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Project Selection and Portfolio

ManagementChapter 3

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1. Explain six criteria for a useful project selection/screening model.

2. Understand how to employ checklists and simple scoring models to select projects.

3. Use more sophisticated scoring models, such as the Analytical Hierarchy Process.

4. Learn how to use financial concepts, such as the efficient frontier and risk/return models.

5. Employ financial analyses and options analysis to evaluate the potential for new project investments.

6. Recognize the challenges that arise in maintaining an optimal project portfolio for an organization.

7. Understand the three keys to successful project portfolio management.

Learning Goals

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Firms are inundated with project opportunities No organization has unlimited resources to work on these

opportunities Screening models help managers pick winners from a pool

of projects Screening models can be qualitative and simple or

quantitative and complex When considering a project selection model, look for:Realism (provides a realistic result?)

Capability, Comparability (works for ST/LT projects?)Flexibility (adjustable?)

Ease of use (understandable?)Cost effectiveness (cheap to

use)

Project Selection

see “Prioritizing Spreadsheet”

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Screening & Selection Issues A list of factors to be considered when evaluating

project alternatives

◦ Risk – unpredictability to the firm, technical, safety, financial, legal

◦ Commercial Impact – reflects market potential, ROI, payback ◦ Impact to internal operations – employee training, safety

issues, equipment needs◦ Additional factors – impact on image, patent, strategic fit

Strategic direction of the company will highlight certain criteria over others

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

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Checklist Simple scoring models Analytic hierarchy process Profile models Financial models

Approaches to Project Screening

Let’s look at each of these…

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Checklist Model

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

A fairly simple device Requires agreement on criteria Assumes all criteria are equally important

Checklists work best in a group setting and are valuable for recording opinions and encouraging discussion

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Example: Simplified Checklist Model For Project Selection

Performance on Criteria High Medium Low Project Criteria Project Alpha Cost X Profit Potential X Time to Market X Development Risks X Project Beta Cost X Profit Potential X Time to Market X Development Risks X Project Gamma Cost X Profit Potential X Time to Market X Development Risks X Project Delta Cost X Profit Potential X Time to Market X Development Risks X

Which do you choose?

Why?

(3) (2) (1)

* good place to make use of a rubric

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Simplified 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

( )Score Weight Score

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Example: Simple Scoring Model

(A) (B) (A) x (B) Importance Weighted Project Criteria Weight Score Score Project Alpha Cost 1 3 3 Profit Potential 2 1 2 Development Risk 2 1 2

Time to Market 3 2 6 Total Score 13 Project Beta Cost 1 2 2 Profit Potential 2 2 4 Development Risk 2 2 4 Time to Market 3 3 9 Total Score 19

Which do you choose?

Why?

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Analytic Hierarchy Process Developed to address the technical and

managerial problem with scoring models Similar to simplified scoring model except these

scores are comparable due to ranking of importance

The AHP is a four step process:1. Construct a hierarchy of criteria and subcriteria2. Allocate weights to criteria through pairwise comparison3. Assign numerical values to qualitative characteristics

with a Likert scale4. Scores determined by summing the products of numeric

evaluations and weightsAnalytic Hierarchy Process/Example Carhttp://en.wikipedia.org/wiki/Talk:Analytic_Hierarchy_Process/Example_Car

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Allows one to plot risk vs. return options for various projects.

Select the project with the maximum return and minimum acceptable risk.

Makes use of a financial management concept called the efficient frontier.◦ A set of options that offers the maximum return

for a given level of risk or the minimum risk for a level of return.

Profile Models

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Profile Model

10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110%0

1

2

3

4

5

6

7

8

9

10

Return

Ris

k

Efficient frontier

Maximum Desired

Risk

Minimum Desired Return

X1

X3

X2

X4X5

X6

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Financial Models

Based on the time value of money principal – comparing what a dollar is worth today to another time period

o Discounted cash flow analysiso Payback periodo Net present valueo Internal rate of return

All of these models use discounted cash flows

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The discounted cash flow (or DCF) describes a method of valuing a project using the time value of money.

All future cash flows are estimated and discounted to give their present values.

The discount rate reflects two things based on risk:◦ the time value of money – projecting a future value

to today’s dollars.◦ a cost of capital – a corporate charge for using cash.

