Project Selection
Chapter 3, part 1
The need for project selection
Firms and programs are literally bombarded with projects intended to solve
problems or to exploit opportunities …
BUT no organization / funder has infinite resources!
Choices must be made!
Why did UAIC choose P1 and not P2?
European Commission Site,
[Link]
efficiency-45-projects-pre-selected-funding
[Link]
environment-28-projects-selected-funding
Project selection models (1/2)
Made by organizational decision makers
Permit them to save time and money while maximizing the likelihood of success
Characteristics of a good selection model are:
Realism – reflects organizational objectives, includes risks, resources availability
Capability – allows comparison of different type of projects, is robust enough
Flexibility – can be easily modified when needed
Ease of use – simple enough, rapid, easy to understand
Cost – not too expensive to apply
Comparability – broad enough to be applied to multiple projects
Project selection models (2/2)
Can be numeric or nonnumeric
The list of factors that can be considered when evaluating project
alternatives is enormous:
Risk – unpredictability to the firm (technical, financial, safety, quality, legal
exposure etc.)
Commercial – market potential (expected ROI, payback period, potential
market share, long term market dominance, ability to generate future
business/new markets etc.)
Internal operating – changes in firm operations (need to develop/train
employees, changes in workforce size or competition, in physical operations,
manufacturing processes etc.)
Additional – impact on company’s image, patent protection etc.
Approaches to Project Screening and
Selection
Checklist model
Simplified scoring models
Profile models
Financial models
3-7
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
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 criterion
Relative scores can be misleading!
Score (Weight Score)
High 3
Medium 2
Low 1
Time to market 3
Profit potential 2
Development Risk 2
Cost 1
Profile Models
Show risk/return options for projects.
Efficient frontier = set of project portfolio options that offers either a maximum return
for every given level of risk or a minimum risk for every level of return
Financial Models
Based on the time value of money (“money earned today is worth more than
money we expect to earn in the future”)
Payback period
Net present value
Internal rate of return
Options models
All of these models use discounted cash flows
(a bird in the hand is worth two in the bush)
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)
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 Divide the cumulative
amount by the cash
0 ($200,000) ($200,000) flow amount in the
third year and subtract
1 $75,000 ($125,000) from 3 to find out the
2 $75,000 ($50,000) moment the project
breaks even.
3 $75,000 $25,000
25,000
3 2.67 years
75,000
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
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%.
Internal Rate of Return
A project must meet a minimum rate of return before it is worthy of
consideration.
t
ACFt
IO Higher IRR values
n 1 (1 IRR)t are better!
where
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
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?
The project doesn’t meet our 17% requirement
and should not be considered further.
