4 Project Selection Realism Capability Flexibility Ease of use Screening models help managers pick winners from a pool of projects. Screening models are numeric or nonnumeric and should have:RealismCapabilityFlexibilityEase of useCost effectivenessComparability
5 Screening & Selection Issues Risk – unpredictability to the firmCommercial – market potentialInternal operating – changes in firm opsAdditional – image, patent, fit, etc.All models only partially reflect reality and have both objective and subjective factors imbedded
7 Checklist ModelA checklist is a list of criteria applied to possible projects.Requires agreement on criteriaAssumes all criteria are equally importantChecklists are valuable for recording opinions and encouraging discussion
8 3.1 SIMPLIFIED CHECKLIST MODEL FOR PROJECT SELECTION Performance on CriteriaHigh Medium LowProject CriteriaProject Alpha Cost XProfit Potential XTime to Market XDevelopment Risks XProject Beta Cost XProfit Potential XTime to Market XDevelopment Risks XProject Gamma Cost XProfit Potential XTime to Market XDevelopment Risks XProject Delta Cost X
9 Simple Scoring ModelsEach 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 criteriaRelative scores can be misleading!
11 Analytic Hierarchy Process The AHP is a four step process:Construct a hierarchy of criteria and subcriteriaAllocate weights to criteriaWeights sum to 1 (normalized)Assign numerical values to evaluation dimensionsScores determined by summing the products of numeric evaluations and weightsUnlike the simple scoring model, these scores are comparable!
14 Profile Models Show risk/return options for projects. Requires: Criteria selection as axesRating each project on criteria
15 Financial Models Based on the time value of money principal Payback periodNet present valueInternal rate of returnOptions modelsAll of these models use discounted cash flows
16 Payback PeriodDetermines how long it takes for a project to reach a breakeven pointCash flows should be discountedLower numbers are better (faster payback)
17 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.
18 Higher NPV values are better! Net Present ValueProjects the change in the firm’s stock value if a project is undertaken.Higher NPV values are better!
19 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 flowDiscountDiscountedFlow-$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 -$4561, so don’t invest!
20 Internal Rate of Return A project must meet a minimum rate of return before it is worthy of consideration.Higher IRR values are better!
21 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?This table has been calculated using a discount rate of 15%YearNet flowDiscountNPV-$40,0001.0000-$40,000.001$14,0000.8696$12,173.912$10,586.013$9,205.234$8,004.55-$30.30The project doesn’t meet our 17% requirement and should not be considered further.
22 Options ModelsNPV and IRR methods don’t account for failure to make a positive return on investment. Options models allow for this possibility.Options models address:Can the project be postponed?Will future information help decide?
23 Option Example Premise Step one Step two $300,000 investment with 12% ERR and 10 year lifeStep oneCalculate NPV using known spread of risk50% chance of $100,00050% chance of $10,0000.5*$100, *$10,000 = $55,0000/yearStep twoWait for more info to improve spread of risk70% chance of $100,00030% chance of $10,0000.7*$100, *$10,000 = $73,0000/year
25 Project Portfolio Management The systematic process of selecting, supporting, and managing the firm’s collection of projects.Portfolio management requires:decision makingprioritizationreviewrealignmentreprioritization