MSIN 3101/G101/M101

Lecture 3
Portfolio management, project selection,
business cases and financial appraisal
Clive Vassel
2017-2018
Aims and objectives
▪ We will cover:
— The project or programme context
— Definition of portfolio management
— Selection criteria for projects and programmes
— Business cases and financial appraisal

▪ You should be able to:

— Define portfolio management and its benefits
— Understand selection criteria for projects and programmes
— Analyse and select projects and programmes to go into the
portfolio

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Portfolio Management

Are we doing the right projects/programmes?

Page 3
What pressures are organisations under?

(student ideas and discussion)

Page 4
Pressures on organisations – the project,
programme or portfolio environment

Page 5
What outcomes are organisations looking
for from their projects and programmes?

(student ideas and discussion)

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Definitions – Portfolios
▪ Portfolio
— “A grouping of an organisation’s projects and
programmes. Portfolios can be managed at an
organisational or functional level”.

▪ Portfolio Management
— “The selection, prioritisation and control of an
organisation’s projects and programmes in line with
its strategic objectives and capacity to deliver”.
(Source: APM Body of Knowledge, 6th edition)
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An example portfolio

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Objectives of portfolio management

▪ Create a mix of projects and programmes most likely to meet organisation’s

strategic objectives
— within capacity/resource (people and funding) constraints
— balancing change and business-as-usual
▪ Ensure that the organisation is delivering them efficiently
— clear governance structure
— emphasis on benefits
— portfolio-wide view of risks/dependencies and scheduling
▪ review capacity of the organisation to absorb change
— participation in project/programme gate reviews
▪ still aligned with corporate strategy?
▪ priority within the portfolio

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Benefits of portfolio management

▪ Align resources to maximise corporate benefits

▪ Swift response to changes in the external environment
▪ Better risk management – picture of risk across the
organisation
▪ Improved productivity – fewer overlaps
▪ Better communication – especially at senior level
▪ Improved “pipeline” – fewer bottlenecks at all stages

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Where do projects and programmes
come from?

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Sources of projects and programmes

▪ Corporate strategy
▪ Ministerial decision
▪ Legal or regulatory requirement
▪ Emergency situations
▪ Public pressure
▪ Competitive pressure
▪ Bright ideas!

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Portfolio management within the
business planning process

Mission Objectives Strategies Tactics

Long-term goals Intermediate goals Short-term goals

5-10 year plans Annual budgets/ Individual project
strategic plans plans
Project/programme Individual operational
portfolio plans
Operational
(Adapted from: The Handbook of Project- campaigns
based Management J Rodney Turner)
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Filling the performance gap

Target
Performance

Performance
gap

Actual
Expected

Time now
Time
(Source: J. Rodney Turner, The Handbook
of Project-Based Management)
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Criteria for project/programme selection

What criteria should we use to decide if a

project or programme should be included
in the portfolio?

(student ideas and discussion)

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How do we chose which
projects/programmes to do?
▪ Always have more candidates than resources
▪ Process for analysis and prioritisation
— Part of regular planning cycle
— Or used to evaluate ad-hoc opportunities
▪ “Scoring” systems ranging from simple to complex

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Decision making criteria
▪ Benefits
▪ Risk
▪ Financial return
▪ Cost/size of project
▪ Strategic importance
— fit to organisation’s goals
▪ Resource constraints
▪ Timing
▪ Capacity bottlenecks
▪ Competitive imperative
— Respond to competition
— Pre-empt competition
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▪ Political pressure
— Press, media
▪ Legal or regulatory obligation
▪ Opportunity for learning
— Develop new competence
▪ Stakeholder requirements
— Key customer needs
— Distribution channels
— Staff retention
▪ Public Relations value
▪ Societal gain
▪ Fit with other projects in the
portfolio
Key decider is risk (threat) vs return

High
Acceptable
Borderline –
consider other
criteria
Return
(financial)

Unacceptable
Low

Low High

(Adapted from: J Rodney Turner)

Risk
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A word about risk

NO TO
HS2 SAVE
GO OUR
HOME FIELDS
NOW

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Key decider is risk (threat) vs return
Acceptable Borderline –
consider other
criteria
High

The lower the risk appetite,

the more return is demanded
Return
for the same level of risk.
(financial)

Unacceptable
Low

Low High

(Adapted from: J Rodney Turner)

Risk
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All projects require an understanding of
risk vs return

▪ Optimism bias in the early stages

— Over-estimate benefits
— Under-estimate cost and time
▪ Need a realistic assessment of probability of
success at the business case approval stage
— Argues for an arms-length approval process
▪ Identified risks then feed into programme and
project risk management
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Example scoring criteria
Below hurdle rate 0
At hurdle rate 1
Hurdle rate + 1 - + 5% 2
Internal Rate of
Return 

  Hurdle rate + >5% 3

Risk score in "red" range 0
Technical risk
Risk score in "amber" range 1
Risk score in "green" range 3
Strategically important customer 3
Customer
  Medium customer 2
  Other 1
Fits 1 objective 1
Strategic objective
  Fits 2 objectives 2
  Fits 3 objectives 3
Excellent fit 3
Portfolio fit
  Good fit Page 22 2
Potential risk areas

▪ Financial
▪ Market
▪ Technical
▪ Logistical
▪ Contractual
▪ Political
▪ People

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Effective project and programme
selection

▪ Independent process
▪ Agreed characteristics and weightings
— quantitative and qualitative benefits
▪ Takes risk into account
▪ Takes interdependencies into account
▪ Agreed budgets
▪ Effective forum for debate and decision
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Example scoring matrix
Project A

Criterion Weight Score Score

(out of 3) Weighted

Financial (Internal Rate of Return) 40% 3 1.20

Technical Risk (lower risk = higher score) 15% 1 0.15

Customer 15% 2 0.30
Strategic Objective 20% 2 0.40
Portfolio Fit 10% 3 0.30
Total proposal score (weighted) 2.35

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Objectivity by “scoring”

▪ Agree criteria
▪ Weight criteria
▪ Allocate points to each criterion
▪ Score proposals against each criterion
▪ Highest score(s) approved
▪ Minimum score required

Approval to proceed to the next stage

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What would a “good” portfolio consist of?

(student discussion)

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Seeking a balanced portfolio

▪ Balance of corporate objectives

— meets the strategic aims of the organisation
▪ Appropriate level of risk across the organisation
— balance of risks (some high, some low)
— meets the organisation’s “risk appetite”
▪ All (most) stakeholders receiving benefits
▪ Effective resource allocation
— Use scarce resource on the most beneficial projects or
programmes (might highlight scarcity of resource in the
organisation)
▪ Timely release of project outputs
▪ Enables innovation Page 28
Getting approval for your project or
programme to proceed

A member of staff suggests that the team should all have

iPads because that would make them more productive.

What would you like to know

to decide about this investment?

(student discussion)

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Business case fundamentals
▪ What the problem/opportunity is
▪ Options for addressing it
— Including a “do nothing” option
▪ Recommended course of action
— Clear description of what the proposed project/programme is about
▪ Why should we invest in it
— Benefits
▪ financial
▪ other (including fit with strategic objectives)
▪ What resources are required
▪ Major risks

▪ Business case = WHAT and WHY for the project or programme

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Business Case Content

▪ Executive summary
▪ Situation analysis (sets the scene for the ‘why’)
▪ Option appraisal
▪ Project description (the ‘what’)
▪ Business benefits/fit with strategy (the ‘why’)
▪ Key deliverables/milestones
▪ Performance indicators
▪ Risks
▪ Overview plan
▪ Costs and financial appraisal
▪ Early exit costs
▪ Other issues (project-specific)

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Commitment and get-outs

▪ How much are we asking for?

▪ What are the stages of commitment
— “points of no-return” (or difficult reversal)
▪ How easy to get out if we have to?
— Customer / supplier relationships
— Reputation
— Contractual liabilities
— Financial write-offs
— Personnel (e.g. redundancies)
— Plant and equipment installed
▪ Help decision-makers to manage liabilities
— Progress / milestone reporting
— Staged investment (and gate reviews)
▪ Failing projects always difficult to kill (and decision makers know this)

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Financial appraisal

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Financial Appraisal

▪ Payback
▪ Net present value (NPV)
▪ Internal Rate of Return (IRR)

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Payback

▪ How long before the project recoups its costs

▪ Breakeven in terms of time
▪ Based on net cash flows
— typically simple cash flow but can use discounted cash flows
▪ Net cash
— additional revenue/savings
— less costs

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Payback Example

Year Net Cash (£) Cum (£)

0 -10,000 -10,000

1 2,000 -8,000

2 3,000 -5,000

3 5,000 0

4 6,000 6,000

Payback time = 3 years

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What’s the payback period for these
projects?
Project Capital Net cash Net cash Net cash
cost (Yr 0) (Yr 1) (Yr 2) (Yr 3)
A (10k) 10K - -

B (10K) 5K 4K 5K

C (10K) 6K 12K 5K

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Advantages and drawbacks

▪ ‘Best project’ = earliest payback

▪ Often used (essential) in fast-moving markets
— easy to understand
— cash flow vital for business
— relatively easy to calculate
▪ although quite hard to estimate timing of future
cashflows
▪ BUT not necessarily most profitable project
— ignores returns beyond payback period

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BUT - which of these projects would you
chose?
Project Capital Net cash Net cash Net cas
Cost Yr 0 Yr 1 Yr 2 Yr 3
(£ K) (£K) (£K) (£K)
A 10 9 1 -

B 10 1 9 -

Payback A = 2 years
Payback B = 2 years
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Time value of money

Which would you prefer?....

£1,000 now
£1,000 in one year’s time

Why?

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Time Value of Money

▪ £1,000 now worth more than £1,000 in a year’s time

— can invest and gain interest
— pay off debt and avoid interest

▪ Invest £1,000 (risk free investment) for one year at interest rate of
10%, in one year’s time you will have £1,100
▪ The Present Value of ‘£1100 in one year’s time’ is £1,000
▪ On this basis, anything that offers a lower return not worth doing

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Net Present Value (NPV)

▪ Compares different projects & considers:

• Cash flow
• Time value of money

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Time Value of Money

▪ Project should generate a return:

— Higher than the risk-free interest rate over time
— Otherwise just invest the money in a risk-free
investment

▪ NPV compares projects on this basis using a

technique called ‘Discounted Cash Flow’
▪ Based on the firm’s cost of capital

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Discount factors

▪ We are trying to discount a figure in the future

to equate it to its present value
▪ £100 now at 10% interest = £110 in one year
▪ BUT £110 discounted by 10% is not £100
— £110 x 0.9 = £99
▪ So we use a formula 1/(1+r) where “r” =
interest rate
▪ Thus 1/1.1 = 0.909
▪ £110 x 0.909 = £100
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NPV Example

A £10,000 investment in a project will earn the following

net cash flows:
— Year 1 £2000
— Year 2 £3000
— Year 3 £5000
— Year 4 £6000
The interest rate (cost of capital) is 10%.

Should the firm invest in this project?

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Value of the cash - undiscounted

“Value” of the project is £6,000

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Taking the net present value into account

Year Cash Discount Net cash

factor
0 -10,000 -10,000
1 2,000 0.9091
1,818.20
2 3,000 0.8264
2,479.20
3 5,000 0.7513
3,756.50
4 6,000 0.6830
4,098.00
Total 6,000 NPV
2,151.90
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NPV Example

Year Net cash (£) Net income on basis of

0 (10,000)
NPV = £2,151.90
1 2,000 ** Assumption: payments are
2 3,000 made in the beginning of
3 5,000 each period.
4 6,000
NPV 2,151.90

To calculate NPV on Excel:

=NPV(0.1,2000:6000)+-10,000
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What Does It Mean?

