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**Project Management and Quality Control Fall 2014**

Project EVALUATION & Selection Lecture03 Mwaffaq Otoom & Shadi Alboon 1

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**Overview What is project selection?**

What techniques are used to select projects? Project selection models and evaluation factors Numeric models Nonnumeric models Lecture03 Mwaffaq Otoom

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Project selection Project selection is the process of evaluating individual projects or groups of projects, and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. Managers often use decision-aiding models to abstract the relevant issues about a problem from the plethora of details in which the problem is embedded. Models represent the problem’s structure and can be useful in selecting and evaluating projects. Lecture03 Mwaffaq Otoom & Shadi Alboon

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What Projects to Bid on Company selection of the projects they will bid on is generally based on: Their own expertise and track record Resources they have available Their chance of winning the bid They do not want to waste that effort on bids where they are unlikely to be successful Preparing a bid is expensive! Lecture03 Mwaffaq Otoom & Shadi Alboon

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**Criteria for Project Selection**

Each project has different risks, benefits and costs – often much uncertainty. Companies need to be able to evaluate and select those projects that most closely fit the firm’s strategic objectives – always done in the context of competing for limited resources. Why Project Selection Models? Models abstract the relevant issues about a problem from the plethora of details in which the problem is embedded (Model is a representative of the reality, not the exact replica (reality is more complex) Models help make rational decisions (Models do not make decisions, people do) Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**Criteria for Project Selection Models**

When a firm chooses a project selection model, the following criteria are most important: Realism – The model should take into account the realities of the firm’s limitations on facilities, capital, personnel, and so forth. Capability- The model should be sophisticated enough to deal with multiple time periods, simulate various situations both internal and external to the project (e.g., strikes, interest rate changes), and optimize the decision. Flexibility – The model should have the ability to be easily modified, or to be self-adjusting in response to changes in the firm’s environment (e.g. tax laws change, new technological advancements alter risk levels, and, above all, the organization’s goals change). Ease of Use - The model should be reasonably convenient, not take a long time to execute, and be easy to use and understand. Cost - Data-gathering and modeling costs should be low relative to the cost of the project. Easy Computerization – It must be easy and convenient to gather, store and manipulate data in the model. Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**Nature of Project Selection Models**

Two basic types of project selection models: Numeric models (Use financial metrics such as cash flow, profit … etc.) Nonnumeric models (do not use numbers as inputs into the model, but other data or considerations). If the estimated level of goal achievement is sufficiently large, the project is selected. Two Critical Facts: Models do not make decisions - People do! A model helps in making project selection decisions. All models, however sophisticated, are only partial representations of the reality they are meant to reflect . (Reality is far too complex for us to capture more than a small fraction of it in any model. ) Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**Project Evaluation Factors**

Production Factors Interruptions, learning, process Marketing Factors Customer management issues Financial Factors Return on investment – what is acceptable? Personnel Factors Skills and training, working conditions – what impact on employee motivation? Administrative and Miscellaneous Factors Regulatory standards, ‘strategic fit’ – with what? Lecture03 Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

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Numeric models Models that return a numeric value for a project that can be easily compared with other projects Two major categories of numeric models: Profit/profitability (considered the sole measure of project acceptability) Scoring (multiple criteria for project evaluation/selection are used) Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**Numeric models: Profit/Profitability**

Models that use profitability as the sole measure of project acceptability– there are several models: Payback Period - Initial fixed investment/estimated annual net cash inflows from the project. فترة الاسترداد. Average Rate of Return - Average annual profit/initial or average investment in the project متوسط معدل العائد . Discounted Cash Flow - Also referred to as the Present Value Method التدفق النقدي المخفض Profitability Index – Net present value (NPV) of all future expected cash flows/initial cash investment مؤشر الربحية Lecture03 Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

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**Cash Inflows & Outflows**

Cash Inflow > Cash Outflow Positive Cash Flow Cash Inflow < Cash Outflow Negative Cash Flow Lecture 03 Shadi Alboon & Mohammad Al Bataineh

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**Payback Period example**

The Payback Period = The length of time until the original investment has been recouped (repaid) by the project net cash inflow the number of years required for the project to repay its initial fixed investment Assuming a project costs $100,000 to implement and has annual net cash inflows of $25,000, then the payback period will be The lower the payback period, the less the risk to which the firm is exposed. The major advantage of this model is its simplicity. The major disadvantage is that it does not take into account the time-value of money. Lecture03 Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

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**Payback Period Drawbacks**

