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Project Selection Models

Project Selection Project selection is the process of evaluating individual projects or groups of projects, and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. The proper choice of investment projects is crucial to the long-run survival of every firm. Daily we witness the results of both good and bad investment choices. Decision Models Models abstract the relevant issues about a problem from the plethora of detail in which the problem is embedded. Reality is far too complex to deal with in its entirety. This process of carving away the unwanted reality from the bones of a problem is called modeling the problem. The idealized version of the problem that results is called a model. Models may be quite simple to understand, or they may be extremely complex. In general, introducing more reality into a model tends to make the model more difficult to manipulate. Criteria for Project Selection Model       Realism Capability Flexibility Ease of use Cost Easy computerization

Numeric and Non-Numeric Models Either widely used, many organizations use both at the same time, or they use models that are combinations of the two. Nonnumeric models, as the name implies, do not use numbers as inputs. Numeric models do, but the criteria being measured may be either objective or subjective. It is important to remember that:   The qualities of a project may be represented by numbers, and Subjective measures are not necessarily less useful or reliable than objective measures.

Nonnumeric Models Nonnumeric models are older and simpler and have only a few subtypes to consider.  The Sacred Cow Suggested by a senior and powerful official in the organization, Often initiated with a simple comment such as, “If you have a chance, why don’t you look into . . .,” and there follows an undeveloped idea for a new product, for the development of a new market, for the design and adoption of a global data

Investment in an operating necessity project takes precedence over a competitive necessity project Both types of projects may bypass the more careful numeric analysis used for projects deemed to be less urgent or less important to the survival of the firm. some projects concern potential new products. or until the boss. No precise way to define or measure “benefit.  The Product Line Extension A project to develop and distribute new products judged on the degree to which it fits the firm’s existing product line. If any group has more than eight members. which is an example of this scenario. The rater may use specific criteria to rank each project. and still others cover a variety of subjects not easily categorized (e.base and information system. When all categories have eight or fewer members. “Sacred” in the sense that it will be maintained until successfully concluded. or extends the line in a new. fair. personally. strengthens a weak link. or may simply use general overall judgment. recognizes the idea as a failure and terminates it. a proposal to create a daycare center for employees with small children). or for some other project requiring an investment of the firm’s resources. desirable direction. Again.  Comparative Benefit Model Organization has many projects to consider but the projects do not seem to be easily comparable. Decision makers can act on their beliefs about what will be the likely impact on the total system performance if the new product is added to the line. the order is determined on the basis of relative merit. Sometimes careful calculations of profitability are not required. the projects within each category are ordered from best to worst. fills a gap. For example. Numeric Models: Profit/Profitability . the projects are divided into three groups—good.g. the primary question becomes: Is the system worth saving at the estimated cost of the project?  The Competitive Necessity The decision to undertake the project based on a desire to maintain the company’s competitive position in that market. a project to build a protective dike does not require much formal evaluation. it is subdivided into two categories. If the project is required in order to keep the system operating..  The Operating Necessity If a flood is threatening the plant. others concern computerization of certain records. the Q-Sort is one of the most straightforward. some concern changes in production methods. First. such as fairplus and fair-minus. and poor—according to their relative merits.”  Q-Sort Method Of the several techniques for ordering projects.

A large majority of all firms using project evaluation and selection models use profitability as the sole measure of acceptability. This is just the reverse of the present value concept.∑ Present Value (Cash Costs)  Future Value The future value method evaluates a project based upon the basis of how much money will be accumulated at some future point in time. Models are:       Present & Future Value Benefit / Cost Ratio Payback period Internal Rate of Return Annual Value Variations of IRR  Present Value (PV) The Present value or present worth method of evaluating projects is a widely used technique. the discount rate equals the minimum rate of return for the investment Where: NPV = ∑ Present Value (Cash Benefits) . In this context. The Present Value represents an amount of money at time zero representing the discounted cash flows for the project.  Annual Value .  Net Present Value (NPV) The Net Present Value of an investment it is simply the difference between cash outflows and cash inflows on a present value basis.

When one invests. Simply the number of years required for the cash income from a project to return the initial cash investment. The argument is that a project may have greater net present value if delayed to the future. . it should be rejected.  Payback Period One of the most common evaluation criteria used. it may fail the selection process.Sometimes it is more convenient to evaluate a project in terms of its annual value or cost. one foregoes the value of alternative future investments.  Benefit/Cost Ratio The benefit/cost ratio is also called the profitability index and is defined as the ratio of the sum of the present value of future benefits to the sum of the present value of the future capital expenditures and costs. its value may increase (or decrease) with the passage of time because some of the uncertainties will be reduced. If the investment can be delayed. or cutoff rate established by the firm. Economists refer to the value of an opportunity foregone as the “opportunity cost” of the investment made. a project selection model was developed based on a notion well known in financial markets. If the IRR exceeds the required rate the project should be accepted. For example it may be easier to evaluate specific components of an investment or individual pieces of equipment based upon their annual costs as the data may be more readily available for analysis.   If the value of the project drops. The acceptance or rejection of a project based on the IRR criterion is made by comparing the calculated rate with the required rate of return. its cost is discounted compared to a present investment of the same amount.∑ PV cash outflows = 0 NPV = 0 for r ∑ PV cash inflows = ∑ PV cash outflows In general. Further. The real options approach acts to reduce both technological and commercial risk. the investor gets a higher payoff. The investment decision criteria for this technique suggests that if the calculated payback period is less than some maximum value acceptable to the company. If the value increases. the proposal is accepted.  IRR & Discount Rates Internal Rate of Return (IRR) refers to the interest rate that the investor will receive on the investment principal. the calculation procedure involves a trial-and-error solution. if not. IRR is defined as that interest rate (r) which equates the sum of the present value of cash inflows with the sum of the present value of cash outflows for a project.  Real Option Model Recently. if the investment in a project is delayed. This is the same as defining the IRR as that rate which satisfies each of the following expressions: ∑ PV cash inflows .

and 0 if it does not.  Constrained Weighted Factor Scoring Model Additional criteria enter the model as constraints rather than weighted factors. We would amend the weighted scoring model to take the form: ∑ ∏ Where: Cik equal 1 if the ith project satisfies the kth constraint. Such models vary widely in their complexity and information requirements. These constraints represent project characteristics that must be present or absent in order for the project to be acceptable. a number of evaluation/selection models hat use multiple criteria to evaluate a project have been developed. it takes the form ∑ Where The total score of the ith project. In general.  Weighted Factor Scoring Model When numeric weights reflecting the relative importance of each individual factor are added. . We might have specified that we would not undertake any project that would significantly lower the quality of the final product (visible to the buyer or not). The score of the ith project on the jth criterion. and The weight of the jth criterion. we have a weighted factor scoring model. particularly their focus on a single decision criterion.Numeric Models: Scoring In an attempt to overcome some of the disadvantages of profitability models. depending on whether or not it qualifies for an individual criterion. Some factors to consider      Production Factors Marketing Factors Financial Factors Personnel Factors Administrative and miscellaneous Factors  Unweighted 0–1 Factor Model A set of relevant factors is selected by management and then usually listed in a preprinted form. One or more raters score the project on each factor. The examples discussed illustrate some of the different types of numeric scoring models.

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