lecture 3 project selection and portfolio management by...

Lecture 3Project Selection and Portfolio Management

By : Prof. Lili Saghafi

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 1

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

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

� 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.

03-02

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


� Recognize the challenges that arise in maintaining an optimal project portfolio for an organization.

� Understand the three keys to successful project portfolio management.

03-03

Project SelectionScreening models help managers pick winners from a pool of projects. Screening models are numeric or nonnumeric and should have:

Realism


Capability

Flexibility

Ease of use

Cost effectiveness

Comparability

03-04

Screening & Selection Issues

� Risk – unpredictability to the firm

� Commercial – market potential

� Internal operating – changes in firm operations


� Additional – image, patent, fit, etc.

All models only partially reflect reality and have both objective and subjective factors imbedded

03-05

Approaches to Project Screening

�Checklist model

�Simplified scoring models


�Analytic hierarchy process

�Profile models

�Financial models

03-06

Checklist Model

A checklist is a list of criteria applied to possible projects.

�Requires agreement on criteria


�Requires agreement on criteria

�Assumes all criteria are equally important

Checklists are valuable for recording opinions and encouraging discussion

03-07

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 criteria

�agreement on weights for criteria

�a score assigned for each criteria

Relative scores can be misleading!

( )Score Weight Score= ×∑

03-08

Analytic Hierarchy Process (AHP)

The AHP is a four step process:

1. Construct a hierarchy of criteria and subcriteria

2. Allocate weights to criteria

3. Assign numerical values to evaluation dimensions

4. Scores determined by summing the products of


4. Scores determined by summing the products of numeric evaluations and weights

Unlike the simple scoring model, these scores can be compared!

The analytic hierarchy process (AHP) is a structured technique for organizing and analyzing complex decisions.

03-09

Watch AHP Software Demo Video

� Watch AHP Software Demo Video

� Watch demo video that presents the use of MakeItRational AHP Software to perform projects prioritization. The process of AHP multi-criteria


prioritization. The process of AHP multi-criteria evaluation would be similar for other applications.

� >> Watch AHP Software Video <<

10

Try AHP Software Online Demo (no

registration required)

� Try MakeItRational AHP Software online demo now. Check available demo projects and build your own model by opening “Blank project” (you will not be able to save it).


to save it).

� Demo starts as online application so you don’t need to install MakeItRational on your computer. All you need to start AHP Software now is Microsoft Silverlight –free web-browser plug-in.

� http://makeitrational.com/analytic-hierarchy-process/ahp-software

11

Analytic Hierarchy Process (AHP)

13

Profile Models

Show risk/return options for projects.

Criteria

selection as

Maximum

Desired Risk

X

X6

X7


selection as axes

Rating each project on criteria

03-14

Ris

k

ReturnMinimum

Desired Return

X1

X4

X2

X3

X5

Efficient Frontier

Figure 3.4

Efficient Frontier

Figure 3.503-15Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall

Financial Models

Based on the time value of money principal

� Payback period

Net present value


� Net present value

� Internal rate of return

� Options models

All of these models use discounted cash flows

03-16

Payback Period

Investment

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)

InvestmentPayback Period

Annual Cash Savings=

03-17

Payback Period ExampleA 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?

Year Cash Flow Cumulative Divide the cumulative 0 ($200,000) ($200,000)

1 $75,000 ($125,000)

2 $75,000 ($50,000)

3 $75,000 $25,000

cumulative amount by the cash flow amount in the third year and subtract from 3 to find out the moment the project breaks even.

25,0003 2.67

75,000years− =

03-18Copyright © 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.

(1 )

t

o t

FNPV I

r p= +

+ +∑


(1 )

t

t

t

t

r p

where

F = net cash flow for period t

R = required rate of return

I = initial cash investment

P = inflation rate during period t

+ +∑

Higher NPV

values are better!

03-19

Net Present Value ExampleShould 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.

Year Net flow Discount NPV

0 -$60,000 1.0000 -$60,000.00

The NPV column total

0 -$60,000 1.0000 -$60,000.00

1 $15,000 0.9009 $13,513.51

2 $15,000 0.8116 $12,174.34

3 $15,000 0.7312 $10,967.87

4 $15,000 0.6587 $9,880.96

5 $15,000 0.5935 $8,901.77

-$4,561.54

column total is negative, so don’t invest!


Internal Rate of ReturnA project must meet a minimum rate of return before it is worthy of consideration.

If you put $1,000 in the bank, the bank pays you interest, and one year later you have $1,042, it is relatively easy to calculate the rate of return is 4.2%. You simply divide the gain of $42 into your original investment of $1,000.

ttACF

IO =∑Higher IRR values


1 (1 )

t

n

t

IOIRR t

where

ACF = annual after tax cash flow for time period t

IO = initial cash outlay

n = project's expected life

IRR = the project's internal rate of return

=

=+

∑Higher IRR values

are better!

03-21

Internal Rate of Return ExampleA 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?

Year Net flow Discount NPV

0 -$40,000 1.0000 -$40,000.00This table has been

1 $14,000 0.9009 $12,173.91

2 $14,000 0.8116 $10,586.01

3 $14,000 0.7312 $9,205.23

4 $14,000 0.6587 $8,004.55

-$30.30

has been calculated using a discount rate of 15%

The project doesn’t meet our 17% requirement and should not be considered further.


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?

03-23

GE Tollgate Review Process Flow Map

A flow charting method that uses general symbols and arrows to

show the flow of the manufacturing process.

03-25Copyright © 2013 Pearson Education, Inc. Publishing as Prentice HallFigure 3.7

Tollgate

� A lesson that marketers can learn from the Six Sigma Methodology is the utilization of the Tollgate.

� The tollgate is use to clearly define measurable objectives that will allow a prospect to pass through


objectives that will allow a prospect to pass through the gate or to the next stage, or be held until the objectives are completed.

26

Project Portfolio ManagementThe systematic process of selecting, supporting, and managing the firm’s collection of projects.

Portfolio management requires:

decision making,


� decision making,

� prioritization,

� review,

� realignment, and

� reprioritization of a firm’s projects.

03-27

Keys to Successful

Project Portfolio Management

�Flexible structure and freedom of communication

Low-cost environmental scanning


�Low-cost environmental scanning

�Time-paced transition

03-29

Problems in Implementing

Portfolio Management

�Conservative technical communities

�Out of sync projects and portfolios


�Unpromising projects

�Scarce resources (A resource with an available

quantity less than its desired use. Scarce resources

are also called factors of production.) 03-30

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


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.

03-31

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.


an optimal project portfolio for an organization.

7. Understand the three keys to successful project portfolio management.

03-32

lecture 3 project selection and portfolio management by...

Documents