Ranking Alternative

List projects in the order of their total scores, with the project having the highest total score at the top and one with the lowest total score at the bottom. Choose the project at the top and as many more in succes- sion from the top as can be pursued within the budget, manpower, and other constraints.

Capital Budgeting: The Basics ❧ 397 Figure฀12-24

Solution of Example 12.10 with Total Weighted Scores from Rating Used in Place of Net Present Values for the Investments or Projects

1 Example 12-10: GOLIATH INDUSTRIES (With investments rated) 2 Input Data

Annual Costs 3 Option

Present

Rating

Year 2 Year 3 4 Modernize existing plant

5 Build new plant

300,000 6 Expand distribution network

20,000 7 Redesign existing product A

45,000 9 Develop new product X

8 Redesign existing product B

200,000 $ 75,000 10 Develop new product Y

250,000 $ 200,000 11 Available funds

Choices 13 (1 = Yes,

Annual Costs 14 Option

Present

Rating

Year 2 Year 3 15 Modernize existing plant

- $ - 16 Build new plant

- $ - 17 Expand distribution network

- $ - 18 Redesign existing product A

- $ - 19 Redesign existing product B

- $ - 20 Develop new product X

200,000 $ 75,000 21 Develop new product Y

22 Total rating score and allocated funds

23 Uncommitted funds

100,000 $ 225,000 24 Build OR modernize plant constraint

25 Sum of uncommitted funds

Key cell entries: C15: =$B15*C4, copty to C15:G21

C22: =SUM(C15:C21), copy to D22:G22 B24: =B15+B16 B25: =SUM(D23:F23) E23: =E11–E22, copy to F23:G23

Solver settings: Target cell is D22, to be maximized.

Cells to vary are B15:B21. Constraints: B15:B21 = binary

E22:G22 <= E11:G11 B24 = 1 (Either modernize or build new plant.)

Ratings can be substituted for net present values for selecting investments with funding over several years. Figure 12-24, for example, illustrates how Example 12.10 can be solved based on maximizing the total rating scores of the chosen investments or projects rather than on their net present values.

To create Figure 12-24, copy Figure 12-19 and insert a column for a set of rating scores (Column

D in Figure 12-24). Enter values that have been determined for the rating scores in Cells D4:D10. Copy the entries in Cell C15:C21 to D15:D21. Figure 12-24 shows that incorporating “nonfinancial considerations” into management decisions can provide markedly different results and decisions based solely on financial values.

398 ❧ Corporate Financial Analysis with Microsoft Excel ®

There are many variations on the simple rating and ranking technique for selecting investments or projects. One of the most sophisticated of these is the Analytic Hierarchy Process (AHP), which is being used for many complex decisions in industry and government. AHP is based on a pairwise comparison of all possible combinations of criteria and investments or projects. Although relatively easy to apply when the number of investments or projects and criteria is small, the number of comparisons and calculations when there are more than three investments and four criteria requires the use of special software to make the technique practical. For more details, see the reference by Saaty in the bibliography.

Students’ Feedback on Rating and Ranking I found the Rating and Ranking scorecard in the section on nonfinancial criteria most interesting because it is

an objective and organized way of arriving at critical decisions in complex situations—personal or professional.

I have probably used this process before, albeit subconsciously, and so it is nice to learn how to do it in an organized way as it will make subsequent decisions more manageable.

I could have used the example of Goliath Industry earlier this year. I was working on an optimization problem that had decisions akin to the binary choices made in the examples. This is a very useful optimization technique, which I will use in the future.

Including nonfinancial criteria is an important consideration for my company. We use two categories: risk and quality. In addition to presenting financial criteria for a project, we provide an assessment of how the project would either reduce risk for the organization or provide improved quality in our products or services.

International businesses must consider political risks when deciding whether or not to invest in projects in foreign countries. Projects in countries with frequent leader changes are very vulnerable to failure because the new government that comes into power may be unfavorable to them.

The most useful thing I found in this chapter was the use of Solver to optimize a set of goals. It allowed us to maximize a goal and, at the same time, while still achieving the first goal, proceed to other goals with lower priorities. Also, with the scenario analysis, we can measure the sensitivity of the outputs to variations in the input variables, which allows us to see the effects of changes more clearly on the outcomes.

This session couldn’t have come at a better time for me. We had one of the divisional controllers come into our staff meeting last week to talk about the capital budgeting process. Among other things, she was showing spreadsheets similar to the ones we’ve been creating in this class.

Ranking Alternative