Chapter_3

Project Selection &Portfolio Management

By
Dr. Doaa Saleh
Objectives

1. Project Selection
2. Approaches to Project Screening and Selection
3. Financial Models
4. Project Portfolio Management
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

 Managers often use decision-aiding models to extract the relevant issues

of a problem from the details in which the problem is embedded

 Models represent the problem’s structure and can be useful in selecting

and evaluating projects
 Selection Models

Organizational decision makers develop guidelines —selection models— that permit

them to:
● Save time.
● Save money.
● Maximize the likelihood of success.

They come in two different classes:

● Numeric [Objective or Subjective Values]
● Nonnumeric [Data other than numbers]
Models Evaluation Criteria
Realism
Model must reflect Model must be flexible and robust
organization’s objectives,
resources, and risks.
Flexibility
Model should be easily modified
in case of changes in exchange
rates, tax laws, etc.
Cost
Model should be
cost-effective.
Capability
enough to allow the company to
use it as widely as possible.
Ease of Use
Model must be simple enough
to be used by people in all
areas of the organization.
Comparablity
Model must be broad enough to
be applied to multiple projects.
Nature of Project Selection Models

 Models do not give any decision

 Partially represent the reality

 Issues in Project Selection
The list of factors that can be considered when
evaluating project alternatives is enormous

The list of factors that can be considered when

evaluating project alternatives is enormous: Vital Issues
●
●
Risk Factors
Commercial Factors
20%
● Internal operation issues

80%
But in reality the strategic direction emphasized
by top management often highlights certain
criteria over others, for many projects, less than
Trivial Issues
20% of all possible decision criteria account for
over 80% of the decision about whether to
pursue the project.
Pareto’s 80/20 principle
 Screening & Selection Issues

•The list of factors that can be considered when evaluating project alternatives is
enormous.
1. Risk – unpredictability to the firm
2. Commercial – market potential
3. Internal operating – changes in firm operations
4. Additional – image, patent, fit, etc.

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Project Selection Models

1. Scoring Models
Unweighted 0-1 Factor Model
Checklist model
Unweighted Factor Scoring Model

Weighted Factor Scoring Model

Simplified scoring models

2. Analytic hierarchy process

3. Profile models
4. Financial models 3-10
Checklist Model: 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, depending
whether or not it qualifies for an individual criterion.

 The criteria for choices are:

 A clear understanding of organizational goals
 A good knowledge of the firm’s potential project portfolio
 Advantage of this model is that it uses several criteria.
 Disadvantages are that it assumes all criteria are of equal importance
and it allows for no gradation of the degree to which a specific project
meets the various criteria.
3-11
Checklist Model: Unweighted 0-1 Factor Model

Project Criteria Qualifies Not Qualifies

A Payoff Potential x
Lack of Risk x
Safety x
Competitive x
Advantage
Total Score 3 1

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Checklist Model: Unweighted 0-1 Factor Model

Simplified Checklist Model for Project Selection

3-13
Checklist Model: Unweighted Factor Scoring Model

 This model is used by constructing a simple linear measure of the degree to

which the project being evaluated meets each of the criteria.
 Often a five-point scale is used to evaluate the project.
 A variant of this selection process might choose the highest scoring project.
 The criteria are all assumed to be of equal importance.

3-14
Checklist Model: Unweighted Factor Scoring Model

Project Project A Project B Project C Project D

Criteria
A Payoff High Low Medium High
Potential
Lack of Risk Low Medium Medium High
Safety High Medium Low Medium
Competitive Medium Medium Low Medium
Advantage

High = 3
Medium = 2
Low = 1
3-15
Checklist Model: Unweighted Factor Scoring Model

Project Project A Project B Project C Project D

Criteria
A Payoff 3 1 2 3
Potential
Lack of Risk 1 2 2 3
Safety 3 2 1 2
Competitive 2 2 1 2
Advantage
Total 9 7 6 10

3-16
Simplified Scoring Models
(Weighted Factor Scoring Model)
•In the simplified scoring model, each criterion is ranked
according to its relative importance.
• Our choice of projects will thus reflect our desire to
maximize the impact of certain criteria on our decision.

3-17
Simplified Scoring Models

Each project receives a score that is the

weighted sum of its grade on a list of criteria.
Scoring models require:
1. agreement on criteria
2. agreement on weights for criteria
3. a score assigned for each criteria

Score   (Weight  Score)

Relative scores can be misleading!
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3-18
Project Management Project Selection
Simplified Scoring Models

3-19
3-19
 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!

3-20
 3- AHP Model

First Step: Structuring the Hierarchy of Criteria.

