1. Project Selection and Portfolio Management
Chapter 3

2. Learning Goals
Explain six criteria for a useful project selection/screening model.
Understand how to employ checklists and simple scoring models to select projects.
Use more sophisticated scoring models, such as the Analytical Hierarchy Process.
Learn how to use financial concepts, such as the efficient frontier and risk/return models.
Employ financial analyses and options analysis to evaluate the potential for new project investments.
Recognize the challenges that arise in maintaining an optimal project portfolio for an organization.
Understand the three keys to successful project portfolio management.

3. Project Selection 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)
see “Prioritizing Spreadsheet”

4. 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

5. Approaches to Project Screening
Checklist
Simple scoring models
Analytic hierarchy process
Profile models
Financial models
Let’s look at each of these…

6. 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

7. Example: Simplified Checklist Model For Project Selection
Which do you choose?
Why?
(3) (2) (1)
* good place to make use of a rubric
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8. 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

9. Example: Simple Scoring Model
Which do you choose?
Why?

10. 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:
Construct a hierarchy of criteria and subcriteria
Allocate weights to criteria through pairwise comparison
Assign numerical values to qualitative characteristics with a Likert scale
Scores determined by summing the products of numeric evaluations and weights
Analytic Hierarchy Process/Example Car

11. Profile Models
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.

12. Minimum Desired Return
Profile Model X6
Maximum Desired Risk
Minimum Desired Return X2 X4 X5 X3
Efficient frontier X1

13. Financial Models
Based on the time value of money principal – comparing what a dollar is worth today to another time period
Discounted cash flow analysis
Payback period
Net present value
Internal rate of return
All of these models use discounted cash flows

14. Discounted Cash Flow (or DCF)
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.

15. Payback Period
Determines how long it takes for a project to reach a breakeven point
Cash flows should be discounted
Lower numbers are better (faster payback)

16. 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
($200,000) 1
$75,000
($125,000) 2
($50,000) 3
$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.

17. Payback Method Advantages/Disadvantages
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
How do you decide on the maximum allowable payback period?

18. Time Value of Money
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

19. Net Present Value (NPV)
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.
Higher NPV values are better!
A positive value indicate the firm will make money

20. Discount factor NPV takes into account a discount factor
The discount factor is simply the reciprocal of the discount rate

21. Net Present Value Example
Should 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
-$60,000
1.0000
-$60,000.00 1
$15,000
0.9009
$13,513.51 2
0.8116
$12,174.34 3
0.7312
$10,967.87 4
0.6587
$9,880.96 5
0.5935
$8,901.77
-$4,561.54
The NPV column total is negative, so don’t invest!

22. Internal Rate of Return (IRR)
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
Higher IRR values are better!

23. 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
-$40,000
1.0000
-$40,000.00 1
$14,000
0.8696
$12,173.91 2
0.7561
$10,586.01 3
0.6575
$9,205.23 4
0.5718
$8,004.55
-$30.30
This table has been calculated using a discount rate of 15%
Actual IRR is %
The project doesn’t meet our 17% requirement and should not be considered further.

24. 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

25. Keys to Successful Project Portfolio Management
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

26. Problems in Implementing Portfolio Management
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

27. Projects selection can be company saving or killing
Eclipse 500
Airbus A380
Tiny? 6 passengers
Boeing 787 Dreamliner
Jumbo? between 550 to 800 passengers
Midsize? between 290 to 330 passengers

28. Chapter 3 Review and Discussion
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?
What are the benefits and drawbacks of project checklists for screening alternatives?
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?
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.
How are financial models superior to other screening models? How are they inferior?
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29. Chapter 3 Review and Discussion
How does the options model address the problem of non-recoverable investment in a project?
What advantages do you see in the GE Tollgate screening approach? What disadvantages do you see? How would you alter it?
Why is project portfolio management particularly challenging in the pharmaceutical industry?
What are the keys to successful project portfolio management?
What are some of the key difficulties is successfully implementing portfolio management practices?
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30. In-class exercise
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?