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ELC 347 project management

Day 5

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Agenda

• Assignment 1 not Graded yet– Will be done by next class

• Assignment 2 Due• Assignment 3 Posted

• Due September 27 @ 12:35

• Quiz 1• October 7• Chapter 1-5• M/C & essay questions

• Integrative Project • part 1 >> Due October 30 (10 more days) • September 27 will be group work

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Project Selection and Portfolio Management

Chapter 3

© 2007 Pearson Education

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Project Selection

Screening 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

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Screening & Selection Issues

• Risk – unpredictability to the firm• Commercial – market potential• Internal operating – changes in firm ops• Additional – image, patent, fit, etc.

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

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Approaches to Project Screening

1. Checklist

2. Simple scoring models

3. Analytic hierarchy process

4. Profile models

5. Financial models

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Checklist Model

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

Requires agreement on criteriaAssumes all criteria are equally important

Checklists are valuable for recording opinions and encouraging discussion

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3.1 SIMPLIFIED CHECKLIST MODEL FOR PROJECT SELECTION Performance on Criteria

High Medium LowProject Criteria

Project Alpha Cost XProfit Potential XTime to Market XDevelopment Risks X

Project Beta Cost XProfit Potential XTime to Market XDevelopment Risks X

Project Gamma Cost XProfit Potential XTime to Market XDevelopment Risks X

Project Delta Cost XProfit Potential XTime to Market XDevelopment Risks X

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Simple 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!

( )Score Weight Score

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Simple Scoring3.2 SIMPLE SCORING MODEL (A) (B) (A) x (B) Importance Weighted Project Criteria Weight Score Score Project Alpha Cost 1 3 3 Profit Potential 2 1 2 Development Risk 2 1 2

Time to Market 3 2 6 Total Score 13 Project Beta Cost 1 2 2 Profit Potential 2 2 4 Development Risk 2 2 4 Time to Market 3 3 9 Total Score 19

simple scoring.xlsx

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Analytic Hierarchy Process

The AHP is a four step process:1. Construct a hierarchy of criteria and subcriteria2. Allocate weights to criteria

1. Weights sum to 1 (normalized)

3. Assign numerical values to evaluation dimensions4. Scores determined by summing the products of

numeric evaluations and weights

Unlike the simple scoring model, these scores are comparable!

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Step 1& 2

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Step 3 & 4

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Profile Models

Show risk/return options for projects. Requires:• Criteria selection as axes• Rating each project on criteria

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Financial Models

Based on the time value of money principal

o Payback periodo Net present valueo Internal rate of returno Options models

All of these models use discounted cash flows

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Payback Period

Cash flows should be discountedLower numbers are better (faster payback)

InvestmentPayback PeriodAnnual Cash Savings

Determines how long it takes for a project to reach a breakeven point

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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?

Year Cash Flow Cumulative

0 ($200,000) ($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.

25,0003 2.67 75,000

years

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Net Present Value

Projects the change in the firm’s stock value if a project is undertaken.

(1 )

to t

t

t

t

FNPV I

r pwhereF = net cash flow for period tR = required rate of returnI = initial cash investmentP = inflation rate during period t

Higher NPV values are

better!

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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 DiscountDiscounted

Flow0 -$60,000 1.0000 -$60,000.001 $15,000 0.9009 $13,513.512 $15,000 0.8116 $12,174.343 $15,000 0.7312 $10,967.874 $15,000 0.6587 $9,880.965 $15,000 0.5935 $8,901.77

-$4,561.54

The NPV column total is -$4561, so don’t invest!

npv.xls

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Internal Rate of Return

A project must meet a minimum rate of return before it is worthy of consideration.

1 (1 )

tt

n

t

ACFIO

IRR twhereACF = annual after tax cash flow for time period tIO = initial cash outlayn = project's expected lifeIRR = the project's internal rate of return

Higher IRR

values are better!

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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?

Year Net flow Discount NPV0 -$40,000 1.0000 -$40,000.001 $14,000 0.8696 $12,173.912 $14,000 0.756144 $10,586.013 $14,000 0.667516 $9,205.234 $14,000 0.571753 $8,004.55

-$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.

irr.xlsx

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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?

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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 $10,000– 0.5*$100,000+0.5*$10,000 = $55,0000/year

• Step two– Wait for more info to improve spread of risk – 70% chance of $100,000– 30% chance of $10,000– 0.7*$100,000+0.3*$10,000 = $73,0000/year

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Option example

Calculations

Rate of Return 0.012

Year Cash flow Discount DCF ∑DCF Year Cash flow Discount DCF ∑DCF0 -$300,000.00 1 -$300,000.00 -$300,000.00 0 1 0 01 $55,000.00 0.988142 $54,347.83 -$245,652.17 1 -$300,000.00 0.988142 -$296,442.69 -$296,442.692 $55,000.00 0.976425 $53,703.39 -$191,948.79 2 $73,000.00 0.976425 $71,279.04 -$225,163.653 $55,000.00 0.964847 $53,066.59 -$138,882.20 3 $73,000.00 0.964847 $70,433.83 -$154,729.824 $55,000.00 0.953406 $52,437.34 -$86,444.86 4 $73,000.00 0.953406 $69,598.65 -$85,131.175 $55,000.00 0.942101 $51,815.55 -$34,629.31 5 $73,000.00 0.942101 $68,773.37 -$16,357.806 $55,000.00 0.93093 $51,201.14 $16,571.83 6 $73,000.00 0.93093 $67,957.87 $51,600.087 $55,000.00 0.919891 $50,594.01 $67,165.84 7 $73,000.00 0.919891 $67,152.05 $118,752.138 $55,000.00 0.908983 $49,994.08 $117,159.92 8 $73,000.00 0.908983 $66,355.78 $185,107.919 $55,000.00 0.898205 $49,401.27 $166,561.18 9 $73,000.00 0.898205 $65,568.95 $250,676.86

10 $55,000.00 0.887554 $48,815.48 $215,376.66 10 $73,000.00 0.887554 $64,791.46 $315,468.31

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Project Portfolio Management

The systematic process of selecting, supporting, and managing the firm’s collection of projects.

Portfolio management requires:decision makingprioritizationreviewrealignmentreprioritization

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GE Model

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ElephantX Model

• A 9 Step process

• 20 questions • Project guide

The 9 steps to successful project implementation

From BD to Operations

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Keys to Successful Project Portfolio Management

Flexible structure and freedom of communication

Low-cost environmental scanning

Time-paced transition

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Problems in Implementing Portfolio Management

Conservative technical communities

Out of sync projects and portfolios

Unpromising projects

Scarce resources