Does not consider the time value of money. More difficult to use when cash flows change over time. Less meaningful over longer periods of time (due to the time value of money). It ignores any cash flows beyond the payback period. However, it is relatively simple to calculate & to understand. Lecture03 Mwaffaq Otoom

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**Average Rate of Return (ARR)**

The Average Rate of Return is the ratio of the average annual profit (either before or after taxes) to the initial or average investment in the project. The ARR is NOT the reciprocal of the payback period, because average annual profits are usually not equivalent to net cash inflows. Example: Assuming that the average annual profits of a project are $15,000, then the Average Rate of Return (ARR) is Average annual profit . Project cost The major advantage of this model is its simplicity. The major disadvantage is that it does not take into account the time-value of money. Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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ARR Example Machine A Machine B Cost $56,125 $58,125 Annual estimated income after reduction (profit) Year 1 $3,375 $11,375 Year 2 $5,375 $9,375 Year 3 $7,375 Year 4 Year 5 Total earnings (profits) $36,875 Estimated life 5 years Average Annual Profit = Total earnings / Estimated life in years Machine A: $36,875/5 = $7,375 Machine B: $36,875/5 = $7,375 ARR for Machine A : 7375/56125 = or 13.1% ARR for Machine B : 7375/58125 = or 12.7% Machine A would be preferred as ARR is higher. Lecture 03 Shadi Alboon & Mohammad Al Bataineh

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**Discounted Cash Flow (NPV)**

(Net Present Value): The current worth of a stream of future cash inflows and outflows in today’s dollars, given a specified rate of return (The rate of return is also called: the Discount Rate or Hurdle Rate or Cutoff Rate). Widely used to evaluate projects. Includes the time value of money (the value of money figuring in a given amount of interest for a given period of time). ($1 today>$1 in 10 years) Includes all inflows and outflows, not just the ones through to the payback point. Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**Discounted Cash Flow (NPV)**

Requires a percentage to use to reduce future cash flows – the discount rate. Discount Rate: the rate of return that could be earned on an investment in the financial markets with similar risk. The discount rate may also be known as a hurdle (difficulty) rate or cutoff rate. There will usually be one overall discount rate that is used as the standard for a company (set internally and used to evaluate all projects). Cash flows are likely to vary over the life of a project. Lecture03 Mwaffaq Otoom

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**Calculating Project NPV**

A0 : Initial cash investment (because this is an outflow, it will be negative). Ft : The net cash flow in time period t (negative for outflows) k : The required rate of return (The discount rate) t : The number of years of the period considered A higher NPV is better. The higher the discount rate, the lower the NPV. If the project is successful, cash flows will become positive. Lecture03 Mwaffaq Otoom & Mohammad Al Bataineh

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**NPV with Inflation Rate**

To include the impact of inflation (or deflation), we have where pt : is the predicted rate of inflation during period t. The project is acceptable if the sum of the net present values of all estimated cash flows over the life of the project is positive. Lecture 03 Mwaffaq Otoom & Mohammad Al Bataineh

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NPV example Initial investment of $100,000 with a net cash inflow of $25,000 per year for a period of 8 years, a required rate of return of 15%, and an inflation rate of 3% per year, we have: The present value of the inflows is greater than the present value of the outflow – the NPV is positive. Therefore the project is acceptable! Mwaffaq Otoom & Mohammad Al Bataineh Lecture03

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**Therefore, the NPV(Project) is $65,816.04**

NPV Example A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over 12 months. This project will have an immediate (t=0) cash outflow of 100,000 (which might include machinery, and employee training costs). The monthly net income is depicted in the income statement sheet each for months 1–12. All values are after-tax. The required rate of return is 10%. Therefore, the NPV(Project) is $65,816.04 Lecture 03 A. Al-Tamimi & Mohammad Al Bataineh

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**NPV Example The hurdle rate is 12% k = 0.12.**

The expected rate of inflation to be about 3% p = The Net Present Value of the project is positive and, thus, the project can be accepted. Lecture 03 Mohammed Alsumady

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**Profitability Index (PI)**

PI: is the net present value of all future expected cash flows divided by the initial cash investment. Also known as the benefit–cost ratio. As the value of the PI increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project: If PI > 1 then the project may be accepted. If PI < 1 then the project is rejected. If PI = 1 then this indicates breakeven (التعادل). Lecture 03 Shadi Alboon & Mohammad Al Bataineh

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**Profitability Index: Example **