Note: Subdividing relevant criteria into a meaningful

hierarchy gives managers a rational method for
sorting among and ordering priorities.
 3- AHP Model

Second Step: Allocating Weights to Criteria.

Pairwise comparison approach: Every criterion is

compared with every other criterion.

The hierarchical allocation of criteria and splitting of

weights resolves the problem of double counting in
scoring models.

Finance received a weighting value of 52%, which was

split between Short-term benefits (30%) and Long-term
benefits (70%). This configuration means that long-term
financial benefits receives an overall weighting of (0.52)
×(0.7) =36.4%.
 3- AHP Model

Third Step: Assigning Numerical Values to Evaluation

Dimensions

Once the hierarchy is established, we can use the

Pairwise comparison approach to assign numerical
values to the dimensions [Poor, Fair, Good, Very Good,
and Excellent] of our evaluation.

With the AHP approach, the “best” outcome receives a

perfect score of 1.00 and all other values represent
some proportion relative to that score.
 3- AHP Model

Fourth Step: Evaluating Project Proposals

Multiply the numeric evaluation of the project by the

weights assigned to the evaluation criteria and then
add the results for all criteria.

Example on Aligned project:

(.1560)(.3) +(.3640)(1.0) +(.1020)(.3) +(.1564)(1.0) +
(.0816)(.3) +(.140 0)(1.0) =.762

Note: Although Aligned and Not Aligned projects received an

equal number of Excellent and Good rankings, the Aligned
project was clearly preferable because it was rated higher on
criteria viewed as more important and thus more heavily
weighted.
 4- Profile Models
In the following example we notice that:
● X2 is eliminated because X3 brings same
return but with lesser risk.
● X4 is also eliminated because X5 has same
risk value but with more return.
● So that leaves us with Efficient Frontier [the
set of project portfolio options that offers
either a maximum return for every given
level of risk or the minimum risk for every
level of return] to be (X3,X5)
Six project alternatives are plotted on a graph
showing perceived Risk on the y-axis and potential
Return on the x-axis. There’s a maximum risk and
minimum return.
 03
Finanical
Models
 Common Financial Models

Discounted Cash Flow Internal Rate of

Analysis Return
Used to calculate the What rate of return will
Payback Period Net Present Value this project earn?

Most popular one. It

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

They all depend on Time Value of Money which

suggests that money earned today is worth more
than money we expect to earn in the future.
 1-Discounted CashFlow Analysis
The goal of the discounted cash flow (DCF) method is to estimate cash outlays and expected cash
inflows resulting from investment in a project.

Payback Period: The estimated amount of time that will be necessary to recoup the investment in a
project.

Payback period =investment/annual cash savings

Note: that the above formula only works in simple circumstances when
cash flows (or annual cash savings) are the same for each year, when
the annual cash flow is unequal we calculate the cumulative cash flow:

Cumulative cash-flow (CF) =(Initial investment) + CF

(year 1) +CF (year 2) +…

Breakeven point: represents the amount of time necessary

to recover the initial investment of capital in the project.
Example
Our company wants to determine which of two project alternatives is the more attractive
investment opportunity by using a payback period approach. We have calculated the initial
investment cost of the two projects and the expected revenues they should generate for us (see
Table 3.5).
Which project should we invest in?
 Example
Cumulative Cash Flow for Project A =
Year 0 : -$500,000
Year 1 : -$500,000 +$50,000 =-$450,000
Year 2 :-$450,000 +$150,000=-$300,000
Year 3 : -$300,000 +$350,000 =$50,000
Year 4 : $50,000 +$600,000 =$650,000
Year 5 : $650,000 +$500,000 =$1,115,000

Year 2 is the last year with negative cash flow, so the

payback period equation is:
2 +(300,000 / 350,000) =2.857
So the payback period is 2.875 years.
 Example
Cumulative Cash Flow for Project B =
Year 0 : -$500,000
Year 1 : -$500,000 +$75,000 =-$425,000
Year 2 : -$425,000 +$100,000 =-$325,000
Year 3 : -$320,000 +$150,000 =-$175,000
Year 4 :-$175,000 +$150,000=-$25,000
Year 5 : -$25,000 +$900,000 =$875,000

Year 4 is the last year with negative cash flow, so the

payback period equation is:
4 +(25,000 / 900,000) =4.028
So the payback period is 4.028 years.

Payback for A < B so we choose A.

