PROJECT EVALUATION/SELECTION

Project ManagementM.Tech – III Sem

Steps in project evaluationEstimate project cash – flows.Establish the cost of capital.Apply a suitable decision or

appraisal criterion.

PROJECT CASH FLOW

Project Cash FlowBasic principlesComponentsExample

Basic PrinciplesIncremental principlesLong-term funds principlesExclusion of financial cost

principlesPost-tax principle.

Incremental principlesProject cash flow for ith year = {cash flow of the firm with the project for ith year

} – {cash flow of the firm without the project for ith

year }Guidelines: Consider all incidental effects – profitability/loss

due to the project on other activities. Ignore sunk costs – already spent for preliminary

works, but not directly connected to the project.(R&D, Market Research, Consultant’s Fees)

Include Opportunity cost – resources already available with the firm like land, equipment can be used for project with opp. Cost.

Allocation of Overhead: indirect expenses.

Net Working CapitalChange in Net Working Capital--

Net working capital is defined as current assets minus current liabilities.

Investment in working capital is a cash outflow during the year in which investment takes place

Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

Long – term funds principleFocused on the profitability of

long term funds like equity stockholders, preference stockholders, debentures etc.,

The sacrifice made by suppliers of long term funds is equal to the outlays on fixed assets and net working capital.

Benefits: Operational cash inflows after taxes and salvage value of fixed assets and net working capital.

Exclusion of Financial CostsThe interest on long term debt is

ignored, while computing profit.The expected dividends are

deemed irrelevant in cash flow analysis.

Post-tax principleTax must be properly deducted in

deriving the cash flow.Cost of capital is also included in

post-tax terms.

Components of cash flowInitial InvestmentOperating cash inflowsTerminal Cash flow

Initial InvestmentNew Project Replacement

Project

Cost of capital assets + Installation costs + working capital Margin + preliminary and pre-operative expenses – Tax shield on capital assets

Cost of replacement capital assets + Installation costs – post tax proceeds from the sale of old capital assets + change in working capital Margin + preliminary and pre-operative expenses* – Tax shield on replacement capital assets* Usually NA for replacement projects

Operating cash inflows

New Project Replacement Project

Profit after Tax + Depreciation + Other non-cash charges +Interest on long term debt(1-tax rate)

Change in Profit after Tax + Change in Depreciation + Change in Other non-cash charges + Change in Interest on long term debt(1-tax rate)

Terminal Cash flows

New Project Replacement Project

Post tax proceeds from the sale of capital assets + Net recovery of working capital margin

Post tax proceeds from the sale of replacement capital assets + Net recovery of working capital margin- Post-tax proceeds from the sale of present capital assets.

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Developing Project Cash Flow Statement

Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expensesTaxable incomeIncome taxesNet income

Cash flow statement

+ Net income+Depreciation

-Capital investment+ Proceeds from sales of depreciable assets- Gains tax- Investments in working capital+ Working capital recovery

+ Borrowed funds-Repayment of principal Net cash flow

Operatingactivities

Investing activities

Financingactivities

+

+

EXAMPLE

COST OF CAPITAL

Cost of CapitalRate of return on investments for the

market value of the firm to remain unaffected.

Components:Equity capitalPreference capitalLong-term debt capital

Firm’s cost of capital is the weighted arithmetic average of the post tax cost of various sources of long term finance used by it.

Conditions to evaluate new investments

Risk of new investment proposal is the same as the risk of existing investments.

Capital structure of the firm will not be affected by the investment proposal.

MiscoceptionsThis concept is too academic or

impractical.Cost of equity is equal to dividend rate or

return on equity.Retained earnings are cost free/lesser

than external equity.Depreciation has no cost.Cost of capital can be defined in terms of

an accounting based measure.If a project is heavily financed by debt , its

weighted average cost of capital is low.

PROJECT SELECTION

Strategic Management and Project Selection

Maturity of Project ManagementCriteria for PS ModelsNature of PS ModelsTypes of PS ModelsUncertainty Analysis and Risk

ManagementInformation Base for PS ModelsProject Portfolio Process (PPP)Project Proposal

Overview of PS Process

Project Management Office (PMO): Aligning corporate needs and project goals

Project Selection: Choose candidate project using Evaluation Criteria

Dealing with Uncertainty: Risk Analysis

Strategically selecting best Projects: Project Portfolio Process (PPP)

Locking up the deal: Writing a Project Proposal

PS Models

Idealized view of realityRepresenting the STRUCTURE of

the problem, not the detailDeterministic or stochastic

Criteria for Project Selection models

Realism (technical-, resource-, market-risk)

Capability (adequately sophisticated)Flexibility (valid results over large

domain)Ease of Use (no expert needed to run

model)Cost (much less than project benefit)Easy Computerization (use standard

software)

Nature of PS models: Caveats

Project decisions are made by PM --- NOT by PS model!