Given: Investment = $40,000. Life of the Machine = 5 Years. Calculate the NPV and Profitability Index (PI) at 10% discount rate Total Present Value = = $ Net Present Value (NPV) = = $3673 PI = /40000 = > 1 Accept the project! Lecture 03 Mohammed Alsumady

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**Profitability Index: Example **

A Company is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the Profitability Index. Profitability Index (PI) = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows − Initial Investment required Net Present Value = $65M-$50M = $15M. The information about NPV and initial investment can be used to calculate Profitability Index as follows: Profitability Index = 1 + ( Net Present Value / Initial Investment Required ) Profitability Index = 1 + $15M/$65 = 1.3 Lecture 03 Shadi Alboon ©

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**Advantages of Profitability Numeric Models**

The undiscounted models are simple to use and understand. All use readily available accounting data to determine the cash flows. Model output is in terms familiar to business decision makers. With a few exceptions, model output is on an “absolute” profit/profitability scale and allows “absolute” go/no-go decisions. Some profit models account for project risk. Lecture03 Mwaffaq Otoom & Shadi Alboon & Mohammad Al Batainegh

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**Disadvantages of Profitability Numeric Models**

These models ignore all nonmonetary factors except risk. Models that do not include discounting ignore the timing of the cash flows and the time–value of money. Models that reduce cash flows to their present value are strongly biased toward the short run. Payback-type models ignore cash flows beyond the payback period. These models rely on accurate estimations of cash flow (which can be difficult to make). These models cannot deal with a lot of the complexity of the modern firm – reliance on financial data only. Lecture03 Mwaffaq Otoom & Shadi Alboon & Mohammad Al Batainegh

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**Numerical Models: Scoring Models**

Scoring models attempt to overcome some of the disadvantages of probability models by incorporating additional decision criteria. Use multiple criteria to evaluate a project with a score for each criteria. Vary widely in their complexity and information requirements. Some scoring models examples Unweighted 0-1 Factor Scoring Model Weighted Factor Scoring Model Lecture03 Mwaffaq Otoom & Shadi Alboon

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**Unweighted (0-1) factor model**

Uses a set of relevant factors as determined by management. Each factor is weighted the same. Less important factors are weighted the same as important ones. Easy to compute - just total or average the scores. The major disadvantage is that the model assumes that all factors are equally important. Lecture03 Mwaffaq Otoom

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**Unweighted (0-1) Factor Model Example**

Lecture03 Mwaffaq Otoom

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**Weighted Factor Scoring Model**

When numeric weights reflecting the relative importance of each individual factor are added ,we have a weighted factor scoring model. Weighting allows important factors to stand out. A good way to include non-numeric data in the analysis. Factors need to sum to one. All weights must be set up so higher values mean more desirable. Small differences in totals are not meaningful. Lecture03 Mwaffaq Otoom

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**Weighted Factor Scoring Model**

For example we can give a score range (0-5) for some parameters according to certain criteria, such as the importance of each parameter : Meaning Weight Very high importance 5 High importance 4 Medium importance 3 Low importance 2 Very low importance 1 Not important Meaning Weight Very high importance 5 Low importance 2 Not important we can make it easier Lecture03 Shadi Alboon

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**Weighted Factor Scoring Model Example**

Lecture03 Mwaffaq Otoom

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**Weighted Factor Scoring Model Example**

Lecture03 Mwaffaq Otoom

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**Weighted factor scoring model example**

Lecture03 Mwaffaq Otoom

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**Advantages of the Scoring Model**

They allow multiple criteria to be used for evaluation. Weighted models recognize that some criteria are more important than others. Structurally simple and relatively easy to understand. They are a direct reflection of management policy. Easily altered to accommodate change in management policy or priorities. They allow for sensitivity analysis, because trade-off between factors is easily observable. Lecture03 Mwaffaq Otoom

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**Disadvantages of the Scoring Model**

Ease of use can lead to the inclusion of too many criteria. The output of a scoring model is strictly a relative measure rather than an absolute go/no go indication. Unweighted scoring models assume all criteria are of equal importance – this is seldom the case. Lecture03 Mwaffaq Otoom

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Summary Primary selection model criteria are: realism, capability, flexibility, ease of use, and cost. In preparing to use a model, a firm must identify its objectives, weighting them relative to each other, and determining the probable impacts of the project on the firm’s competitive abilities. Models can be numeric or nonnumeric. Lecture03 Mwaffaq Otoom

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Questions 39 Lecture03 Mwaffaq Otoom

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