 2- Net Present Value

NPV calculation consists of construction of a table listing:

● The outflows
● The inflows
● The discount rate
● The discounted cash flows across the relevant time
periods
 Example
Assume that you are considering whether or not to invest in a project that will
cost $100,000 in initial investment. Your company requires a rate of return of
10%, and you expect inflation to remain relatively constant at 4%.
You anticipate a useful life of four years for the project and have projected
future cash flows as follows:
Year 1: $20,000
Year 2: $50,000
Year 3: $50,000
Year 4: $25,000
 Example
Discount Factor
NPV at year 0 =-$100,000
NPV at year 1 =$20,000 * (1/(1 +.10 +.04)^1 ) =$17,544
NPV at year 2 =$50,000 * (1/(1 +.10 +.04)^2 ) =$38,475
and so on..

Total NPV =Summation of all NPVs =$4,567

Net flows: the difference between inflows and

outflows
Discount factor: the reciprocal of the
discount rate (1/(1 +r +p) t )
 Pros & Cons
Advantages
● It allows firms to link project
alternatives to financial
performance, ensuring that the
projects a company chooses to
invest its resources in are likely
to generate profit.
Disadvantages
● The difficulty in using NPV to make
accurate long-term predictions due to
constant changes in interest rates,
etc..
 Discounted Payback Period
A simple example will illustrate the difference
between straight payback and discounted
payback methods.
Suppose we require a 12.5% return on new
investments, and we have a project opportunity
that will cost an initial investment of $30,000 with
a promised return per year of $10,000.
Under the simple payback model, the initial
investment should be paid off in only three years.
However, as Table 3.9 demonstrates, when we
discount our cash flows at 12.5% and start
adding them, it actually takes four years to pay
back the initial project investment.
 3- Internal Rate of Return

The IRR is found through a straightforward process, although it

requires tables representing present value of an annuity in order
to determine the project’s rate of return. Alternatively, many
pocket calculators can determine IRR quickly.

If the IRR is greater than or equal to the company’s required rate

of return, the project is worth funding.
 Example
Suppose that a project required an initial cash investment of $5,000 and was
expected to generate inflows of $2,500, $2,000, and $2,000 for the next three
years. Further, assume that our company’s required rate of return for new
projects is 10%.

The question is: Is this project worth funding?

 Example
Solution: Answering this question requires four steps:

1. Pick an arbitrary discount rate and use it to determine the net present
value of the stream of cash inflows.
2. Compare the present value of the inflows with the initial investment; if
they are equal, you have found the IRR.
3. If the present value is larger (or less than) than the initial investment,
select a higher (or lower) discount rate for the computation.
4. Determine the present value of the inflows and compare it with the initial
investment. Continue to repeat steps 2–4 until you have determined the
IRR.
 Example
Try 12%:

Decision: Present value difference at 12% is 250.50, which is too high.

Try a higher discount rate.
 Example
Try 15%:

Decision: Present value difference at 15% is $3, which suggests that

15% is a close approximation of the IRR.

15% > 10% so take the project.

 Pros & Cons
Advantages
● It’s ability to compare alternative
projects from the perspective of
expected return on investment
(ROI). Projects having higher IRR
are generally superior to those
having lower IRR.
Note: NPV is more robust than IRR.
Disadvantages
● It’s not the rate of return for a project.
In fact, the IRR equals the project’s
rate of return only when project-
generated cash inflows can be
reinvested in new projects at similar
rates of return.
 Options Models

Let’s say that a firm has an opportunity to build a power plant in a

developing nation. The investment is particularly risky:
The company may ultimately fail to make a positive return on its investment and may fail to
find a buyer for the plant if it chooses to abandon the project. Both the NPV and IRR
methods fail to account for this very real possibility—namely, that a firm may not recover
the money that it invests in a project.

Clearly, however, many firms must consider this option when making investment decisions.
An organization facing this possibility should determine two things:
1. Whether it has the flexibility to postpone the project
2. Whether future information will help in making the decision
 04
Project
Portfolio
Management
 Project Portfolio Management

It is the systematic process of selecting, supporting, and managing a

firm’s collection of projects.

Project portfolio management poses a constant challenge between balancing long-term

strategic goals and short-term needs and constraints. Managers routinely pose such
questions as the following:

•What projects should the company fund?

•Does the company have the resources to support them?
•Do these projects reinforce future strategic goals?
•Does this project make good business sense?
•Is this project complementary to other company projects?
 PPM Tasks
Decision Making Prioritization
Influenced by market Criteria: Cost, Opportunity, Top
conditions, capital availability, Management Pressure, Risk,
perceived opportunity, and Strategic “fit”, Desire for Portfolio
acceptable risk. balance.

Review
Projects selected for the firm’s
portfolio are the ones that,
based on priorities, offer
maximum return.
Realignment
When portfolios are altered by
the addition of new projects,
managers must reexamine
company priorities.

RePrioritzation
If strategic realignment means
shifting the company’s focus, then
managers must also reprioritize
corporate goals and objectives.