▪ Compared to risk-free investment:

NPV = positive number, project makes surplus
NPV = negative number, project makes loss
NPV = 0, project breaks even

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Internal Rate of Return (IRR)

Variation of NPV
Interest rate where NPV = 0

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IRR Example

Year Net cash (£) At interest rate of 18%

0 (10,000) NPV = 0
1 2,000
2 3,000
3 5,000
4 6,000
IRR 18%

To calculate IRR on Excel:

=IRR(-10000:6000)
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What Does It Mean?

▪ When interest rate = 18%, project breaks even

▪ If can fund project for < 18% interest, it makes a
surplus
▪ If interest is > 18%, project makes loss
▪ Sensitivity to interest rate changes
▪ The further away interest is from 18%, the better
▪ Most organisations have target/hurdle IRR

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Comparing projects
— The largest NPV is the ‘best project’ only for similar levels of original investment. NPV
should not be used to choose between projects (unless the projects have similar levels of
investment), but to check whether a project is profitable, considering a given discount rate.
— IRR (internal rate of return) is a better number to compare different projects with different
levels of investments. However, IRR has some limitations (it is not possible to calculate the
IRR in a project with more than one negative cash flow, and IRR does not take into account
the duration of the investment).
— If you can choose only one project among others, then choose the highest NPV, which will
mean to choose the project which will bring more monetary units to the company (although
not necessarily the highest internal rate of return or return on investment or profitability).
— You can also prefer to use the return on investment (ROI):
▪ ROI = (gain from investment – cost of investment)/ cost of investment

▪ ROI example = (2K+3K+5K+6K-10K)/10K = 60%

— The best approach is to use a combination of financial indicators, which combined could
better express the financial benefits considering the particular situation of the company and
of the programmes and projects.

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Benefits of Financial Appraisal

▪ Common base for evaluation of options

▪ Finance a key driver for organisations
▪ Identify & test assumptions
▪ Financial planning
▪ Baseline for performance measurement
▪ Accountability to e.g. shareholders
▪ Credibility

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Limitations of Financial Appraisal

▪ Forecasts are estimates of the future

▪ Manipulation of numbers
— be aware of who has provided the numbers, what assumptions
they have used, what interest they have in providing the
numbers
▪ Different measures suggest different ‘best’ projects
▪ Stand-alone approach: what would be the impact of the
project in relation to the others?
▪ Status quo assumption: what is the impact of not doing
the project – in addition to the financial appraisal
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How it all fits together

How it all fits together

CORPORATE
STRATEGIC
OBJECTIVES

CORPORATE
STRATEGIC
BUSINESS STRATEGIES
OBJECTIVES

BUS INES S STRATEGIES

INCREMENTAL
INCREMENTAL
STEP CHANGE
S TEP CHANGE
GROWTH GROWTH
GROWTH GROWTH
ACTIVE
CURRENT NEW IDEAS PROGRAMMES
OPERATIONS OPPORTUNITIES & S TAND-ALONE
PROJECTS ACTIVE
CURRENT NEW REVIEW PROGRAMMES
IDEASAND PRIORITIZE
CONTINUOUS OPPORTUNITIES
OPERATIONS & STAND-ALONE
IMPROVEMENT PROJECTS
PORTFOLIO OF APPROVED ACTIVE PROGRAMMES
AND S TAND-ALONE PROJECTS

REVIEW AND PRIORITIZE

CONTINUOUS
(Source: Young, 2008: 23)
£ BUS INES S BENEFITS £
IMPROVEMENT Page 56
PORTFOLIO OF APPROVED ACTIVE PROGRAMMES
AND STAND-ALONE PROJECTS

(Source: Young, 2008: 23)

£ BUSINESS BENEFITS £
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Further reading

▪ Financial appraisal test questions in the folder

‘Portfolios’
▪ Trevor Young – Chapter 3
▪ Turner – Chapter 16

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This week’s seminar

▪ Portfolio selection exercise

— Scenario to read
— Online graphics to help
— Online questionnaire to complete
▪ Cluster Room
▪ Feedback in seminar next week

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Thank you