Presentation on theme: "Project Selection and Portfolio Management"— Presentation transcript:
1 Project Selection and Portfolio Management Chapter 3
2 Learning GoalsExplain 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 opportunitiesScreening models help managers pick winners from a pool of projectsScreening models can be qualitative and simple or quantitative and complexWhen 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 alternativesRisk – unpredictability to the firm, technical, safety, financial, legalCommercial Impact – reflects market potential, ROI, paybackImpact to internal operations – employee training, safety issues, equipment needsAdditional factors – impact on image, patent, strategic fitStrategic direction of the company will highlight certain criteria over othersAll models only partially reflect reality and have both objective and subjective factors imbedded
5 Approaches to Project Screening ChecklistSimple scoring modelsAnalytic hierarchy processProfile modelsFinancial modelsLet’s look at each of these…
6 Checklist ModelA checklist is a list of criteria applied to possible projects.A fairly simple deviceRequires agreement on criteriaAssumes all criteria are equally importantChecklists 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 rubricjimakers.com
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 criteriaagreement on weights for criteriaa 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 modelsSimilar to simplified scoring model except these scores are comparable due to ranking of importanceThe AHP is a four step process:Construct a hierarchy of criteria and subcriteriaAllocate weights to criteria through pairwise comparisonAssign numerical values to qualitative characteristics with a Likert scaleScores determined by summing the products of numeric evaluations and weightsAnalytic Hierarchy Process/Example Car
11 Profile ModelsAllows 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.
13 Financial ModelsBased on the time value of money principal – comparing what a dollar is worth today to another time periodDiscounted cash flow analysisPayback periodNet present valueInternal rate of returnAll 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 PeriodDetermines how long it takes for a project to reach a breakeven pointCash flows should be discountedLower 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?YearCash FlowCumulative($200,000)1$75,000($125,000)2($50,000)3$25,000Divide 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 useEmphasizes the early recovery of capitolCashflow beyond the payback period are uncertain, so they are ignoredDisadvantageIgnores timing of the cash flow within the payback periodEmphasis is on the recovery of capital, not on profitabilityDoes not provide a decision criterion for acceptanceHow do you decide on the maximum allowable payback period?
18 Time Value of MoneyNeeds to be accounted for in the capital investment decisionMain reason: capital could be used for something elseCapital 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.YearNet flowDiscountNPV-$60,0001.0000-$60,000.001$15,0000.9009$13,513.5120.8116$12,174.3430.7312$10,967.8740.6587$9,880.9650.5935$8,901.77-$4,561.54The 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) processHigher 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?YearNet flowDiscountNPV-$40,0001.0000-$40,000.001$14,0000.8696$12,173.9120.7561$10,586.0130.6575$9,205.2340.5718$8,004.55-$30.30This 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 projectsPrioritization of resourcesReview of potential projectsRealignment with strategic fitReprioritization of a firm’s projects
25 Keys to Successful Project Portfolio Management Flexible structure and freedom of communicationCannot be constrained by bureaucracy, poor communication, rigid processesLow-cost environmental scanningFinding a way to “test the waters” before full commitmentMarket testing a number of experimental product prototypesTime-paced transitionHaving a process to transition from one project to another
26 Problems in Implementing Portfolio Management Conservative technical communitiesTechnical reps holding onto projects too longOut of sync projects and portfoliosProjects must stay aligned with the current strategic direction of the firmUnpromising projectsWilling to “kill” a project when it is necessary?Scarce resourcesNo one has unlimited resourcesResources need to be allocated where they are most beneficial
27 Projects selection can be company saving or killing Eclipse 500Airbus A380Tiny? 6 passengersBoeing 787 DreamlinerJumbo? between 550 to 800 passengersMidsize? 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?jimakers.com
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?jimakers.com
30 In-class exerciseGoodAnswers’ controller, Sal Reigh, has negotiated a four-year lease agreement with Columbia Management.Included in the agreement isOption #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?