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CHAPTER 2

PROJECT SELECTION AND


PROJECT PORFOLIO PROCESS

MSc Bui Thu Hien

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Chapter outline

2.1 Project selection


2.2 Project portfolio process (PPP)

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2.1 PROJECT SELECTION

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Problems With Multiple Projects

Delays in one project delays others


Inefficient use of resources
Bottlenecks in resource availability

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Project Results

30 Percent canceled midstream


Over half of completed projects came in
up to190 percent over budget
Over half of completed projects came in
up to 220 percent late

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Challenges

Making sure projects are closely tied to


goals and strategy
How to handle the growing number of
projects?
How to make these projects successful?

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Project Management Maturity

Project management maturity refers to


the mastery of skills required to manage
projects competently
Number of ways to measure
Most organizations do not do well

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Project Selection and Criteria of Choice

Project selection
Evaluating
Choosing
Implementing
Same process as other business
decisions

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Types of Companies

Companies considering projects fall into two


broad categories:
Companies whose core business is completing
projects
Companies whose core business is something else
They can also be broken down as:
Companies looking at projects to do for others
Companies looking at projects to do for themselves

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Model Criteria

Realism
Capability
Flexibility
Ease of use
Cost
Easy computerization

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The Nature of Project Selection Models

Models turn inputs into outputs


Managers decide on the values for the inputs
and evaluate the outputs
The inputs never fully describe the situation
The outputs never fully describe the expected
results
Models are tools
Managers are the decision makers

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Types of Project Selection Models

Nonnumeric models
Numeric models

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Nonnumeric Models

Models that do not return a numeric value


for a project to be compared with other
projects
These are really not models but rather
justifications for projects
Just because they are not true models
does not make them all bad

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Types of Nonnumeric Models

Sacred Cow
A project, often suggested by the top management,
that has taken on a life of its own
Operating Necessity
A project that is required in order to protect lives or
property or to keep the company in operation
Competitive Necessity
A project that is required in order to maintain the
companys position in the marketplace

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Types of Nonnumeric Models Continued

Product Line Extension


Often, projects to expand a product line are
evaluated on how well the new product
meshes with the existing product line rather
than on overall benefits
Comparative Benefit
Projects are subjectively rank ordered based
on their perceived benefit to the company

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Numeric Models

Models that return a numeric value for a


project that can be easily compared with
other projects
Two major categories:
Profit/profitability
Scoring

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Profit/Profitability Models

Models that look at costs and revenues


Payback period
Discounted cash flow (NPV)
Internal rate of return (IRR)
Profitability index
NPV and IRR are the more common
methods

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Payback Period

The length of time until the original


investment has been recouped by the
project
A shorter payback period is better

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Payback Period Example

Project Cost
Payback Period
Annual Cash Flow

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Payback Period Drawbacks

Does not consider time value of money


More difficult to use when cash flows
change over time
Less meaningful for longer periods of
time (due to time value of money)

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Discounted Cash Flow

The value of a stream of cash inflows and


outflows in todays dollars
Also know as discounted cash flow or just
discounting
Widely used to evaluate projects
Includes the time value of money
Includes all inflows and outflows, not just
the ones through payback point
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Discounted Cash Flow Continued

Requires a percentage to use to reduce


future cash flows
This is known as the discount rate
The discount rate may also be known as
a hurdle rate or cutoff rate
There will usually be one overall discount
rate for the company

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NPV Formula

n
Ft
NPV (project) A0
1 k
t
t 1

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NPV Formula Terms

A0 Initial cash investment


Ft Cash flow in time period t (negative for
outflows)
k The discount rate
t The number of years of life
A higher NPV is better
Higher the discount rate lower the NPV

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NPV Example

Our project require $100,000 initial


investment with a net cash inflow of
$25,000 per year for a period of 8 years,
a required rate of return of 15% and an
inflation rate of 3% per year.
8
$25,000
NPV (project) $100,000
t 1 1 0.15 0.03
t

$1,939
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Projects with Unequal Lives

Suppose a firm chooses between two


machines of unequal lives. They are
mutually exclusive. How do you decide
which one to purchase?
In this case, if you use NPV, you will
ignore the fact that you need to buy a
new machine sooner in one case than the
other!
Example
Two machines have the following maintenance expenses
during their lives: (r=10%)

0 1 2 3 4
Machine A -500 -120 -120 -120
Machine B -600 -100 -100 -100 -100

SumPV(A) = -$798.42 > SumPV(B) = -$916.99.


Seems like one should choose the 1st machine, since the
PV of its expenses is lower than for the 2nd machine.
.This may be wrong!
Methods to Handle this

Use replacement chains


Matching Cycle Approach
Annualized NPV approach or The
Equivalent Annual Cost Method (EAC)
Replacement Chains

Calculate PV (costs) for the same time horizon.

In this example, Machine A has a lifetime of 3


years, and Machine B has a lifetime of 4 years.

