial projections.

The IRR method provides a measure of the rate of return that an investment is expected to generate. Projects with higher IRRs are more likely to meet or exceed the organization’s required rate of return. However, it’s important to note that the IRR method can sometimes lead to ambiguous or multiple IRRs, especially for projects with unconventional cash flow patterns. In such cases, careful interpretation and consideration of cash flow profiles are necessary.

Ranking of project – Multiple internal rate of return method

The Multiple Internal Rate of Return (MIRR) method is an improved variation of the Internal Rate of Return (IRR) method that addresses some of the limitations associated with IRR, particularly when there are multiple changes in cash flow direction (i.e., both positive and negative cash flows) over the life of a project. MIRR calculates a single rate of return that accounts for reinvestment and financing aspects more realistically. Here’s how to rank projects using the Multiple Internal Rate of Return method:

  1. Identify Project Candidates:
    • Begin by identifying the list of potential projects or investments that need to be ranked.
  2. Estimate Initial Investments (Costs):
    • Determine the initial investments required for each project. This includes costs such as capital expenditures, equipment, labor, and any other expenses associated with project initiation.
  3. Forecast Future Cash Flows:
    • Estimate the expected future cash flows that each project will generate over its anticipated lifespan. Cash flows typically include revenue, operating expenses, taxes, and depreciation.
  4. Calculate the Net Cash Flow at the End of the Project Period:
    • Determine the net cash flow that occurs at the end of the project’s life by subtracting the final cash outflow (e.g., project disposal or liquidation costs) from the final cash inflow (e.g., project sales proceeds).
  5. Calculate the Present Value of Terminal Cash Flows:
    • Calculate the present value of the net cash flow at the end of the project period. Use the appropriate discount rate (often the cost of capital) to discount this terminal cash flow back to its present value.

    Where:

    • =  Present Value of Terminal Cash Flow
    • = Net cash flow at the end of the project
    • = Discount rate
    • = Number of years until the end of the project
  6. Calculate the Present Value of Initial Investments:
    • Calculate the present value of the initial investments (project costs) using the same discount rate.

    Where:

    • = Present Value of Initial Investment
    • = Initial project costs
    • = Discount rate
    • = Number of years until the initial investment
  7. Calculate the MIRR:
    • Calculate the Multiple Internal Rate of Return (MIRR) for each project by finding the discount rate that makes the present value of initial investments equal to the present value of terminal cash flows. This can be done using iterative methods or financial software.
  8. Rank Projects by MIRR:
    • Rank the projects in descending order of their MIRR. Projects with higher MIRRs are ranked higher, as they are expected to generate a higher rate of return, considering both initial investments and terminal cash flows.
  9. Review and Consider Qualitative Factors:
    • While the MIRR method is primarily based on financial metrics, it’s essential to consider qualitative factors, strategic alignment, and specific organizational goals in the ranking process.
  10. Finalize the Ranked List:
    • Take into account the MIRR rankings along with qualitative considerations. Finalize the ranked list of projects.
  11. Resource Allocation:
    • Allocate resources and funding to the projects based on their rankings. Projects with higher MIRRs are typically prioritized if maximizing the rate of return is a primary objective.
  12. Monitor and Review:
    • Continuously monitor the progress of projects, including their actual cash flows and MIRRs. Adjust rankings if projects deviate significantly from initial projections.

The MIRR method is particularly useful when projects have unconventional cash flow patterns or when there is uncertainty regarding reinvestment rates. It provides a more accurate assessment of the rate of return, considering both the initial and terminal aspects of a project.

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