MBA666FinalSlides Usable

PROJECT MANAGEMENT
(MBA666)
Raghu Nandan Sengupta
Industrial & Management Department
Indian Institute of Technology Kanpur
Project RNSengupta,IME Dept.,IIT 1

Management:MBA666 Kanpur,INDIA
Few rules for the classes
• Class/group assignments: 30%, Quizzes: 20%, Mid-
semester examination: 20%, Final Examination: 25%,
Attendance: 05%.
• All quizzes, examination are closed notes/books.
• In case a student is absent during any class/group
assignment, quiz , mid-semester, final examination then
it will be re-conducted as per PG norms.
• No mobiles in class.
• Be exactly on time or do not be in class.

Syllabus of Project Management
Introduction to Project Management, Generation and Screening of
Project Ideas, Project Appraisal/Evaluation, Risk Management in
Project Management, AHP, DEA, Utility Analysis, Decision Trees,
Cost Benefit Analysis, Project Characteristics, Project Life Cycle,
Valuing Projects, Cash Flow Problems, Credit Risk in Project
Finance, GANTT charts, Precedence diagrams, PERT, CPM,
Resource levelling, Crashing of Jobs, GERT, AND gateways, OR
gateways, Q-GERT.

References
1) Chandra, P., Projects, Tata McGraw-Hill Education, 2009, ISBN: 0070077932 | ISBN:
9780070077935
2) Gatti, S., (2008), Project Finance in Theory and Practice, Academic Press, ISBN: 978-0-12-373699-
4.
3) Levy, F. K. and Wiest, J. D., A Management Guide to PERT/CPM, Prentice Hall, 1969, ISBN-10:
0135485118 | ISBN-13: 9780135485118.
4) Lewis, R., Project Management, McGraw-Hill, 2006, ISBN 0-07-147160-X.
5) Moder, J. J. and Phillips, C. R., Project Management With CPM, PERT and Precedence
Diagramming, Van Nostrand Reinhold,1983, ISBN-10: 0442254156 | ISBN-13: 978-0442254155.
6) Morris, P. W. G., and Pinto, J. K., The Wiley Guide to Managing Projects, 2004, JohnWiley & Sons,
ISBN: 9780471233022.
7) Phillips, J., PMP Project Management Professional Study Guide, McGraw-Hill, 2003. ISBN 0-07-
223062-2.
8) Pritsker, A. A. B., Modeling and analysis using Q-GERT networks, John Wiley & Sons Inc, 1979,
ISBN: 0470266481 | ISBN: 9780470266489.
9) Project Management Institute, A Guide to the PMBOK, Project Management Institute, 2008, ISBN:
978-1-933890-51-7.

Few points regarding the teaching
methodology for Project Management
 Examples solved are marked with numbers, 1, 2, etc.
 Apart from that other small problems are also given in the ppt
slides.
 Assignment to be solved are marked with numbers, 1, 2, etc.
 Reading has to be done as required from the reference list
given.
 Cases/caselets will be given and have to be analyzed
accordingly.
 Class timings are: (i) Tuesday: 1030-1200 hours (IST) in C2
and (ii) Thursday 1200-1330 hours (IST) in C2
 Meeting the instructor can be scheduled as required
What are Projects
General Introduction: For most organizations and societies,
projects are the principal means for changing our world. Whether
we are talking about building the latest G4 network Smartphone,
designing a new composite material passenger aircraft, planning a
major fund-raising event, engineering and constructing an oil and
gas platform, or developing a high-speed rail network, the goal is
to create something of value to address a business opportunity or
prevent the loss of competitive advantage. Thus projects represent
human accomplishments; sometimes on a grand scale (the Hoover
Dam or Space Station Freedom) and sometimes through small,
incremental changes (the creation of “new and improved”
household products).

Difference between Production
and Projects
· In manufacturing theory distinction is made between engineering and
production
· Engineering comprise both product and production engineering.
· These two cycles are repeated for every new or updated product
specifications or production process specifications.
· The production can be repeated continuously, in batches, or just once.
· If production is continuous, it is referred to as a production line where
operations are continuously repeated.
· If production is only one piece, it is referred to as one-of-a-kind
production. Thus this one-of-kind production is actually a project, where
the focus is on the unique product made only once in contrast to the
repetitive manufacturing making a large number of the same product.

A typical Production Cycle

Special characteristics of Projects
Projects operate outside the bounds of an organization’s normal
processes and offer an exciting alternative to many of the
repetitive, on-going systems within a firm. Thus projects are
different from other forms of organizational processes.
All projects share the following characteristics:
• They are complex and unique.
• They have a clear goal or set of goals.
• They are limited by budget, schedule, and resources.
• They are customer focused.

What is Project Management
“the application of knowledge, skills,
tools, and techniques to project
activities to meet the project
requirements.”

What is Project Management
• Several techniques apply to project planning activities
(e.g., scope management, risk management, work
breakdown structures, and cost estimation),
scheduling processes (network development,
precedence diagrams, Gantt and PERT charts), and
means for controlling projects (earned value
management).
• Taken together, however, they represent a powerful
suite of tools and means for becoming successful at
managing projects.
Two schools of Project
Management
• One school emphasizes methods and techniques
for planning and control. This can be referred to
as task perspective.
• Other emphasizes organization and human
relationships. This can be referred to as
organizational perspective.

Methods of Project Management
• Scope Management
• Risk Management
• Work breakdown structure
• Cost Estimation, RIO, EV, IRR, etc.
• GANTT Chart, AHP, DEA(Data envelopment analysis), etc.
• PERT (Program Evaluation and Review Technique) is based on networks with
stochastic activity durations
• CPM (Critical Path Method) technique is concerned with determining the optimal
duration of a project where the duration of each single activity is known without
uncertainty
• Generalized Evaluation Review Technique (GERT)
• Queueing Generalized Evaluation Review Technique (Q-GERT)
Note: The main difference is that PERT uses stochastic(probabilistic) estimates for
activity durations whilst the CPM considers activity duration as a deterministic
value
Changing philosophy of Project
Management
 Initial focus was on obtaining control through
more detailed planning and monitoring.
 Present focus is on human relationship/cultural
issues involved in a project. Thus team building
and team composition has become important
factors for the success of the project execution.
 Risk management is also considered a very
important aspect of focus to obtain success in the
completion of a project.
Brief history of Project
Management
 Development of the network scheduling
techniques during the 1950s, and the
breakthrough came with the US Polaris project.
This is the so called PERT method
 Independently the CPM technique was developed
in the US by E.L. DuPont de Nemours while
exploring potential applications for their newly
acquired Univac computers

Important for Project
Management
 With respect to cost and schedule systems
criteria for performance measurement, it is
important to note two important principles
which are:
Breaking the project scope down to
manageable units of work (work breakdown).
Controlling progress using the earned value
concept

Management
 Another important achievement for the project
management community was the development of the
PMI’s A Guide to the Project Management Body of
Knowledge (PMBOK Guide) first published in 1987
and last revised in 2008 (PMI 2008).
 It is an American National Standards Institute (ANSI)
<https://www.ansi.org/> standard and serves as the
major reference document for good practice in project
management throughout the world.

Management
 As you remember we had mentioned that now a days
organization focus is the main thrust area of Project
Management study.
 Hence today it is equally important to address how you
can motivate project personnel to collaborate and to
develop ownership for the different objectives of the
project.
 Hence team building and team composition has become
important factors for the success of the project
execution.
Management
 Risk management is today also considered
important to obtain successful project results.
 Risk assessment has to be done and contingencies
have to be allocated.
 It is important to forecast as accurately as possible
all potential deviations in the project and to
provide adequate contingencies against it.

Management
 In spite of efforts from our side, cost and schedule overruns still
occur.
 Thus rather than forecast, contingency planning is more important.
 Reason being risks and variations are normal and cannot be fully
avoided, thus it is important that we develop project management
competence to manage the risk and variations as they occur.
 Hence many organizations have realized that too tight control
prevents creativity and that less focus on detailed plans can
encourage creativity and lead to better and more effective project
execution.

What is new in Project
Management
 Considering all these, researchers have
focused on one new approach which
has found wide application for
development of information systems is
agile project management.

Agile Project Management
 Agile project management is a method of project management applying a
team approach.
 The scope of the project is allowed to change rapidly and frequently, and
this is obtained by strong focus on stakeholder involvement and
communications.
 In the agile environment, projects are the business, while in the traditional
environment, the triple constraint of scope, resources and schedule, is the
main focus.
 In an agile strategy, the project manager takes an outward-facing
perspective to facilitate the integration of the project and the business.
 Focus is on delivering business results rather than staying within preset
boundaries, as the original project boundaries will quickly diverge from
the business reality in an uncertain environment.

Good example for Agile Project
Management
• In the software industry, agile project
management is used applying a method called
Scrum.
• In Scrum the basic development unit is a
sprint.
• Each sprint is preceded by a planning meeting,
where the tasks for the sprint are identified.

Good example for Agile Project
Management
 During a sprint the project team will create parts of
the finished product. Scrum teams consist of three
core roles:
Product owner representing the voice of the
customer
Development team responsible for delivering
finished parts of the final product
Scrum master facilitating the process and
enforcing the Scrum rules.

Success of Project Management
 Project success must be defined in terms of the elements that
characterize the very nature of the project: for example, time
(adherence to schedule), cost (adherence to budget),
quality/functionality, and customer satisfaction. Project
success follows a quadruple constraint, consisting of:
 Time
 Cost
 Quality and Functionality
 Client Satisfaction

 One should note that a distinction has to be made between:
 Key performance indicators: Key performance indicators
are parameters, indicators or values that can be measured to
evaluate whether a project is successful or not. As a
consequence of this, key performance indicators can only be
measured after a project has been completed.
 Success factors: Success factors are conditions or factors
that must be present for a project to be successful. Such
factors may be observed and influenced during project
execution.

 Project success must be related to objectives or
goals.
 An interesting question is, however, whether there
is any difference between project success and
project management success.
 Hence the question is, can an unsuccessful project
be successfully managed? Vice versa, could
unsuccessful project management lead to a
successful project?
 A perfect project management organization is no
guaranty for a successful project. Opposite,
unsuccessful project management may complete a
project successfully.
 An example of the latter is the oil platform Statfjord A
in the North Sea. When it was towed to field, it was
over two years late and at the end the final cost was
almost three times of the first estimated cost.
 Still this platform has performed well, produced oil and
generated revenue far beyond what was expected.
Project Organizational Maturity
 As the project work model is being deployed in
industry, it becomes increasingly important to
understand how well an organization is able to
handle projects or how mature the organization is
with respect to project management.
 This is referred to as project management
maturity (PMM) or organizational project
management maturity.

 The company can obtain an impression of how well it is
doing compared to best practice.
 A best practice represents an industrially accepted best
way of achieving a given goal.
 Benchmarking and best practice definitions within the
manufacturing industry have for a long time been
regarded as a good approach to enhance competitiveness.
 Within project management, project management maturity
measurement is a tool to achieve continuous improvement
and organizational learning.

 Measurement of project management maturity
will help a company to understand what processes
influence competitiveness and what processes
need further development and improvement.
 Thus project management maturity measurement
becomes a strategic tool for developing project
management competence and building a project
culture characterized by excellence.

Project Organizational Maturiy
 For each capability there is a measurable result.
 This measurement is the basis for the determination of
the project organization project management maturity.
 For the measurement, key performance indicators
(KPIs) are used.
 A KPI differs from a success criterion.
 A success criterion is used to decide whether a goal is
met or not.
 A KPI is used to indicate the performance of a process.

Examples for Project
Organizational Maturity
 Apple’s <https://www.apple.com/> and
<https://en.wikipedia.org/wiki/Apple_Inc.> creation of the new iPad and the
thousands of applications that can be used with either it or their best-selling iPod
products.
 Bechtel’s <http://www.bechtel.com/> and <https://en.wikipedia.org/wiki/Bechtel>
construction of a large-scale chemical refining plant in South Africa.
 The West Coast High-speed Route Modernization rail renovation project in the
UK, designed to update the most heavily traveled passenger and freight rail
network in Britain <https://en.wikipedia.org/wiki/High-
speed_rail_in_the_United_Kingdom>.
 Chile’s rescue operation to free 33 miners trapped a half mile below the surface
following the catastrophic collapse of a mine
<https://en.wikipedia.org/wiki/2010_Copiap%C3%B3_mining_accident>.

Examples for Project
Organizational Maturity
 The subsea installations for producing oil and gas at the Ormen Lange field in
Norway <https://en.wikipedia.org/wiki/Ormen_Lange_(gas_field)>.
 A World Bank project to reclaim nearly 3 million acres of poor soil for farming in
the Uttar Pradesh state in India
<http://www.worldbank.org/en/news/feature/2006/10/18/india-in-uttar-pradesh-
farmers-green-their-barren-lands>.
 Development of Chevrolet’s Volt electric car <http://www.chevrolet.com/> and
<https://en.wikipedia.org/wiki/Chevrolet_Volt>.
 The Droid™ operating system for Smart phones
<https://en.wikipedia.org/wiki/Android_(operating_system)>.
 The reconfiguration of Cummins’ diesel engine assembly line to streamline their
manufacturing processes <http://www.cummins.com/> and
<http://www.cumminseurope.com/cummins-darlington-plant-celebrates-50-years-
of-engine-production/>.

 Project success must always be measured against
goals or objectives.
 However, there are normally several sets of
objectives.

Project Mission and Objectives

Project Management Objectives
 There are normally three sets of
objectives (project results) derived from
the mission for any project and they
are:
Project objectives
Business objectives
Social objectives
Project Management Objectives
 The objectives would normally include a precise definition
of the scope of work, the schedule and a budget.
 Successfully completion of project: How successful is the
project with respect to the end user.
 Successful use of project results: Whether the
results/experience obtained/gained can be emulated in future.
 Successful influence of project on society: How beneficial
is the project for the society in the long run. Remember this
is different from successful completion and its positive effect
to the end user.

Classification of Projects
 Small, large and mega.
 ICT, construction, research.
 Engineering & construction, research &
development

Classification of Projects
 Engineering & construction
 No uncertainty as to whether the project objectives can
be technically met or not.
 Uncertainty connected to resource consumption,
schedule, scope of work, etc.
 Research & development
 Can be broken down into product development,
systems development, organizational development, and
new knowledge development.

Functions of Management
Planning
Control Organizational Organization

Goal
Leadership

Characteristics of Project
Management
• A person heads the project and the cross
functional, goal oriented view point
embodies the characteristics of the project
• The focal point of the project management
is the project manager
• Due to its multi functional work the cross
functional areas reflect the work focus as
desired in the project
Management
• The project manager is responsible for
integrating the whole work
• The project manager negotiates with the
functional managers
• The project manager focuses on delivering
a particular product/service at a certain
time

Management
• The project manager has two chain of command
• Responsibility, awards, etc., are shared amongst
members of the project management team
• Projects can originate at different places but the
goal is the same
• Project management sets into motion different
other functions not directly related tp project
management

When to use Project Management
• Unfamiliarity
• Magnitude of the effort
• Changing environment
• Interrelatedness
• Reputation of the organization

Different forms of Project
Management
• Basic Project Management
• Program Management
• New Venture Management
• Product Management

Management
• Attributes
• Environment and boundary
• Objectives
• Structure of the system
• Inputs, Processes and Outputs
• Constraints and conflicts

Stages of Project Management
• Systems concept
• System Definition and Preliminary design
• Detailed design and development
• System production and fabrication
• Detailed design and development
• System operation and support

Project Management
Development Cycle
• Project life cycle
• Managing the project life cycle
• System Development Cycle
– Conception phase
– Definition phase
– Execution phase
– Operation Phase

Project Management
Development Cycle
• Labour
• Facilities
• Time
• Knowledge
• Technology

Project Management
Development Cycle
• Conception: Project Initiation
• Project Feasibility
– The user should state the needs very clearly
– Ask a set of questions to the user to understand
his/her needs clearly
– Conduct research to understand the need
– Give the restated needs to user
– Keep in mind needs do change

Project Management
Development Cycle
• Feasibility
– The use should state the needs very clearly
– Ask a set of questions to the user to understand
his/her needs clearly
– Conduct research to understand the need
– Give the restated needs to user
– Keep in mind needs do change

Project Life Cycles
 A project life cycle represents the stages of a project’s
development.
 Life cycles are critical for managing projects because
they help us understand the logic behind its
development and make it easier to plan for resource
needs and schedule appropriate points to measure
project progress and assess its status.
 It is also a way of reducing the complexity of the
project task and making the project better manageable.

Project Stages
 Starting the project
 Organizing and preparing
 Carrying out the project work
 Closing the project

Project Life Cyle

Project life cycle
Cumulative
Concept Planning Execution Termination
Cost
Time

Project life cycle
Introduction Growth Maturity Stagnation Decline
Cost
Time

Project life cycle
Phases
1) Conceptualisation
2) Planning
3) Execution
4) Termination

Project life cycle
Stages under Conceptualisation
1) Concept
a) Trigger an event in the sense some one comes up
with an idea.
b) Capture the concept and try to visualize it.
c) Clarification of the concept in terms of the project
d) Elaboration of the concept
e) Evaluation of the concept

Project life cycle
Stages under Planning
1) Design
a) Make the basic design
b) Develop a performance criteria according to which the project is evaluated
c) Design and development of the concept for the project
d) Evaluate the design and get multiple feedbacks
2) Plan
a) Make a base plan on which to build up the project
b) Develop targets and milestone, i.e., when to finish a certain portion of the project or at which stage
of the project would one like to reach at a certain time
c) Plan the development of how one would proceed with the project
d) Concretize the evaluation criteria
3) Allocation
a) Develop a plan for allocation of resources both manpower, money, time etc.
b) Plan the allocation in detail
c) Concretize evaluation criteria for the allocation

Project life cycle
Stages under Execution
1) Control
a) Modification of targets and milestones
b) Allocation modification
c) Evaluation modification
d) Evaluation control

Project life cycle
Stages under Termination
1) Deliver
a) Basic deliverable condition
b) Deliverable modification if required and necessary
c) Modification of performance criteria
d) Deliver evaluation
e) Evaluation control
2) Review
a) Basic review
b) Review development
c) Review evaluation
3) Support
a) Basic maintenance and liability perception
b) Development of support criteria
c) Support evaluation

Stages of Project Life Cycle
 Conceptualization
 Planning
 Execution
 Termination

Project Execution Mode
 Splitting the project into a number of
phases forms the basis for a project
execution model. Such a model will in
addition include:
Decision gates
Acceptance Gates

Project Phases and Decision
Gates

Project Life Cycle

Project Capital Value Process

Management of a Project
“is a discipline which now transcends its earlier, more mechanistic
focus. It is now about defining and delivering successful projects to
clients--projects which give optimal value. It is developing fast,
evolving in a Total Quality, process improvement environment
towards new levels of performance which demand new work styles
and new attitudes. Technology, finance, environmental responsibility
and commercial astuteness figure prominently in this new era, as of
course does management itself. Project management
professionalism--project managers acting professionally in their
clients' best interests--is increasingly significant.”

Project Management Stake
Holders
 A stakeholder is a person or an organization
actively involved in the project or having an
interest in or conflict of interest with the
project execution or the project end result.
 There are three obvious stakeholders: the
project owner, the project organization and
the society.

Project Owner
 The project owner can be split into
three stakeholders:
Sponsor
Owner
User

Schematic diagram of Project
Stake Holders

Project Management
 The base organization which is the permanent organization
of the project’s personnel
 The base organization is an indirect stakeholder since it will
frequently define frame conditions and policies for the
execution of the project.
 Project management comprises the project manager or
leader, the management group and possibly a project office.
 The project team consists of all personnel working on the
project.
 Contractors are all external suppliers of goods and services
to the project.
Risk in Project Management
 An example can serve to illustrate the concept of risk management in Project
Management.
 Assume that we are constructing a house. We are about to pour concrete for
the ground floor.
 We have already ordered the concrete for June 10. However, it might be that
the piping installations for the floor may not be finished in time for this.
 Let us assume that there is a 90 % probability that the piping will be finished
in time and that the pouring of concrete can start as planned on June 10.
 In the case that the pouring of concrete must be cancelled or postponed, there
is a cancellation fee of INR 2,000.The probability that the fee will apply is 10
%, and the consequence is INR 2,000.The risk associated with this decision
(pour concrete on June 10) is thus 2000*0.10 = INR 200

Risk in Project Management
 The technical and economic risk of a
project fall into four categories:
Scope of work
Quality
Schedule
Cost

Uncertainty and Risk in Project
Management

Types of Risks in Project
Management
 Operational risk: Connected to internal circumstances in
the project and can be controlled by the project team.
 Strategic risk: It is the prospective impact on earnings
or capital from adverse business decisions, improper
implementation of decisions or lack of responsiveness
to industry changes.
 Contextual risk: It is connected to circumstances
outside the project that may influence the scope of
work and the performance of the organization.

Project Management Risk
 Broadly speaking, project risk management requires us to
ask the following questions:
 What is likely to happen (the probability and impact)?
 What can be done to minimize the probability or impact
of these events?
 What clues will signal the need for such action (i.e., what
clues should I actively be looking for)?
 What are the likely outcomes of these problems and my
anticipated responses?

Risk Management in Projects
 Risk management follows a four-stage
process:
Risk identification
Analysis of Probability and Consequences
Risk Mitigation Strategies
Control and Documentation

Risk Identification
 Financial Risk
 Technical Risk
 Commercial Risk
 Contractual or Legal Risk

Risk Impact Matrix for Project
Management

Strategies when Risk is there in
Project
 Accept Risk as it is
 Minimize Risk to the maximum possible
extent
 Share Risk with other parties involved in the
Project Management work
 Transfer Risk to other parties (who may not be
a part of the project management work)

Project Management Decision
Process

Model

Model
 There are three different decision problems dependent
on the result of the non-controllable factors:
The results are known with certainty. Such problems
are called decision under certainty.
The probability distribution of the result is known.
Such problems are called decision under risk.
The probability distribution of the results is
unknown. Such problems are called decision under
uncertainty

Expected Value Concept
 A commonly applied technique for solving project management
decision problems is the expected value concept.
 The expected value concept assumes that we know the potential
results of the project with associated probabilities.
 Hence by multiplying each potential result by its probability and
aggregating, we obtain an expected value for the total project.
 This is the average value we would obtain if we were able to
execute the project a large number of times.
 The value is not necessarily the value of one specific result. It is
just a reference value for taking the best decision by comparing
alternatives.

Decision Tree Modeling in
Project Management
 For complicated project we use the concept of
Decision Tree concept.
 Here the concept of probability and
conditional probability is brought in to the
picture to have a good understanding about the
expected value as well s the risk of the
project.

Decision Tree Analysis in Project
Management
9
5
2 10
11
6
1 3 12
7
13
4
8
14

Decision Tree Analysis
The key steps in decision tree analysis are as follows
• Identify the problem and alternatives.
• Delineate the decision tree.
• Specify the probabilities and monetary outcomes.
• Evaluate the various decision alternatives.
• Remember the decision points, also called decision forks,
denoted by D, and the alternative actions are available for
experimentation and actions are possible at these points, while
the chance points, called chance forks, denoted by C, are the
points where the outcomes are dependent on a chance process
and the likely outcomes at these points.
You as the CEO of a company (which manufactures
three different ratings of electrical motors) have the
following information in front of you
1) Motor rating 75 KW with a certain unknown demand,
d1 (remember this is in units)

You have the SP for these ratings
as Rs. 15,000 for 75 KW, Rs.
35,000 for 150 KW and Rs.
50,000 for 200 KW

You are interested in finding these numbers, d1, d2 and d3 in order to
find your total sales value. To ascertain these numbers you give this
task to an industrial marketing firm and they supply you with the
following information
1) The optimistic demand for 75 KW is 300 with a chance of 7/10,
while the pessimistic demand is 200 with a chance of 3/10
2) The optimistic demand for 150 KW is 210 with a chance of 5/15,
while the pessimistic demand is 100 with a chance of 10/15
3) The optimistic demand for 200 KW is 90 with a chance of 1/5, while
the pessimistic demand is 30 with a chance of 4/5

Probabilistic scenario
7
300 units with chanceof
10
3
75KW 200 units with chanceof
10
5
150KW 15
10
1 15
200KW 90 units with chanceof
5
4
5

For the probabilistic decision process the
value/units for any particular rating of motor
would be found by the expected value, which
can be calculated by no*co+np*cp

Thus
 d1 = {300*(7/10)+200*(3/10)} units of 75 KW
motor
 d2 = {210*(5/15)+100*(10/15)} units of 150
KW motor
 d3 = {90*(1/5)+30*(4/5)} units of 200 KW
motor

• Hence expected sales figure is
[{300*(7/10)+200*(3/10)}*15000
+{210*(5/15)+100*(10/15)}*3500
0 + {90*(1/5)+30*(4/5)}*50000]

Probabilistic versus Deterministic
w1
p1 w2 1 w
p2
p3 w3
p4
w4

Decision Tree Analysis (Examples)
Let us consider two different examples in the area
of Decision Tree Analysis
• Example # 01: Simple problem with
unconditional probability
• Example # 02: Simple problem with
conditional probability
..\..\..\Consultancy\VLFM\VLFM_01_Decision_T
rees.docx

Decision Tree Analysis (Utility Analysis)
Utility analysis
Consider the same type of construction project is being
undertaken by more than one company, who we will
consider are the investors. Now different investors
(considering they are investing their money, time,
energy, skill, etc.) have different attributes and risk
perception for the same project
That is to say, each investor has with him/her an
opportunity set. This opportunity set is specific to that
person only.

Consider a shop floor manager has two
different machines, A and B, (both
doing the same operation) with him/her.
The outcomes for the two different
machines are given

A B
Outcome value(i) P[i] Outcome value(i) P[i]
15 1/3 20 1/3
10 1/3 12 1/3
15 1/3 8 1/3
In reality what would a person do if he or she has two outcome sets
in front of him/her.
For A we have the expected value of outcome as 13.33 and for B also
it is 13.33

A B
Outcome value(i) P[i] Outcome value(i) P[i]
15 ½ 20 1/3
10 ¼ 12 1/3
15 ¼ 8 1/3
Now for A we have the expected value of outcome as 13.75 and for B
it is still 13.33.
Here outcome is something in value sense.

Outcome Team X Team Y
Wins 40 45
Draws 20 5
Losses 10 20
Case I Case II
Outcome Points Outcome Points
Win 2 Win 5
Draw 1 Draw 1
Lose 0 Lose 0

Case I
Team A = 100; Team B = 95, which means A
> B, i.e., A is ranked higher than B.
Case II
Team A = 220; Team B = 230, which means
B > A, i.e., B is ranked higher than A.

On a general nomenclature we should have
the expected value or utility given by
N (W )
E[U ]   U (W )
W  N (W )
W
here U(W) is the utility function which is a
function of the wealth, W, while N(W) is the
number of outcomes with respect to a certain
level of income W.

Remember in general utility values
cannot be negative, but many function
may give negative values.
For analysis to make the problem
simple we may consider the value to
be zero even though in actuality it is
negative.
Consider an example where a single individual is facing the same set of outcomes at any
instant of time but we try to analyze his/her expected value addition or utility separately
based on two different utility functions
1) U[W(1)] = W(1) +1
2) U[W(2)] = W(2)2 + W(2)
Outcome W(1) U[W(1)] P(W(1) W(2) U[W(2)] P(W(2)
15 1.5 2.5 0.15 1.5 3.75 0.15
20 2.0 3.0 0.20 2.0 6.00 0.20
25 2.5 3.5 0.25 2.5 8.75 0.25
10 3.0 4.0 0.10 3.0 12.00 0.10
5 0.5 1.5 0.05 0.5 0.75 0.05
25 5.0 6.0 0.25 5.0 30.00 0.25
Accordingly we have E[U(1)] = 3.825 and E[U(2)] = 12.69. So we can have a different
decision depending on the form of utility function we are using.

Now we have two different utility functions used one at a time for two different decisions
1) U[W(1)] = W(1) - 5 and
2) U[W(2)] = 2*W(2)-W(2)1.25
Outcome W U[W(1)] U[W(2)] Decision (A) Decision (B)
8 4 0 2.34 Yes No
3 5 0 2.52 No Yes
4 6 1 2.60 No Yes
6 7 2 2.61 Yes No
9 8 3 2.54 Yes No
5 9 4 2.41 No Yes
For utility function U[W(1)]

U(A,1)=0*8/(8+6+9)+2*6/(8+6+9)+3*9/(8+6+9)=1.69
U(B,1)=0*3/(3+4+5)+1*4/(3+4+5)+4*5/(3+4+5)=2.00
For utility function U[W(2)]

U(A,2)=2.34*8/(8+6+9)+2.61*6/(8+6+9)+2.54*9/(8+6+9)2.50
U(B,2)=2.52*3/(3+4+5)+2.60*4/(3+4+5)+2.41*5/(3+4+5) 2.50

Example # 03: A venture capitalist is considering

two possibilities of investment. The first alternative is
buying government treasury bills which cost Rs.
6,00,000. While the second alternative has three
possible outcomes, the cost of which are
Rs.10,00,000, Rs. 5,00,000 and Rs. 1,00,000
respectively. The corresponding probabilities are 0.2,
0.4 and 0.4 respectively. If we consider the power
utility function U(W)=W1/2, then the first alternative
has a (E(U)) expected utility value of Rs.776 while
the second has an expected utility value of Rs. 609.
Hence the first alternative is preferred.

Would the above problem give a
different answer if we used an
utility function of the form U(W)
= W1/2 + c (where c is a positive or
a negative constant)?
Ans. The answer will not change
because utility is still same and c
is a consatant.
In a span of 6 days the price of a security fluctuates and a person
makes his/her transactions only at the following prices. We
assume U[P] = ln(P)
DayP U[P] Number of Outcomes Probability
1 1000 6.91 35 0.35
2 975 6.88 20 0.20
3 950 6.86 10 0.10
4 1050 6.96 15 0.15
5 925 6.83 05 0.05
6 1025 6.93 15 0.15
Expected utility is 6.91
If U[P]= P0.25, then expected utility is 33.63

Utility Analysis (Important properties)
General properties of utility functions
1) Non-satiation: The first restriction placed on
utility function is that it is consistent with
more being preferred to less. This means
that between two certain investments we
always take the one with the largest outcome,
i.e., U(W+1) > U(W) for all values of W. Thus
dU(W)/dW > 0

2) If we consider the investors or the
decision makers perception of absolute
risk, then we have the concept/property
of (i) risk aversion, (ii) risk neutrality
and (iii) risk seeking. Let us consider
an example now

Invest Prob Do not invest Prob
2 ½ 1 1
0 ½
Price for investing is 1 and it is a fair gamble,
in the sense its value is exactly equal to the
decision of not investing

Thus
 U(I1)*P(I1) + U(I2)*P(I2) < U(DI)*1
 risk averse
 U(I1)*P(I1) + U(I2)*P(I2) = U(DI)*1
 risk neutral
 U(I1)*P(I1) + U(I2)*P(I2) > U(DI)*1
 risk seeker

Another characteristic by which to classify a
risk averse, risk neutral and risk seeker person
is
 d2U(W)/dW2 = U(W) < 0  risk averse
 d2U(W)/dW2 = U(W) = 0  risk neutral
 d2U(W)/dW2 = U(W) > 0  risk seeker

Utility curves
U (W )

(Utility Analysis and Marginal Utility)
Marginal Utility Function
 Marginal utility function looks like a concave
function  risk averse
 Marginal utility function looks neither like a
concave nor like a convex function  risk
neutral
 Marginal utility function looks like a convex
function  risk seeker

Marginal Utility Rate
 Marginal utility rate is increasing at a
decreasing rate  risk averse
 Marginal utility rate is increasing at a constant
rate  risk neutral
 Marginal utility rate is increasing at a
increasing rate  risk seeker

Risk avoider
U (W )
W1 W1  1 W1  2
W

Risk neutral
U (W )
W1 W1  1 W1  2 W

Risk seeker
U (W )
W1 W1  1 W1  2 W

Few other important concepts
Condition Definition Implication
Risk aversion Reject a U(W) < 0
fair gamble
Risk neutrality Indifference to U(W) = 0
a fair gamble
Risk seekingSelect a U(W) > 0
fair gamble

Utility Analysis
(Other concepts, i.e., A(W))
3) Absolute risk aversion property of utility
function where by absolute risk aversion we
mean
A(W)= - [d2U(W)/dW2]/[dU(W)/dW]
= - U(W)/U(W)

Utility Analysis
• Assume an investor has wealth of amount W and a
security with an outcome represented by Z, which is a
random variable.
• Assume Z is a fair gamble, such that E[Z] = 0 and V[Z] =
2Z and the utility function is U(W).
• If WC is the wealth such that we can write this as a
decision process having two chooses, i.e.,
Choice A Choice B
W+Z WC

Utility Analysis
• Now if the person is indifferent between decision/choice
A and decision/choice B, then we must have E[A] =
E[B], i.e., E[U(W+Z)] = E[U(WC)] = U(WC)*1
• The person is willing to give maximum of (W – WC) to
avoid risk, i.e., the absolute risk (say ) = (W- WC).
• Expanding U(W+Z) in a Taylors series around W and we
would get the answer.
Assignment # 01: This is an assignment and for the
proof check any good book in economics or game theory
which has utility as a part of it

Utility Analysis
For the three different types of persons
 Decreasing absolute risk aversion
 A(W) = dA(W)/d(W) < 0
 Constant absolute risk aversion
 A(W) = dA(W)/d(W) = 0
 Increasing absolute risk aversion
 A(W) = dA(W)/d(W) > 0

Utility Analysis
Condition Definition Property
1) Decreasing As wealth A(W) < 0
absolute risk increases the amount
aversion held in risk assets
increases
2) Constant As wealth A(W) = 0
remains the same
3) Increasing As wealth A(W) > 0
decreases

Utility Analysis
(Other concepts, i.e., R(W))
4) Relative risk aversion property of utility
function where by relative risk aversion we
mean
R(W) = - W * [d2U(W)/dW2]/[dU(W)/dW]
= - W * U(W)/U(W)

Utility Analysis
• Consider the same example as the previous
prove but now with /= (W- WC)/W, which is
the per cent of money the person will give up in
order to avoid the gamble and E[Z]=1.
• Z represented the outcome per rupee invested.
• Therefore for W invested we obtain W*Z
amount of money. On the other hand we have a
sure investment of WC.

