Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Day 6

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Copyright 2005 Prentice HallCh 1 -2 Agenda Questions? Assignment 2 Due Assignment 3 Posted Read Case Study 3.1, Keflavik Paper Company one page 103, and Case Study 3.2, Project Selection at Nova Western on page 104, Inc Due September 30 prior to class IP part 1 due September 26 (Next Class). Project Selection and Portfolio Management IP Group Work

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Project Selection and Portfolio Management 03-03

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Chapter 3 Learning Objectives After completing this chapter, students will be able to: 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

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Chapter 3 Learning Objectives After completing this chapter, students will be able to: 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

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Approaches to Project Screening 1. Checklist model 2. Simplified scoring models 3. Analytic hierarchy process (easier than it sounds) 4. Profile models 5. Financial models 03-06

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Checklist Model A checklist is a list of criteria applied to possible projects. Requires agreement on criteria Assumes all criteria are equally important Checklists are valuable for recording opinions and encouraging discussion 03-07

3-8 Table 3.2 SIMPLIFIED CHECKLIST MODEL FOR PROJECT SELECTION Performance on Criteria HighMediumLow ProjectCriteria Project AlphaCost X Profit PotentialX Time to MarketX Development RisksX Project BetaCostX Profit PotentialX Time to Market X Development RisksX Project GammaCost X Profit Potential X Time to MarketX Development Risks X Project DeltaCostX Profit PotentialX Time to Market X Development RisksX

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 Relative scores can be misleading! 03-09

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3-10 Simple Scoring simple scoring.xlsx

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Analytic Hierarchy Process The AHP is a four step process: 1. Construct a hierarchy of criteria and sub-criteria 2. Allocate weights to criteria 1.  Criteria weights = 1 2.  sub-criteria weights = criteria weight 3. Assign numerical values to evaluation dimensions 4. Scores determined by summing the products of numeric evaluations and weights Unlike the simple scoring model, these scores can be compared!

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3-12 Step 1& 2

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3-13 Step 3 & 4

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Profile Models Show risk/return options for projects. Criteria selection as axes Rating each project on criteria Risk Return Maximum Desired Risk Minimum Desired Return X1X1 X4X4 X2X2 X3X3 X6X6 X5X5 Efficient Frontier X7X7 Figure 3.4 More Desirable

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Efficient Frontier Figure Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall X5X5 X 6

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Financial Models Based on the time value of money principal Payback period Net present value Internal rate of return Options models DCF Example.xlsx All of these models use discounted cash flows 03-16

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Payback Period Cash flows should be discounted Lower numbers are better (faster payback) Determines how long it takes for a project to reach a breakeven point 03-17

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 0($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 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall

Net Present Value Projects the change in the firm’s stock value if a project is undertaken. Higher NPV values are better! 03-19

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 flowDiscountNPV 0-$60, $60, $15, $13, $15, $12, $15, $10, $15, $9, $15, $8, $4, The NPV column total is negative, so don’t invest! Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall npv.xls

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Internal Rate of Return A project must meet a minimum rate of return before it is worthy of consideration. Higher IRR values are better!

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall IRR Calculations IRR calculations is the dame process as NPV except Vary the discount rate such that NPV = 0 IF NPV is negative Discount rate is too high If NPV is positive Discount rate is too low Keep varying untill NPV is close enough to Zero Quick Check method Do NPV with target rate If NPV is negative  NO GO If NPV is postive  Go 22

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 0-$40, $40, $14, $12, $14, $10, $14, $9, $14, $8, $30.30 This table has been calculated using a discount rate of 15% The project doesn’t meet our 17% requirement and should not be considered further Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall irr.xlsx

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Options Models NPV and IRR methods don’t account for failure to make a positive return on investment. Options models allow for this possibility. Options models address: 1. Can the project be postponed? 2. Will future information help decide? 03-24

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3-25 Option Example Premise $300,000 investment with 12% ERR and 10 year life Step one Calculate NPV using known spread of risk 50% chance of $100,000 50% chance of $10, *$100, *$10,000 = $55,0000/year Step two Wait for more info to improve spread of risk 70% chance of $100,000 30% chance of $10, *$100, *$10,000 = $73,0000/year

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3-26 Option example Options.xlsx

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Project Portfolio FIGURE 3.6 GE’s Tollgate Process

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall GE Tollgate Review Process Flow Map Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 3.7

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Project Portfolio Management The systematic process of selecting, supporting, and managing the firm’s collection of projects. Portfolio management requires: decision making, prioritization, review, realignment, and reprioritization of a firm’s projects

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Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Pharmaceuticals Development Process Figure 3.8 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall

Keys to Successful Project Portfolio Management (Brown & Eisenhardt)  Flexible structure and freedom of communication  Low-cost environmental scanning  Time-paced transition 03-32

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Problems in Implementing Portfolio Management  Conservative technical communities  Out of sync projects and portfolios  Unpromising projects (HD-DVD vs Blu-ray)  Scarce resources 03-33

3-34 ElephantX Model A 9 Step process 20 questions Project guide

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Summary 1. Explain six criteria for a useful project-selection screening model. 2. Understand how to employ checklists and simple scoring models to select projects, including the recognition of their strengths and weaknesses. 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

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Summary 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

03-37 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall