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Project Selection and Portfolio Management

Chapter 3

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Project Selection

Screening models help managers pick winners from a pool of projects. Screening models are numeric or nonnumeric and should have:

Realism

Capability

Flexibility

Ease of use

Cost effectiveness

Comparability

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Approaches to Project Screening

• Checklist

• Simple scoring models

• Analytic hierarchy process

• Profile models

• Financial models

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Checklist Model

A checklist is a list of criteria applied to possible projects.

• Require a relative small amount of information• Provide a rough estimate – first level screening.

� Requires agreement on criteria� Assumes all criteria are equally important

Checklists are valuable for recording opinions and encouraging discussion

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Simple Scoring Models

Each project receives a score that is the weighted sum of its grade on a list of criteria. Scoring models require:

� agreement on criteria� agreement on weights for criteria� a score assigned for each criteria

Relative scores can be misleading!

( )Score Weight Score= ×∑

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EXAMPLELet consider the situation where you have to decidebetween pursuing study at postgraduate level or take ajob after completing your degree. The four majorfactors affecting the decision are employmentopportunities, intellectual satisfaction, earning potentialand growth potential. The scores for each criteriarange from 1 to 3:

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Exercise 2

Determine the weighted score for each product

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Analytic Hierarchy Process

The AHP is a four step process:1. Construct a hierarchy of criteria and

subcriteria2. Allocate weights to criteria3. Assign numerical values to evaluation

dimensions4. Scores determined by summing the

products of numeric evaluations and weightsUnlike the simple scoring model, these scores are comparable!

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Weights on criteria

numerical values to evaluation 70%30% 30%

46%24%

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• E

Eg, Aligned project:

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Analytic Hierarchy Process

� Break decision into stages or levels.� Starting at the lowest level, for each

level, make pairwise comparison of the factors.� 9-step scale:

1. equally preferred2. equally to moderately preferred3. moderately preferred4. moderately to strongly preferred5. strongly preferred6. strongly to very strongly preferred7. very strongly preferred8. very to extremely preferred9. extremely preferred

3-17To accompany Quantitative Analysis for Management, 9e \by Render/Stair/Hanna

M1-17 © 2006 by Prentice Hall, Inc. Upper Saddle River, NJ 07458

Beginning Comparison MatrixUse the 9-point scale for pairwise comparison to evaluate each criterion

Criterion

C -

1C-1

C-2

C-3C

-2

3 9

6

1

1

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Comparison Matrix (continued)

Criterion

C-1

C-1

C-2

C-3

3 9

6

1

1

1

1/3

1/9 1/6

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Criterion

C-1

C-2

C-3

3 9

6

1

1

1

1/3

1/9 1/6

1.444 4.167 16.0ColumnTotals

Normalizing the Matrix

The totals are used to create a normalized matrix

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Criterion

C-1

C-2

C-3

0.6923 0.7200

0.2300 0.2400 0.3750

0.0769 0.0400 0.0625

Normalized Matrix

0.5625

= 1/ 1.444 = .333/ 1.444

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Final Matrix for Criterion

3/)0625.00400.00769.0(

3/)3750.02400.02300.0(

3/)5625.07200.06923.0(

0.0598

0.2819

0.6583

Averages Row

++++++

=

C-1 C-2 C-3

Weightage 0.6583 0.2819 0.0598

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Profile ModelsShow risk/return options for projects.

Requires:• Criteria selection as axes• Rating each project on criteria

Maximum Desired Risk

Minimum Desired Return

Return

Risk X1

X3

X5

X6

X4

X2

Efficient Frontier

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Financial Models

Based on the time value of money principal

o Payback periodo Net present valueo Internal rate of returno Options models

All of these models use discounted cash flows

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Payback Period

Cash flows should be discountedLower numbers are better (faster payback)

InvestmentPayback Period

Annual Cash Savings=

Determines how long it takes for a project to reach a breakeven point

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Payback Period Example

A project requires an initial investment of $200,000 and will generate cash savings of $75,000 each year for the next five years. What is the payback period?

Year Cash Flow Cumulative

0 ($200,000) ($200,000)

1 $75,000 ($125,000)

2 $75,000 ($50,000)

3 $75,000 $25,000

Divide the cumulative amount by the cash flow amount in the third year and subtract from 3 to find out the moment the project breaks even.

25,0003 2.67

75,000years− =

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Net Present Value

Projects the change in the firm’s stock value if a project is undertaken.