Utility Analysis
• For the investor to be indifferent between the two
decision processes we must have: E[U(W*Z)] =
E[U(WC)]
• Consider now E(U(W*Z)] and expanding it in a
Taylors series around W and we would get our
result
Assignment # 02: This is an assignment and for
the proof check any good book in economics or
game theory which has utility as a part of it
Utility Analysis
For the three different types of persons
 Decreasing relative risk aversion
 R(W) = dR(W)/dW < 0
 Constant relative risk aversion
 R(W) = dR(W)/dW = 0
 Increasing relative risk aversion
 R(W) = dR(W)/dW > 0

Utility Analysis
Condition Definition Property
1) Decreasing As wealth increases R(W) < 0
relative risk the % held in risky
aversion assets increases
2) Constant As wealth increases R(W) = 0
aversion assets remains the
same
3) Increasing As wealth increases R(W) > 0
aversion assets decreases

Examples of Utility Functions
Some useful utility functions
1) Quadratic: U(W) = W – b*W2 (b is a
positive constant)
2) Logarithmic: U(W) = ln(W)
3) Exponential: U(W) = - e-aW ( a is a positive
constant)
4) Power: c*Wc (c  1 and c  0)

U(W) = W – b*W2
Then:
 A(W)=4*b2/(1- 2*b*W)2
 R(W)=2*b/(1- 2*b*W)2
Hence we use this utility function for people
with
(i) increasing absolute risk aversion and
(ii) increasing relative risk aversion.

W W-b*W^2 A(W) A'(W) R(W) R'(W)
2.00 3.00 -0.25 0.06 -0.50 -0.13
3.00 5.25 -0.20 0.04 -0.60 -0.08
4.00 8.00 -0.17 0.03 -0.67 -0.06
5.00 11.25 -0.14 0.02 -0.71 -0.04
6.00 15.00 -0.13 0.02 -0.75 -0.03
7.00 19.25 -0.11 0.01 -0.78 -0.02
8.00 24.00 -0.10 0.01 -0.80 -0.02
9.00 29.25 -0.09 0.01 -0.82 -0.02
10.00 35.00 -0.08 0.01 -0.83 -0.01
11.00 41.25 -0.08 0.01 -0.85 -0.01

U( W) =W- b*W^ 2
45.00
40.00
35.00
30.00
25.00 U( W)
A( W)
20.00
A' ( W)
15.00 R( W)
R' ( W)
10.00
5.00
0.00
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00
- 5.00

U(W) = ln(W)
Then:
 A(W) = - 1/W2
 R(W) = 0
We use this utility function for people with
(i) decreasing absolute risk aversion and
(ii) constant relative risk aversion

W ln(W) A(W) A'(W) R(W) R'(W)
1.00 0.00 -1.00 -1.00 -1.00 0.00
2.00 0.69 -0.50 -0.25 -1.00 0.00
3.00 1.10 -0.33 -0.11 -1.00 0.00
4.00 1.39 -0.25 -0.06 -1.00 0.00
5.00 1.61 -0.20 -0.04 -1.00 0.00
6.00 1.79 -0.17 -0.03 -1.00 0.00
7.00 1.95 -0.14 -0.02 -1.00 0.00
8.00 2.08 -0.13 -0.02 -1.00 0.00
9.00 2.20 -0.11 -0.01 -1.00 0.00
10.00 2.30 -0.10 -0.01 -1.00 0.00
U(W)=ln(W)
2.50
2.00
1.50
1.00 U(W)
U (W )
A(W)
0.50
A'(W)
0.00 R(W)
R'(W)
-0.50
-1.00
-1.50
W

U(W) = - e-aW
Then:
 A(W) = 0
 R(W) = a
(i) constant absolute risk aversion and
(ii) increasing relative risk aversion.

W U(W) A(W) A'(W) R(W) R'(W)
2.00 -1.65 -0.25 0.00 0.50 0.25
3.00 -2.12 -0.25 0.00 0.75 0.25
4.00 -2.72 -0.25 0.00 1.00 0.25
5.00 -3.49 -0.25 0.00 1.25 0.25
6.00 -4.48 -0.25 0.00 1.50 0.25
7.00 -5.75 -0.25 0.00 1.75 0.25
8.00 -7.39 -0.25 0.00 2.00 0.25
9.00 -9.49 -0.25 0.00 2.25 0.25
10.00 -12.18 -0.25 0.00 2.50 0.25
11.00 -15.64 -0.25 0.00 2.75 0.25

U(W)=-exp(-a*W)
5.00
0.00
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 U(W)
-5.00 A(W)
U(W)
A'(W)
-10.00 R(W)
R'(W)
-15.00
-20.00
W

U(W) = c*Wc
Then:
 A(W) = (c-1)/W2
 R(W) = 0.
(i) decreasing absolute risk aversion
(ii) constant relative risk aversion.

W U(W) A(W) A'(W) R(W) R'(W)
2.00 0.30 0.38 -0.19 -0.75 0.00
3.00 0.33 0.25 -0.08 -0.75 0.00
4.00 0.35 0.19 -0.05 -0.75 0.00
5.00 0.37 0.15 -0.03 -0.75 0.00
6.00 0.39 0.13 -0.02 -0.75 0.00
7.00 0.41 0.11 -0.02 -0.75 0.00
8.00 0.42 0.09 -0.01 -0.75 0.00
9.00 0.43 0.08 -0.01 -0.75 0.00
10.00 0.44 0.08 -0.01 -0.75 0.00
11.00 0.46 0.07 -0.01 -0.75 0.00
U(W)=cW^c
0.60
0.40
0.20
U(W)
0.00
A(W)
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00
U(W)
-0.20 A'(W)
-0.40 R(W)
R'(W)
-0.60
-0.80
-1.00
W

Utility Function (An Example)
Example # 04:Suppose U(W) = W1/4 and we are required to
find the properties of this utility function and also draw the
utility function graph.
Now

Let us find absolute risk aversion and relative risk aversion
properties of this particular utility function.

Now from the two equations we easily see that:
1. We have decreasing absolute risk aversion property,
i.e., as the amount of wealth (W) increases the
amount held in risky assets also increases.
2. We have constant relative risk aversion property, i.e.,
as the amount of wealth (W) increases the % held in
risky assets remains the same.

Now the U(W) looks like as shown in the graph.

The actual value of expected utility is of no
use, except when comparing with other
alternatives. Hence we use an important
concept of certainty equivalent, which is the
amount of certain wealth (risk free) that has
the utility level exactly equal to this expected
utility value.
We define U(C) = E[U(W)], where C is the
certainty value

How is this value of C useful
 Suppose that we have a decision process with a
set of outcomes, their probabilities and the
corresponding utility values. In case we want to
compare this decision process we can find the
certainty equivalent so that comparison is easier.
 To find the exact form of the utility function for a
person who is not clear about the form of utility
function he/she uses.

Example # 05: Suppose you face two options. Under
option # 1 you toss a coin and if head comes you win
Rs. 10, while if tail appears you win Rs. 0. Under
option # 2 you get an amount of Rs. M. Also assume
that your utility function is of the form U(W) = W –
0.04*W2. It means that after you win any amount the
utility you get from the amount you won.
For the first option the expected utility value would be
Rs. 3, while the second option has an expected utility of
Rs. M – 0.04*M2. To find the certainty equivalent we
should have U(M) = M – 0.04*M2 = 3. Thus M = 3.49,
i.e., C = 3.49, as U(3.49) = E[U(W)]

The above example illustrates that you would be
indifferent between option # 1 and option # 2.
Now suppose if you face a different situation
where you have option # 1 as before but a
different option # 2 where you get Rs. 5. Then
obviously you would choose option # 2 here, as
U(5) = (5 - 0.04*52) = 4 > 3.49.
For the venture capital problem the certainty
value for the option # 2 is Rs. 370881, as
U(370881) = (370881)0.5 = 609(slide # 108)

 A risk averse person will select a
equivalent certain event rather than the
gamble
 A risk neutral person will be indifferent
between the equivalent certain event and
the gamble
 A risk seeking person will select the
gamble rather than the equivalent certain
event

A B
Expected Value

• A and B are wealth values, i.e., values of W. Also for
ease of our analysis we consider that U(W)=W.
• Form a lottery such that it has an outcome of A with
probability p and the other outcome is B with a
probability (1-p).
• Change the values of p and ask the investor how much
certain wealth (C) he/she will have in place of the
lottery. Thus C varies with p.
• Now the expected value of lottery is {p*A+(1-p)*B}. A
risk averse person will have C > {p*A+(1-p)*B}.
• Plot the values of C and you already have the expected
values of the lottery.

• How would you find the explicit form of the utility
function of a person. Suppose you know that it is of the
form U(W) = - e –aW.
• You ask the person that given a lottery which has a 50-50
chance of winning Rs. 1,000,000 or Rs. 4,00,000. In order
to buy this lottery what was he/she willing to pay.
• Suppose the answer is Rs. 5,00,000 (say for example),
then it means that the person is indifferent between a
certain equivalent amount of Rs. 5,00,000 and the lottery
(which is a fair gamble).
• Hence: 1*(- e-500000*a)= 0.5*(-e-1000000*a) + 0.5*(-e-400000*a).
• Solving through iteration process we can find a.

Utility Analysis (Axioms)
Axioms of utility functions
1) An investor can always say whether A = B, A> B or A <
B
2) If A > B and B > C, then A > C
3) Consider X = Y. Then assume we combine with X with
another decision Z, such that X is with P(X) = p and Z is
with P(Z) =1-p. On the same lines we have the same
decision Z with Y, such that Y is with P(Y) = p and Z is
with P(Z) = 1-p. The X+Z = Y+Z
4) For every gamble there is a certainty equivalent such
that a person is indifferent between the gamble and the
certainty equivalent

Comparison of MV and Utility Analysis
Comparison between mean-variance and utility function
The utility function used is (U(W)=W-bW2), which is quadratic
Consider we have three assets and the prices are as follows
No A B C R(A) R(B) R(C) P(i)
1 100 105 80 --- --- --- 1/5
2 110 115 90 1.101.091.131/5
3 115 120 95 1.051.041.061/5
4 120 125 105 1.041.041.111/5
5 125 130 130 1.041.041.241/5
Here R(x) is return : R(A) = I1/I0

r(A) = I1-I0 / I0 ; I1 is the investment at time t=t1
and I0 is the investment at time t = 0

Then:
R A  1.06 ; RB  1.05; RC  1.14
 A  0.025 ;  B  0.022; C  0.052
W A  114 ;WB  119;WC  100
If risk less interest (in terms of total return) is 0.5, then using mean-
variance analysis we rank the assets as
     
B RB  R f /  B  25.0  A R A  R f /  A  22.4  
C  RC  R f  /  C   12.3
Using quadratic utility function U(W) = W – b*W2, with b = 0.002 we
rank the assets as
B [U(B) = 90.68] > A [U(A) = 88.01] > C [U(C) = 80.00]
#### U(B) = 119 – 0.002*119*119 = 90.68
Consider the following example with two different sets of outcomes. The
utility function is U[W] = W2 + W
Outcome Outcome W U[W] P(W)
Scenario 1 Scenario 2
15 20 1.5 3.75(15+20)/212
20 12 2.0 6.00(20+12)/212
25 25 2.5 8.75(25+25)/212
10 17 3.0 12.00 (10+17)212
5 8 3.5 15.75 (5+8)/212
25 30 4.0 20.00 (25+30)/212
Accordingly we have to calculate the expected utility value

Investment and Utility Analysis
Deterministic vs Probabilistic b1
h1
w1
1  h1 0
p1 w2
p2
p3 w3
h4 b4
p4
w4
1  h4 0

People have other criteria for
investment/project/portfolio solutions
and they are
 Geometric mean return
 Safety first criteria
 Stochastic dominance
 Analysis in terms of characteristics of
the return distribution

Geometric mean return
For the selection process we consider
the maximum GM has:
 The highest probability of reaching or
exceeding any given wealth level in the
shortest possible time.
 The highest probability of exceeding
any given wealth level over any given
period of time
Ri,j = ith possible return on the jth portfolio.
p1, j pn, j
RG , j  (1  R1, j )  ......  (1  Rn, j ) 1
pi,j = probability of ith outcome for jth portfolio.

Then choose the maximum of the GM values

Example # 06: Consider we have the following
combinations of assets A, B and C in the following ratios
(weights) to form a portfolio P. The returns are 10, 20, 30
respectively.
A B C
1 0.20 0.20 0.60
2 1/3 1/3 1/3
3 0.25 0.25 0.50
• RP,1 = (1+0.10)0.20*(1+0.20)0.20*(1+0.30)0.60 – 1 = 0.237
• RP,2 = (1+0.10)1/3*(1+0.20)1/3*(1+0.30)1/3 – 1 = 0.197
• RP,3 = (1+0.10)0.25*(1+0.20)0.25*(1+0.30)0.50 – 1 = 0.222
Note: Hence choose scenario # 1

 Maximizing GM return is equivalent to
maximizing the expected value of log
utility function
 Projects/Investment/Portfolios that
maximize the GM return are also mean-
variance efficient if returns are log-
normally distributed

Safety first principle
Under safety first principle the basic
tenet(principle) is that the decision
maker is unable or unwilling to
consider the utility theorem for making
his/her decision process. Under this
methodology people make their
decision placing more importance to
bad outcomes

Few Project Investment Process (Concepts)
Safety first principles (rules)

 Min Pr[RP<RL]
 Max RL
 Max RP

If returns are normally distributed then the optimal
portfolio would be the one where RL was the maximum
number of SD away from the mean
Let us consider an example for Min P[Rp < RL].
Remember we consider the returns are normally
distributed and the suffix P denotes the portfolio while
RL means a fixed level of return (5).
A B C
RP 10 14 17
P 5 4 8
Diff from 5% -1*A -2.25* B -1.5*C

2 * A 2 * B
RL RA RB

In order to determine how many SDs, RL

lies below the mean we calculate RL minus
the mean return divided by the SD. Thus
we have
 RL  R P   RP  RL 
min    max  
 P   P 
 R P  RF 
This is equivalent to max  
 P 

Even though for our example we have

simplified our assumption by considering
only normal distribution, but this would
hold for any distributions having first and
second moments.

According to Tchebychev (Chebyshev)

inequality for any random variable X, such
that E(X) and V(X) exists, then
 X  E X   1  RP  RP  1
Pr  t   2  Pr  K   2
 VX   t
   P  K

As we are interested in lower limit hence

we simply it and have
 RP  RP  1
Pr  K   2
 P  K
 RP  RP RL  RP   P2
Pr   
    RL  RP 
2
 P P

The right hand side of the inequality is

exactly equal to the decision process # 1
under safety first principle we have
considered previously
 RP  RP RL  RP   P2
Pr   
  P  P 
 RL  RP  2
Pr  RP  RL 

For the second criterion we have

max RL
s.t.: Pr(RP < RL)  
We are given  (say 0.05), then we should
have
 RP  RP RL  RP 
Pr    0.05
 P P 

`
  0.05
z RB

RP P*
RL , 4
RL,3
RL , 2
RL,1
P

The criterion is maxsuch RP that Pr(RP  RL)

= , here  is predertermined depending
on the investors own constraints. Thus
with the condition we have
RP  R L  z *  P

A2
RP A1
B2
B1
RL
P

Safety First Principle (Example)
Example # 07: Considering we have projects A, B,
C and D and we need to rank them using the
concept of safety first principle. The information is
as follows


As per safety first principle we have: min {RP,jRL}
where: (i) i = 1, 2,….., m, (number of projects) and (ii)
j = 1, 2,….., n (number of jobs/activities/financial
decisions in each project).
Thus:


Stochastic Dominance
• First-order stochastic dominance
• Second-order stochastic
dominance
• Third-order stochastic dominance

Stochastic Dominance
• Assume W is the wealth level, s.t., the set of wealth
can be designated by {W1, W2, ....}.
• Let the utility function be U(W), which is
strongly/weakly increasing.
• Consider the gamble/lotteries/project investment
decisions are represented by their cumulative
distribution functions say for example F, G.

First-order stochastic dominance

• A lottery F dominates G then the
decision maker prefers F to G
regardless of what U(W) is, as long as
it is
– Weakly increasing (i.e., U(Wi)  U(Wj),
where Wi  Wj)


• F dominates G iff
• Simply stated it means that every

individual with increasing utility
function prefers FW to GW regardless
of his/her risk preferences.

• F dominates G iff FW(W)GW(W)
• This definition requires that FW gives
more wealth than GW realization by
realization.

Second-order stochastic dominance

• A lottery F dominates G if the decision
maker prefers F to G as long as he/she
is
– Risk averse
– U(W) is weakly increasing (i.e., U(Wi) 
U(Wj), where Wi  Wj)

Decision Analysis Revisited
You are the owner of a company manufacturing shoes
and the company has been in an expansion phase. In
order to meet the demand of the customers you are
planning to test market any one of the three brands of
shoes (A, B and C) in any one of the three cities of
India, namely Calcutta, Bhubaneshwar and Ranchi. You
know that for an amount of investment, W, in Calcutta
the return, U(W), is given by W2-0.5*W. For
Bhubaneshwar it is W2-0.75*W, while for Ranchi it is
W2-W.