If we repeat the analysis over a period of 12 years,


A would have 4 replacement cycles and B would
have 3.
This is tedious! If we were added a machine with
a 5 year lifetime, our chain would be 60 years long.
Matching Cycle Approach
Repeat projects until they end at the
same time
Assumption: the projects can be repeated
The easiest: repeat the projects forever
Compare NPV of the repeated projects
NPV(T) : NPV of the original project of T
years
NPV(T,) = NPV(T) / (1 (1+R)-T) : NPV of
the original project replicated at const scale
to
Annualized NPV approach
(or Equivalent Annual Cost EAC)

ANPV = value of the level payment


annuity that has the same NPV as the
original set of cash flows.
NPV = ANPV ART
If only costs: EAC (Equivalent Annual Cost)
Compare ANPV (or EAC)
This method requires less restrictive
assumptions
Annualized NPV approach
(or Equivalent Annual Cost EAC)

Idea: Amortize the cash flows to get a per-year cost for


each piece of equipment. This gives the Equivalent
Annual Cost of each machine.
0 1 2 3 4
Machine A -500 -120 -120 -120
EACa EACa EACa
Machine B -600 -100 -100 -100 -100
EACb EACb EACb EACb
This results in an annual payment on the Machine A of
$321. The Machine B costs $289 per year. (Show this in
excel)
Thus, you should prefer Machine B.
Exercise:

Consider a factory which must have an air


cleaner.
There are two mutually exclusive choices (r =
10%):
The Cadillac cleaner costs $4,000 today,
has annual operating costs of $100 and
lasts for 10 years.
The cheaper cleaner costs $1,000 today,
has annual operating costs of $500 and
lasts for 5 years.
Which one to select?
Solution:

At first glance, the cheap cleaner has


lower NPV:
NPV (Cadillac) = - 4,614.46
NPV (Cheap) = - 2,895.39
This overlooks the fact that the Cadillac
cleaner lasts twice as long => choose
the Cadillac cleaner
Solution: Matching Cycle Approach

Repeat projects until they end at the same


time
Assumption: the projects can be repeated
The easiest: repeat the projects forever
Compare NPV of the repeated projects
NPV(T) : NPV of the original project of T years
NPV(T,) = NPV(T) / (1 (1+R)-T) : NPV of the
original project replicated at const scale to
In our example, NPV of the infinitely
repeated project is -$7509.8 for Cadillac
and -$7638 for Cheap
Solution: Annualized NPV approach
ANPV = value of the level payment annuity that
has the same NPV as the original set of cash
flows.
NPV = ANPV ART
If only costs: EAC (Equivalent Annual Cost)
Compare ANPV (or EAC)
This method requires less restrictive assumptions
In our example, the EAC for Cadillac is $750.98
10 10
$100 $750.98
$4,000 t
4,614.46 t
t 1 (1.10) t 1 (1.10)

The EAC for the cheaper air cleaner is


$763.80 which confirms our earlier
decision to reject it.
Application: Example of Replacement Projects

A Belgian Dentist needs an autoclave to sterilize his


instruments. He has an old one that is in use, but the
maintenance costs are rising. So he is considering
replacing it.
New Autoclave
Cost = $3,000 today,
Maintenance cost = $20 per year
Resale value after 6 years = $1,200
NPV of new autoclave (at r = 10%):
6
$20 $1,200
$2,409.74 $3,000
t 1 (1.10)t (1.10)6
EAC of new autoclave = -$553.29
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$553.29
$2,409.74
t 1 (1.10) t
Existing Autoclave
Year 0 1 2 3 4 5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600 500
Total Annual Cost 340 435 478 620 660

Total Cost for year 1 = (900 1.10 850) + 200 = $340


Total Cost for year 2 = (850 1.10 775) + 275 = $435
Total Cost for year 3 = (775 1.10 700) + 325 = $478
Total Cost for year 4 = (700 1.10 600) + 450 = $620
Total Cost for year 5 = (600 1.10 500) + 500 = $660
Note that the total cost of keeping an autoclave for the first
year includes the $200 maintenance cost as well as the
opportunity cost of the foregone future value of the $900
we didnt get from selling it in year 0 less the $850 we have
if we still own it at year 1.
Choosing the Moment of Replacement
New Autoclave
EAC of new autoclave = -$553.29
Existing Autoclave
Year 0 1 2 3 4 5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600 500
Total Annual Cost 340 435 478 620 660

We should keep the old autoclave until its cheaper to buy a


new one.
Replace the autoclave after year 3: at that point the new
one will cost $553.29 for the next years autoclaving and the
old one will cost $620 for one more year.
Internal Rate of Return [IRR]

The discount rate (k) that causes the NPV


to be equal to zero
The higher the IRR, the better
While it is technically possible for a series to
have multiple IRRs, this is not a practical
issue
Finding the IRR requires a financial
calculator or computer
In Excel =IRR(Series,Guess)

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Profitability Index

a k a Benefit cost ratio


NPV divided by initial cash investment
Ratios greater than 1.0 are good

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Advantages of Profitability Models