(1 )

to t

t

t

t

FNPV I

r p

where

F = net cash flow for period t

R = required rate of return

I = initial cash investment

P = inflation rate during period t

= ++ +∑

Higher NPV values are

better!

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Net Present Value ExampleShould you invest $60,000 in a project that will return $15,000 per year for five years? You have a minimum return of 8% and expect inflation to hold steady at 3% over the next five years.

Year Net flow Discount NPV

0 -$60,000 1.0000 -$60,000.00

1 $15,000 0.9009 $13,513.51

2 $15,000 0.8116 $12,174.34

3 $15,000 0.7312 $10,967.87

4 $15,000 0.6587 $9,880.96

5 $15,000 0.5935 $8,901.77

-$4,561.54

The NPV column total is -$4561, so don’t invest!

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Internal Rate of Return

A project must meet a minimum rate of returnbefore it is worthy of consideration.

1 (1 )

tt

n

t

ACFIO

IRR t

where

ACF = annual after tax cash flow for time period t

IO = initial cash outlay

n = project's expected life

IRR = the project's internal rate of return

=

=+∑ Higher IRR

values are better!

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Internal Rate of Return Example

A project that costs $40,000 will generate cash flows of $14,000 for the next four years. You have a rate of return requirement of 17%; does this project meet the threshold?

Year Net flow Discount NPV

0 -$40,000 1.00 -$400001 $14,000 0.87 $121742 $14,000 0.76 $105863 $14,000 0.66 $92054 $14,000 0.57 $8005

-$30

This table has been calculated using a discount rate of 15%

The project doesn’t meet our 17% requirement and should not be considered further.

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Options Models

NPV and IRR methods don’t account for failure to make a positive return on investment. Options models allow for this possibility.

Options models address:1. Can the project be postponed?2. Will future information help decide?

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Example Options Model: Corporation A is trying to decide whether or not to invest in a new software project. The initial investment will be $5 million dollars. The project has a 40% chance of returning $1 million per year into the future and a 60% chance of generating only $100,000 in revenues. Assuming that Corporation A requires 15% return on capital investments, determine whether or not this is a viable project.

If Corporation A decides to wait one year before investing in the project, its odds of returning $1 million per year improve to 70%. Should Corporation A wait for a year to initiate the project?

Can the project be postponed?

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We can first calculate the NPV of the proposed investment as follows:

Cash Flows = .4($1,000,000) + .6($100,000) = $460,000

NPV = - $5,000,000 + Σ $460,000/(1.15)t

= - $5,000,000 + ($460,000/.15)= - $5,000,000 + $3,066,667= - $1,933,333

NPV is negative, suggesting that the project is not a good investment under the economic conditions expected;

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However, if we decide to wait the additional year, when the odds are better for stronger returns, the formula is calculated as follows:

Expected Cash Flow = 0.70 ($1,000,000) + 0.30 ($100,000) = 730,000

NPV = [- $5,000,000/1.15 + Σ $730,000/(1.15)t]= [ - $5,000,000/1.15 + ($730,000/.15)] = (- $4,347,826 + $4,866,667)= $518,841

Therefore, by waiting an additional year, the value of this investment is positive, suggesting that Corporation A should hold off on the project for one year.

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Project Portfolio Management

The systematic process of selecting, supporting, and managing the firm’s collection of projects.

Why project portfolio management?• more projects than resources-selection• Staff burdened by conflicting priorities from multiple

projects• Trouble ensuring that company is investing in the

right projects• Accounting/balancing for risk that company willing

to accept

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Portfolio management requires:• Decision making/selection-strategic directions & project• Prioritization – cost, opportunity, risk, strategic fit, portfolio balance, top management pressure• Review- select projects that offer maximum returns• Realignment- new projects addition, reexamine priorities, new strategic direction?• Reprioritization-corporate goals & objectives

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Screening & Selection Issues

• Risk – unpredictability to the firm• Commercial – market potential• Internal operating – changes in firm ops• Additional – image, patent, strategic fit, etc.

All models only partially reflect reality and have both objective and subjective factors imbedded

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Keys to Successful Project Portfolio Management

� Flexible structure and freedom of communication: Allowing improvisation of existing product to drive new innovative ideas

� Low-cost environmental scanning: developing and

market-testing experimental prototypes.

� Time-paced transition: product life cycle planning

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Problems in Implementing Portfolio Management

�Conservative technical communities

�Out of sync projects and portfolios

�Unpromising projects

�Scarce resources