Decision Analysis Revisited
The proportions of the total investment, where the total
amount of investment is Rs.5,00,000, for the test
marketing phase for brands A, B and C in the three
cities would be (i) 0.4, 0.4, 0.2 in Calcutta (ii) 0.3, 0.3,
0.4 in Bhubaneshwar and (iii) 0.2, 0.3, 0.5 in Ranchi.
The probabilities, which you guess from historical data,
of outcomes for brand A, B and C in the three cities are
(i) 0.1, 0.2, 0.7, (ii) 0.5, 0.4, 0.1 and (iii) 1/3, 1/3, 1/3
respectively

Project Management Control
 In any project there are three factors (also
called project control variables) that need to be
planned and controlled:
Scope of work
Time
Cost

Project Management Basic
Planning Technique
 Open creative techniques: Exploits the creativity in organizations
seeking new and non-traditional solutions. They are based on experts
that are motivated to creative thinking. The most widely used
technique is brainstorming.
 Forecasting techniques: This method is based on development trends
over time. Under this there are two methods which are: explorative
techniques and normative techniques.
 Organization development methods: In this method we try to involve
the whole or a special part of the organization in creating ideas. One
of the best known techniques is the Strength Weakness Opportunity
Threat (SWOT) analysis.

Project Management Evaluation
 After planning we need to evaluate a project
and they are:
Direct evaluation methods
Criteria-based evaluation methods

Project Management Evaluation
 Technical evaluation could be related to functionality,
quality, reliability, etc.
 It is often necessary to measure these factors in
economic units.
 The most commonly used direct evaluation methods
are:
Check list
Pair wise ranking

Evaluation of Complex Project
Management
 For more complex problems, a method developed by
Saaty (1980) can be applied.
 The method is called Analytical Hierarchy Process
(AHP).
 It uses a hierarchy of criteria that each alternative
should be evaluated against.
 We first have to assign priorities to each criterion in the
hierarchy. This is done using pair wise comparisons.
 Next we develop a set of matrices where all alternatives
are compared to each other for each criterion.
Analytic Hierarchy Process(AHP)
· The Analytic Hierarchy Process (AHP) is a

structured technique for organizing and
analyzing complex decisions.
· It was developed by Thomas L. Saaty in the
1970s.
· Application in group decision making.

Wide range of applications exists:

· Selecting a car for purchasing
· Deciding upon a place to visit for
vacation
· Deciding upon an MBA program
after graduation

AHP algorithm is basically composed of two steps:

1. Determine the relative weights of the decision
criteria
2. Determine the relative rankings (priorities) of
alternatives
Note: Both qualitative and quantitative
information can be compared by using informed
judgments to derive weights and priorities.

(Example)
Example # 08
·Objective: Selecting a car
·Criteria: Style, Cost, Fuel-economy
·Alternatives: Civic , i20 , Escort,
Alto

S e le c t in g
a N ew C ar
S t y le C ost FuelE conom y
Civic i20 Escort Alto

Alternative courses of action

Ranking Scale for Criteria and Alternatives

Ranking of criteria(Pair wise comparison matrix)
Style Cost Fuel Economy
Style 1 1/2 3
Cost 2 1 4
Fuel Economy 1/3 1/4 1
Row element/Column element

Ranking of priorities
• Consider [Ax = maxx] where
 A is the comparison matrix of size n×n, for n criteria, also called the priority matrix.
 x is the Eigenvector of size n×1, also called the priority vector.
 max is the Eigenvalue.
• To find the ranking of priorities, namely the Eigen Vector X:

1) Normalize the column entries by dividing each entry by the sum of the column.
2) Take the overall row averages.
Row
Normalized 0.30 0.28 0.37
1 0.5 3 Column Sums
averages 0.32
A= 2 1 4 0.60 0.57 0.51 X= 0.56
0.33 0.25 0.10 0.15 0.12 0.12
1.0 Priority vector
Column sums 3.33 1.75 8.00 1.00 1.00 1.00

Analytic Hierarchy Process(AHP) Ranking of priorities
Criteria weights
• Style 0.32
• Cost 0.56
• Fuel Economy 0.12
Selecting a New Car

1.00

0.32 0.56 0.12

Checking for Consistency
· The next stage is to calculate a Consistency Ratio

(CR) to measure how consistent the judgments
have been relative to large samples of purely
random judgments.
· AHP evaluations are based on the aasumption that
the decision maker is rational, i.e., if A is preferred
to B and B is preferred to C, then A is preferred to
C.
· If the CR is greater than 0.1 the judgments are
untrustworthy because they are too close for
comfort to randomness and the exercise is
valueless or must be repeated.

Calculation of Consistency Ratio
• The next stage is to calculate max so as to lead to the
Consistency Index and the Consistency Ratio.
• Consider [Ax = max x] where x is the Eigenvector.
A x Ax x
1 0.5 3 0.32 0.98 0.32

0.56 1.68 = max
0.56
2 1 4 =
0.12
0.12 0.36
0.333 0.25 1.0
• λmax=average{0.98/0.32, 1.68/0.56, 0.36/0.12}=3.04

• Consistency index , CI is found by
CI=(λmax-n)/(n-1)=(3.04-3)/(3-1)= 0.02

C.R. = C.I./R.I. where R.I. is the random index
n 1 2 3 4 5 6 7
R.I. 0 0 .52 .88 1.11 1.25 1.35
C.I. = 0.02
n=3
R.I. = 0.50(from table)
So, C.R. = C.I./R.I. = 0.02/0.52 = 0.04
C.R. ≤ 0.1 indicates sufficient consistency for decision.

Analytic Hierarchy Process(AHP) Ranking
alternatives
Priority vector
Style Civic i20 Escort Alto
Civic 1 1/4 4 1/6 0.13
i20 4 1 4 1/4 0.24
Escort 1/4 1/4 1 1/5 0.07
Alto 6 4 5 1 0.56
Cost Civic i20 Escort Alto

Civic 1 2 5 1 0.38
i20 1/2 1 3 2 0.29
Escort 1/5 1/3 1 1/4 0.07
0.26
Alto 1 1/2 4 1
Ranking alternatives
Miles/gallon Priority Vector
Fuel Economy Civic 34 .30

i20 27 .24
Escort 24 .21
Alto 28 .25
1.0
113
Note: Since fuel economy is a
quantitative measure, fuel consumption
ratios can be used to determine the
relative ranking of alternatives.
Selecting a New Car
1.00

0.32 0.56 0.12
Civic 0.13 Civic 0.38 Civic 0.30

i20 0.24 i20 0.29 i20 0.24
Escort 0.07 Escort 0.07 Escort 0.21
Alto 0.56 Alto 0.26 Alto 0.25

Economy
Fuel
Cost
Style
Civic .13 .38 .30 .28
.32
i20 .24 .29 .24 .25
x
.56 =
Escort .07 .07 .21 .07
Alto .56 .26 .25 .12 .34
Priority matrix Criteria Weights

Including Cost as a Decision Criteria
 Adding “cost” as a a new criterion is very difficult in AHP.
 A new column and a new row will be added in the evaluation matrix.
 However, whole evaluation should be repeated since addition of a new
criterion might affect the relative importance of other criteria as well!
 Instead one may think of normalizing the costs directly and calculate the
cost/benefit ratio for comparing alternatives!
Normalized Cost/Benefits
Cost Benefits Ratio
Cost
• CIVIC $12k 0.22 0.28 0.78
• i20 $15K 0.28 0.25 1.12
• ESCORT $ 9K 0.17 0.07 2.42
• Alto $18K 0.33 0.34 0.97

• The “ESCORT” is the winner with the
highest benefit to cost ratio and we
rank it 1st ,
• Then at 2nd position i20,
• At 3rd is Alto,
• While at 4th position is Civic.

More about AHP: Pros and Cons
Pros
•It allows multi criteria decision making.
•It is applicable when it is difficult to formulate criteria
evaluations, i.e., it allows qualitative evaluation as well as
quantitative evaluation.
•It is applicable for group decision making environments
Cons
•There are hidden assumptions like consistency.
Repeating evaluations is cumbersome.
•Difficult to ue when the number of criteria or alternatives is high,
i.e., more than 7.
•Difficult to add a new criterion or alternative
•Difficult to take out an existing criterion or alternative, since the
best alternative might differ if the worst one is excluded.

