Screening Models Essay

Section 2 – Features and characteristics of screening models

There are a number of selection methods or screening models available to managers when faced with choosing potential projects. These include several numeric (Quantitative) and non-numeric (Qualitative) models. Each of these models have their benefits, however, to be effective, they should all share common characteristics. Firstly they should be realistic. This means that an effective model must reflect the organisations objectives, strategy and mission. It should also take into account the availability of resources such as money or personnel, and account for performance, cost and time, as well as the potential risk that the project carries. The second characteristic is capability.

Companies tend to favour financial models as they evaluate the benefit of projects in terms of profitability and return on investment, or time it takes to repay an investment. Numeric models use numbers as the basis for selecting whether a project should be undertaken or not. Examples of numeric models include;

Payback Period

The payback period refers to the length of time it takes for a project to repay its initial investment. The project which pays back the investment in the shortest time is the most desired under this model. It is calculated by dividing the initial investment by annual cash flows and has several advantages. It is simple to use as it utilises accounting information which is readily available to decision makers to identify cash flows. It reduces uncertainty as it selects the project with the shortest payback period. It is helpful to organisations which may have limited cash flow, as it measures the speed of cash recovery. This method also quantifies the criteria for a project in a manner decision makers are more familiar

However, IRR differs from NPV as it provides an answer in percentage terms rather than an absolute figure. IRR determines the discount rate at which an investment will return a zero net present value. Organisations use this technique to determine if investment in a project makes financial sense. Thus, organisations will calculate the estimated IRR when evaluating one or more potential projects. When faced with multiple projects, management will choose the one with the highest rate of return, assuming it exceeds the cost of capital. One advantage of this model is that IRR uses cash flows, instead of accounting profits. It also takes the time value of money into consideration. This method also considers the timings of cash flows. However, like NPV, IRR does not consider risk associated with later cash flows, and is more difficult to understand than other techniques. IRR also requires the use of an interpolation