Easy to use and understand


Based on accounting data and forecasts
Familiar and well understood
Gives a go/no-go indication
Can be modified to include risk

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Disadvantages of Profitability
Models

Ignore nonmonetary factors


Some ignore time-value of money
Biased toward the short-term
Payback ignores cash flow after payback
IRR can have multiple solutions
All are sensitive to errors
Nonlinear
Dependent on determination of cash flows

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Scoring Models

Unweighted 01 factor model


Unweighted factor model
Weighted factor model

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Unweighted 0-1 Factor Model

Factors selected
Listed on a preprinted form
Raters score the project on each factor
Each project gets a total score
Main advantage is that the model uses
multiple criteria
Major disadvantages are that it assumes
all criteria are of equal importance
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Unweighted 0-1 Factor Model Example

Figure 2-2 2-46


Unweighted Factor Scoring Model

Replaces Xs with factor score


Typically a 1-5 scale
Column of scores is summed
Projects with high scores are selected

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UnWeighted Factor Model

Each factor is weighted the same


Less important factors are weighted the
same as important ones
Easy to compute
Just total or average the scores

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Weighted Factor Model

Each factor is weighted relative to its


importance
Weighting allows important factors to stand out
A good way to include nonnumeric data in the
analysis
Factors need to sum to one
All weights must be set up, so higher values
mean more desirable
Small differences in totals are not meaningful

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Weighted Factor Model Example

Figure A Page 56 2-50


Weighted Factor Model Example

Figure B Page 56 2-51


Advantages of Scoring Models

Allow multiple criteria


Structurally simple
Direct reflection of managerial policy
Easily altered
Allow for more important factors
Allow easy sensitivity analysis

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Disadvantages of Scoring Models

Relative measure
Linear in form
Can have large number of criteria
Unweighted models assume equal
importance

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Risk Considerations in Project Selection

Both costs and benefits are uncertain


Benefits are more uncertain
There are many ways of dealing with risk
Can make estimates about the probability of
outcomes
Subjective probabilities
Uncertainty about:
Timing
What will be accomplished?
Side effects
Pro forma (expected) documents

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2.2 PROJECT PORTFOLIO PROCESS
(PPP)

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The Project Portfolio Process (PPP)

Links projects directly to the goals and


strategy of the organization
Means for monitoring and controlling
projects

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Symptoms of a Misaligned Portfolio
More projects
Inconsistent determination of benefits
Projects that dont contribute to the
strategy
Competing projects
Costs exceed benefits
No risk analysis of projects
Lack of tracking against the plan
No client for project 2-57
Purpose of Project Portfolio Process

Identify nonprojects
Prioritize list of projects
Limit number of projects
Identify the real options for each project
Identify projects with good fit
Identify co-dependent projects

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Purpose of Project Portfolio Process
Continued

Eliminate risky projects


Eliminate projects that skip the formal
selection process
Keep from overloading the organization
To balance the resources with needs
To balance returns
To balance short-, medium-, and long-
term returns

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Project Portfolio Process Steps

1. Establish a project council


2. Identify project categories and criteria
3. Collect project data
4. Assess resource availability
5. Reduce the project and criteria set
6. Prioritize the projects within categories
7. Select the projects to be funded and held in
reserve
8. Implement the process

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Step 1: Establish a Project Council

Senior management
The project managers of major projects
The head of the Project Management
Office
Particularly relevant general managers
Those who can identify key opportunities
and risks facing the organization
Anyone who can derail the PPP later on

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Step 2: Identify Project Categories and
Criteria

Derivate projects
Platform projects
Breakthrough projects
R&D projects

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Step 3: Collect Project Data

Assemble the data


Document assumptions
Screen out weaker projects
The fewer projects that need to be
compared and analyzed, the easier the
work of the council

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Step 4: Assess Resource Availability

Assess both internal and external


resources
Assess labor conservatively
Timing is particularly important

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Step 5: Reduce the Project and Criteria
Set

Organizations goals Use strengths


Have competence Synergistic
Market for offering Dominated by
How risky the project is another
Potential partner Has slipped in
desirability
Right resources
Good fit

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Step 6: Prioritize the Projects Within
Categories

Apply the scores and criterion weights


Consider in terms of benefits first and
resource costs second
Summarize the returns from the projects

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Step 7: Select the Projects to be Funded
and Held in Reserve

Determine the mix of projects across the


categories
Leave some resources free for new
opportunities
Allocate the categorized projects in rank
order

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Step 8: Implement the Process

Communicate results
Repeat regularly
Improve process

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Project Proposals

The project proposal is essentially a


project bid
Putting together a project proposal
requires a detailed analysis of the project
Project proposals can take weeks or
months to complete
A more detailed analysis may result in not
bidding on the project
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Project Proposal Contents

Cover letter
Executive summary
The technical approach
The implementation plan
The plan for logistic support and
administration
Past experience

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END OF CHAPTER 2 !!!