Download Chapter 3

Project Selection and
Portfolio Management
03-01
Chapter 3 Learning Objectives
After completing this chapter, students will be able to:
 Explain six criteria for a useful projectselection/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
03-02
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
03-03
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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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
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-05
Approaches to Project Screening
Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
Financial models
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-06
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
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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 weights for criteria
 a score assigned for each criteria
Score   (Weight  Score)
Relative scores can be misleading!
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-08
Analytic Hierarchy Process
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
numeric evaluations and weights
Unlike the simple scoring model, these scores can be
compared!
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03-09
FIGURE 3.1 Sample AHP with Rankings for Salient Selection Criteria
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03-10
Profile Models
Show risk/return options for projects.
X7
X6
Maximum
Desired Risk
Criteria
selection as
axes
Risk
X2
X4
X5
Efficient Frontier
X3
X1
Minimum
Desired Return
Rating each
project on
criteria
Return
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
Figure 3.4
03-11
Efficient Frontier
Figure 3.5
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03-12
Financial Models
Based on the time value of money principal
 Payback period
 Net present value
 Internal rate of return
 Options models
All of these models use discounted cash flows
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03-13
Payback Period
Determines how long it takes for a project
to reach a breakeven point
Investment
Payback Period 
Annual Cash Savings
Cash flows should be discounted
Lower numbers are better (faster payback)
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-14
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
25, 000
3
 2.67 years
75, 000
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
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.
03-15
Net Present Value
Projects the change in the firm’s stock value if a project
is undertaken.
Ft
NPV  I o  
(1  r  pt )t
where
Ft = net cash flow for period t
Higher NPV
values are better!
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-16
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.
Year
0
Net flow Discount
-$60,000 1.0000
NPV
-$60,000.00
1
2
3
$15,000
$15,000
$15,000
0.9009
0.8116
0.7312
$13,513.51
$12,174.34
$10,967.87
4
5
$15,000
$15,000
0.6587
0.5935
$9,880.96
$8,901.77
-$4,561.54
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
The NPV
column total
is negative,
so don’t
invest!
03-17
Internal Rate of Return
A project must meet a minimum rate of return
before it is worthy of consideration.
t
ACFt
IO  
n 1 (1  IRR )t
where
Higher IRR values
are better!
ACFt = 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
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-18
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
NPV
0
-$40,000
1.0000
-$40,000.00
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
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
03-19
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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03-20
Project Portfolio
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FIGURE 3.6 GE’s Tollgate Process
03-21
GE Tollgate Review Process Flow Map
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Figure 3.7
03-22
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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03-23
Pharmaceuticals Development Process
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
Figure 3.8
03-24
Keys to Successful
Project Portfolio Management
Flexible structure and freedom of
communication
Low-cost environmental scanning
Time-paced transition
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03-25
Problems in Implementing
Portfolio Management
 Conservative technical communities
 Out of sync projects and portfolios
 Unpromising projects
 Scarce resources
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-26
Summary
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.
1.
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-27
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.
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-28
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall
03-29