A PS model APPROXIMATES, but does NOT DUPLICATE reality!

Nature of PS Models: Methodology

Start with detailed list of firm’s goalsCreate list of project evaluation

factors (PEF’s)Weigh every element in PEF listCompute an overall score for project

based on weighted PEF’sSelect project that has the closest

alignment with firm’s goals

Project Evaluation Factors (PEFs)

Production FactorsMarketing FactorsFinancial FactorsPersonnel FactorsAdministrative and Misc. Factors

Types of PS Models: Nonnumeric

Sacred CowOperating

NecessityCompetitive

NecessityProduct Line

ExtensionComparative

Benefit Model

Numeric PS Models: Profit / Profitability

Payback Period (PB)Average Rate of ReturnDiscounted Cash Flow (NPV-net

present value)Internal Rate of ReturnProfitability IndexOther Profitability Models

Numeric PS Models: Scoring

Unweighted 0-1 Factor Model

Unweighted Factor Scoring Model

Weighted Factor Scoring Model

Constrained Weighted Factor Scoring Model

S = ∑(x)

S = ∑(s)

S = ∑(s·w)

S = ∑(s·w) ∏(c)

Choosing the PS Model

Dependent on wishes and philosophy of management

80% of Fortune 500 firms choose “nonnumeric” PS models

Firms with outside funding often chose scoring PS models

Firms without outside funding often chose profit / profitability PS models

Management of Risk: Terminology

Risk: Decision based on complete information about the probability of each possible outcome.

Uncertainty: Decision based on incomplete or insufficient data.

Game: Decision based under conditions of conflict.

Areas of Uncertainty

Project timing & expected cash flow.

Direct outcome of project, i.e. what exactly will the project accomplish

Side effects and unforeseen consequences of project

Window-of-Opportunity Analysis

Estimate IN ADVANCE economic impact of innovation before R&D is undertaken

Set up a baseline of current process as the sum of all current sub processes

Compute cost / performance of new innovation as a multiple of each sub process in the baseline system

Problems Affecting Data Used in PS Models

Accounting: arbitrary assignment of overhead costs, linear cost and revenue forecasts

Measurements: (subjective vs. objective), (quantitative vs. qualitative), (reliable vs. unreliable), (valid vs. invalid)

Technology shock: New technology has to overcome initial resistance threshold.

PROJECT PORTFOLIO

Project Portfolio Process (PPP)

Step 1: Establish a Project CouncilStep 2: Identify Project Categories &

CriteriaStep 3: Collect Project DataStep 4: Assess Resource AvailabilityStep 5: Reduce Project and Criteria SetStep 6: Prioritize Projects within

CategoriesStep 7: Prioritize the projects within

categoriesStep 8: Implement the Process

Project Proposal: Content

Cover letterExecutive summaryDescription and past experience of

project teamNature of technical problem to be

solvedHow to approach solution of technical

problemPlan for implementation of projectPlan for logistic support and

administration

Project Proposal:Cover letter & Executive summary

Compose a cover letter as key marketing instrument

Explain fundamental nature and general benefits of project

Minimally technical language

Project Proposal:Past Experience of Project Team

List all key project personnel with titles and qualifications

Include full resume of each principal

Provide all pertinent references

Project Proposal:Technical Approach

General description of problem to be addressed or project to be undertaken

Major subsystems of problem or project

Methodology of solving the problem

Special client requirementsTest and inspection procedures

Project Proposal:Implementation Plan

Estimates of time, cost and materials for each subsystem and the whole project

Establish major milestones to break project into phases

List equipment, overhead and administrative cost

Develop contingency plans (incl. slack time)

Project Proposal:Plan for Administration and Logistic Support

Control over subcontractorsNature and Timing of all reports

(progress, budget, audits)Change managementTermination Procedures“touch of class” capabilities

(artist’s renderings, meeting facilities, video conferencing, computer graphics)