Very similar to net present value.

Discounted Cash Flow (or DCF)

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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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Advantage◦ Easy to understand and use◦ Emphasizes the early recovery of capitol◦ Cashflow beyond the payback period are

uncertain, so they are ignored Disadvantage

◦ Ignores timing of the cash flow within the payback period

◦ Emphasis is on the recovery of capital, not on profitability

◦ Does not provide a decision criterion for acceptance

Payback Method Advantages/Disadvantages

How do you decide on the maximum allowable payback period?

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Needs to be accounted for in the capital investment decision

Main reason: capital could be used for something else

Capital has an opportunity cost in any given use

Time Value of Money

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One of the most common project selection metrics. Predicts the change in the firm’s value if a project is

undertaken. We attempt to equate all cash flows to current dollars.

Net Present Value (NPV)

(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!

A positive value indicate the firm will make money

r

o

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NPV takes into account a discount factor The discount factor is simply the reciprocal

of the discount rate

Discount factor

1discount factor

(1 )

rate of return

inflation rate

time period

tr p

r

p

t

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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 negative, so don’t invest!

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Answers the question: What rate of return will this project earn?

It is the interest rate at which the NPV of the cash flows is equal to zero.

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

Need to be solved with MSExcel or a financial based calculator – by hand is an iterative (guessing) process

Internal Rate of Return (IRR)

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 1.0000 -$40,000.00

1 $14,000 0.8696 $12,173.91

2 $14,000 0.7561 $10,586.01

3 $14,000 0.6575 $9,205.23

4 $14,000 0.5718 $8,004.55

-$30.30

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

Actual IRR is 14.9625%

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

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Project Portfolio Management

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

Portfolio management requires:◦Decision making on continued support of

projects ◦Prioritization of resources◦Review of potential projects◦Realignment with strategic fit◦Reprioritization of a firm’s projects

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Flexible structure and freedom of communication◦ Cannot be constrained by bureaucracy, poor

communication, rigid processes Low-cost environmental scanning

◦ Finding a way to “test the waters” before full commitment

◦ Market testing a number of experimental product prototypes

Time-paced transition◦ Having a process to transition from one project to

another

Keys to Successful Project Portfolio Management

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Conservative technical communities◦ Technical reps holding onto projects too long

Out of sync projects and portfolios◦ Projects must stay aligned with the current

strategic direction of the firm Unpromising projects

◦ Willing to “kill” a project when it is necessary? Scarce resources

◦ No one has unlimited resources◦ Resources need to be allocated where they are

most beneficial

Problems in Implementing Portfolio Management

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Projects selection can be company saving or killing

Midsize? between 290 to 330 passengers

Jumbo? between 550 to 800 passengers

Tiny? 6 passengers

Airbus A380

Eclipse 500

Boeing 787 Dreamliner

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1. If you were to prioritize the criteria for a successful screening model, which of those criteria do you rank at the top of your priority list? Why?

2. What are the benefits and drawbacks of project checklists for screening alternatives?

3. How does use of the Analytical Hierarchy Process (AHP) aid in project selection? In particular, what aspects of the screening process does the AHP seem to address and improve directly?

4. What are the benefits and drawbacks of the profile model for project screening? Be specific about the problems that may arise in identifying the efficient frontier.

5. How are financial models superior to other screening models? How are they inferior?

Chapter 3 Review and Discussion

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6. How does the options model address the problem of non-recoverable investment in a project?

7. What advantages do you see in the GE Tollgate screening approach? What disadvantages do you see? How would you alter it?

8. Why is project portfolio management particularly challenging in the pharmaceutical industry?

9. What are the keys to successful project portfolio management?

10. What are some of the key difficulties is successfully implementing portfolio management practices?

Chapter 3 Review and Discussion

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GoodAnswers’ controller, Sal Reigh, has negotiated a four-year lease agreement with Columbia Management.

Included in the agreement is ◦ Option #1, a lump sum payment of $40,000 upon signing

the four-year lease to pay for the cost of configuring the office to meet the needs of GoodAnswers. -or -

◦ Option #2, to pay nothing up front, but to incur an annual lease in the amount of $11,000 paid at the end of each year for the four-year term of the lease.

Assuming GoodAnswers has a cost of capital of 10%, which option should Sal choose?

In-class exercise