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.
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”
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 subjectivefactors imbedded
Approaches to Project Screening • Checklist • Simple scoring models • Analytic hierarchy process • Profile models • Financial models Let’s look at each of these…
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
Example: Simplified Checklist Model For Project Selection Which do you choose? Why? (3) (2) (1) * good place to make use of a rubric
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
Example: Simple Scoring Model Which do you choose? Why?
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 Carhttp://en.wikipedia.org/wiki/Talk:Analytic_Hierarchy_Process/Example_Car
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.
Profile Model X6 Maximum Desired Risk X2 X4 X5 X3 Efficient frontier X1 Minimum Desired Return
Financial Models Based on the time value of moneyprincipal – 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
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.
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)
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? 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.
Payback Method Advantages/Disadvantages • Advantage • 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?
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
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
Discount factor • NPV takes into account a discount factor • The discount factor is simply the reciprocal of the discount rate
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. The NPV column total is negative, so don’t invest!
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!
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% Actual IRR is 14.9625% The project doesn’t meet our 17% requirement and should not be considered further.
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
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
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
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
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?
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?
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?