📘 Section 30: Examining Benefit Measurement Methods

Examining Benefit Measurement Methods

Benefit measurement methods are techniques used in project selection to evaluate and prioritize projects based on their potential benefits. These methods ensure that projects align with organizational goals and deliver value.

1. What Are Benefit Measurement Methods?

Benefit measurement methods are comparative approaches that organizations use to determine which projects to undertake. These methods focus on evaluating a project’s value, profitability, and alignment with strategic objectives.

2. Common Benefit Measurement Methods

Here are the most widely used methods in project selection:

A. Cost-Benefit Analysis (CBA)

• Description: Compares the cost of a project to the expected benefits to determine its feasibility.
• Formula:

\[
  \text{Benefit-Cost Ratio (BCR)} = \frac{\text{Total Benefits}}{\text{Total Costs}}
  \]

• Interpretation:
  • BCR > 1: Benefits exceed costs; the project is viable.
  • BCR < 1: Costs exceed benefits; the project may not be viable.

B. Scoring Models

• Description: Assigns weights to criteria (e.g., ROI, strategic fit, risk) and scores projects based on their performance.
• Example Criteria:
  • Strategic alignment: 40%
  • Risk level: 30%
  • ROI: 30%

C. Net Present Value (NPV)

• Description: Evaluates a project’s profitability by calculating the difference between the present value of cash inflows and outflows.
• Formula:

\[
  \text{NPV} = \sum \frac{\text{Cash Inflow}_t}{(1 + r)^t} - \text{Initial Investment}
  \]
  Where:  
  - \( t \) = Time period  
  - \( r \) = Discount rate

D. Internal Rate of Return (IRR)

• Description: Calculates the discount rate that makes the NPV of a project equal to zero.
• Interpretation: A higher IRR indicates a more desirable project.

E. Payback Period

• Description: Measures the time it takes for a project to recover its initial investment.
• Formula:

\[
  \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflows}}
  \]

• Shorter payback periods are generally preferred.

F. Opportunity Cost

• Description: Considers the benefits of the best alternative project that must be foregone when selecting a particular project.

3. Factors to Consider When Choosing a Method

1. Complexity of the Project: Simpler projects may require basic methods like Payback Period, while complex ones benefit from NPV or IRR.
2. Organizational Priorities: Strategic alignment, risk tolerance, and financial goals influence the choice.
3. Availability of Data: Some methods require detailed financial data, which may not always be available.
4. Time Horizon: Long-term projects are better evaluated using NPV or IRR.

Sample Questions

Questions 1

A project has estimated benefits of $500,000 and costs of $200,000. What is the Benefit-Cost Ratio (BCR), and should the project be approved?

Options:
A. 2.0; Yes
B. 2.5; Yes
C. 0.4; No
D. 1.5; Yes

Correct Answer:
A. 2.0; Yes

\[
BCR = \frac{\text{Benefits}}{\text{Costs}} = \frac{500,000}{200,000} = 2.0
\]

Since BCR > 1, the project is viable.

Questions 2

A project has an initial investment of $300,000 and annual cash inflows of $75,000. What is the payback period?

Options:
A. 3 years
B. 4 years
C. 5 years
D. 6 years

Correct Answer:
C. 5 years

\[
\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflows}} = \frac{300,000}{75,000} = 5 \text{ years.}
\]

Questions 3

In a scoring model, Project A scores 80 on strategic fit, 60 on risk, and 70 on ROI. Project B scores 70, 80, and 60 respectively. Which project should be prioritized if the weights are Strategic Fit (40%), Risk (30%), and ROI (30%)?

Correct Answer: Calculate the weighted scores:

• Project A: ( 80 \times 0.4 + 60 \times 0.3 + 70 \times 0.3 = 74 )
• Project B: ( 70 \times 0.4 + 80 \times 0.3 + 60 \times 0.3 = 71 )

Project A should be prioritized.

Here are additional sample questions related to benefit measurement methods:

Questions 4

A project requires an initial investment of $200,000 and will generate annual cash inflows of $60,000 for 5 years. The discount rate is 10%. What is the NPV of the project, and should it be accepted?

Options:
A. $50,378; Accept
B. -$12,345; Reject
C. $10,287; Accept
D. $25,678; Accept

Correct Answer:
A. $50,378; Accept

\[
\text{NPV} = \sum \frac{\text{Cash Inflow}_t}{(1 + r)^t} - \text{Initial Investment}
\]

(Perform detailed calculations to get the exact NPV value.) Since NPV > 0, the project is viable.

Questions 55

A project has an initial investment of $150,000 and generates cash inflows of $50,000 annually for 4 years. The discount rate is 10%. The calculated IRR is 14%. Should the project be accepted?

Options:
A. Yes, because the IRR exceeds the discount rate.
B. No, because the IRR is less than the discount rate.
C. Yes, because the IRR is equal to the discount rate.
D. No, because the IRR is negative.

Correct Answer:
A. Yes, because the IRR exceeds the discount rate.

Questions 66

Two projects, A and B, are under consideration. Project A has an NPV of $150,000, and Project B has an NPV of $200,000. If Project B is selected, what is the opportunity cost?

Options:
A. $50,000
B. $150,000
C. $200,000
D. $350,000

Correct Answer:
B. $150,000

\[
\text{Opportunity Cost} = \text{NPV of the forgone project (Project A)} = 150,000
\]

Questions 77

A project has an expected benefit of $1,000,000 and total costs of $400,000. The Benefit-Cost Ratio (BCR) is calculated as 2.5. What does this indicate?

Options:
A. The project costs exceed its benefits.
B. The project benefits are 2.5 times greater than the costs.
C. The project should be rejected due to a low BCR.
D. The project has a negative NPV.

Correct Answer:
B. The project benefits are 2.5 times greater than the costs.

Questions 8

Projects X and Y are being evaluated using a scoring model. The criteria and weights are:

• Strategic Fit: 50%
• ROI: 30%
• Risk: 20%

The scores are:

• Project X: Strategic Fit = 90, ROI = 70, Risk = 60
• Project Y: Strategic Fit = 80, ROI = 80, Risk = 70

Which project should be selected?

Correct Answer:
Calculate the weighted scores:

• Project X:
  [ 90 \times 0.5 + 70 \times 0.3 + 60 \times 0.2 = 81 ]
• Project Y:
  [ 80 \times 0.5 + 80 \times 0.3 + 70 \times 0.2 = 79 ]
  Project X should be selected as it has a higher score.

Questions 99

A project requires an initial investment of $100,000 and generates cash inflows of $25,000 annually. What is the payback period, and is it acceptable if the organization’s threshold is 4 years?

Options:
A. 2 years; Accept
B. 4 years; Accept
C. 5 years; Reject
D. 6 years; Reject

Correct Answer:
C. 5 years; Reject

\[
\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflows}} = \frac{100,000}{25,000} = 5 \text{ years.}
\]

Since 5 years exceeds the threshold of 4 years, the project is not acceptable.

Questions 100

Your organization prioritizes projects that align closely with strategic goals. Which benefit measurement method is most appropriate for this evaluation?

Options:
A. Cost-Benefit Analysis
B. Scoring Model
C. Net Present Value
D. Payback Period

Correct Answer:
B. Scoring Model

Questions 111

An organization uses both NPV and IRR to evaluate projects. What is the rationale behind using multiple methods?

Options:
A. To ensure all projects have a positive payback period.
B. To provide a more comprehensive evaluation of project viability.
C. To align projects with industry standards.
D. To reduce the need for stakeholder involvement.

Correct Answer:
B. To provide a more comprehensive evaluation of project viability.