Profitability Analysis for Project
Management
 Calculation of profitability of investment projects
is based on the project’s cash flow.
 The cash flow shows the difference between all
ingoing and outgoing payments over time.
 There are three different types of outgoing
payments:
 Investments (capital expenditures - CAPEX)
 Operating expenditures (OPEX)
 Taxes
Cost calculation in Project
Management
 Consider
 C0 is the initial cost of the project
 r is the interest rate for the project calculated per year
 n is the time in years
 Then the total price is given by S=C0(1+r/100)n
 If they are to be calculated on a yearly basis we
have Ci= C0(1+ri/100)i
 Hence total cost is TC= C1(1+r1/100)1+
C2(1+r2/100)2+….+ Cn(1+rn/100)n
Cost calculation concepts in
Project Management
 Discounting factor
 Net Present Value (NPV)
 Fixed Discounting rate (r)
 Variable Discounting rate (ri)
 Internal rate of return (IRR)
 Payback time
 Return on investment
 Discounted return on investment

Discounting factor

221
Discounting factor

Net Present Value (NPV)
 Consider we have Ct and rt as the amount received and
interest rate at time t for t=0,…,T (time for the cash
flow)
 NPVt=0 = {C0/(1+r0)0 + C1/(1+r1)1 + ….. + CT/(1+rT)T}
 In general, the cost (Ct) and benefit (Rt) may be
separated if required such that NPVt=0 = [{-C0/(1+r0,C)0 +
R0/(1+r0,R)0}+ {-C1/(1+r1,C)1 + R1/(1+r1,R)1} + ……. + {-
CT/(1+rT,C)T + RT/(1+rT,R)T}]

Fixed Discounting rate (r)
 A fixed discounting rate is a rate where the interest rate
does not fluctuate during the fixed rate period of the
loan. This allows for accurate prediction of the future
payments.
 Concept of variable interest rate is when the interest rate
changes depending on the economic conditions.
 A fixed discounting rate is based on the assumption
about the average discount rate over the fixed rate
period.

 For example, when the interest rate is historically low,
fixed rates are normally higher than variable rates
because interest rates are more likely to rise during the
fixed rate period.
 Conversely, when interest rates are historically high,
lenders normally offer a discount to borrowers to fix
their interest rate over time, as rates are more likely to
fall during the fixed rate period.
 Example being MIBID vs MIBOR or LIBID vs LIBOR

 NPV t=0 = {C 0 /(1+r) 0

+ C 1 /(1+r) 1
+
….. + CT/(1+r)T}
 NPVt=0 = [{-C0/(1+r)0 + R0/(1+r)0}
+ {-C1/(1+r)1 + R1/(1+r)1} + ….. +
{-CT/(1+r)T + RT/(1+r)T}]

Variable Discounting rate (ri)
 NPVt=0 = {C0/(1+r0)0 + C1/(1+r1)1 + ….. +

CT/(1+rT)T}
 NPVt=0 = [{-C0/(1+r0,C)0 + R0/(1+r0,R)0}+
{-C1/(1+r1,C)1 + R1/(1+r1,R)1} + ……. +
{-CT/(1+rT,C)T + RT/(1+rT,R)T}]

Internal rate of return (IRR)
 Internal rate of return (IRR) is used to measure

the profitability of potential project investments.
 IRR is a discount rate that makes the NPV of all
cash flows from a particular project equal to
zero.
 IRR calculations rely on the same formula as
NPV does, i.e., {I0/(1+irr)0 + I1/(1+irr)1 + ……. +
IT/(1+irr)T} = 0

Interest Rates
 n-year zero rate/n-year zero/n-year spot rate:
Interest rate earned on project investment that
starts today and ends n years from hence.
 Note
a) There is NO intermediate project payments
b) In case intermediate payments are made they
would be considered accordingly

Project Cost and Yield from Project
 How do you calculate the price of a project, if
time to maturity is T years and it pays
semiannual or quarterly or monthly returns?
 Remember the zero rate for different maturities
of project is used to calculate the value of
projects at different times which are not equal
 The yield from a project bearing some payback
is the discount rate that equates the cash flows
on the project to its market value.

Project Pricing
Maturity Zero Rate

(years) (% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

Project Pricing
Example # 10: Consider where we have

a two year project with a initial value of
INR 100 crores and it provides a rate of
6% per annum with the return from the
project being paid semi-annually. We
are to find the project price as of today

Project Pricing
To calculate the project price we discount each
cash flow at the appropriate zero rate
 6   0.050.5  6  0.0581.0  6   0.0641.5
 e   e   e
2 2 2
 6  0.0682.0
 100  10  e
7
 2

Yield from Project
• The yield of the project (y) is the discount rate that
makes the present value of the cash flows of the
project equal to the market price of the project.
• Suppose that the market price of the bond in our
example equals to its theoretical price as calculated.
• Then the yield of the project (y) is given by solving:
(6/2)exp(-y*0.5) + (6/2)exp(- y*1.0) + (6/2)exp(-
y*1.5) + (100*107+6/2)exp(-y*2.0) = (6/2)exp(-
0.050*0.5) + (6/2)exp(-0.058*1.0) + (6/2)exp(-
0.064*1.5) + (100*107+6/2)exp(-0.068*2.0).

Yield from Project
 Use Newton-Raphson method or Runge-Kutta
method etc.
 Newton Raphson method
a) Start with any value x0 for solving f(x)=0.
b) Use successively xi+1=xi-f(xi)/f’(xi) to find x1, x2, x3,. ….
and so on.

Par Yield of the project
 The par yield of the project (c)for a certain
maturity is the rate that causes the project price to
equal its face value (which we consider as the initial
value which is 100*107).
 In our example we solve
c  0.050.5 c  0.0581.0 c 0.0641.5
e  e  e
2 2 2
 c   0.0682.0
 100  10  e
7
 100  10 7
 2

Continuous Compounding vis-à-vis Other Rates
of Compounding
If
 rc is the continuous compounding rate.
 rm is the equivalent rate with compounding m times per annum.
 n is the number of years.
 m is the number of times of compounding for rm.
 rm 
rc  m log e 1  
 m
Note: Proof the above simple formulae. This is not an assignment for
class but do the proof yourself and for any queries get in touch with
the instructor

Determining the Zero Curve (Example # 11)
Project Time to Annual Project
Principal Maturity Coupon Price
(INR) (years) (INR) (INR)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6

Determining the Zero Curve
 We assume that ½ of the stated

coupon is assumed to be paid every
six months (i.e., ½ year duration)

The Bootstrapping the Zero Curve
 An amount (100.0-97.5)=2.5 can be earned

on 97.5 during 3 months.
 The 3-month rate is 4 times (2.5/97.5) or
10.256% with quarterly compounding
 This is 10.127% with continuous
compounding

 An amount (100.0-94.9)=5.1 can be earned

on 94.9 during 6 months.
10.748% with semi annual compounding
compounding

 An amount (100.0-90.0)=10.0 can be

earned on 90.0 during 12 months.
11.111% with annual compounding
compounding

The Bootstrap Method
To calculate the 1.5 year rate we solve
 8   0.104690.5  8   0.105361.0
 e   e
2 2
 8   R1.5
 100  e  96
 2
and R = 0.10681 or 10.681%

The Bootstrap Method
To calculate the 2.0 year rate we solve
 12   0.104690.5  12   0.105361.0
 e   e
 2   2 
 12   0.106811.5  12   R  2.0
  e  100  e  101.6
2  2
and R = 0.10808 or 10.808%

Continuously Compounded Zero Rates
Maturity (yrs) Zero Rate (Continuous

Compounding
0.25 10.127
0.50 10.469
1.00 10.536
1.50 10.681
2.00 10.808

Zero Curve Calculated from the Data
12
Zero
Rate (%)
11
10.68 10.808
10.469 10.53 1
10 6
10.127
9 Maturity (yrs)
0 0.5 1 1.5 2 2.5

Forward Rates
A forward interest rate is the interest

rate implied by current zero rates for a
specified future time period

Calculation of Forward Rates
Zero Rate for Forward Rate

an n -year Investment for n th Year
Year (n ) (% per annum) (% per annum)
1 10.0
2 10.5 11.0
3 10.8 11.4
4 11.0 11.6
5 11.1 11.5

Formula for Forward Rates
 Suppose that the zero rates for

maturities T1 and T2 are R1 and R2
respectively, with both rates
continuously compounded.
 The forward rate for the period between
times T1 and T2 is {(R2T2 – R1T1)/(T2–
T1)}
Sloping of the different rates curves, when
Yield curve upward sloping
Rate
FR
ZR
PY
Maturity
Sloping of the different rates curves when
Yield curve is downward sloping
Rate
PY
ZR
FR
Maturity

Instantaneous Forward Rate
• The instantaneous forward rate for a maturity T
is the forward rate that applies for a very short
time period starting at T. It is R  T R
T
where R is the T-year rate
Assignment # 03: This is an assignment and
for the proof check any good book in finance

Forward Rate Agreement
A forward rate agreement (FRA) is a

forward contract where the parties agree
that a certain interest rate will apply to a
certain principal during a specified future
time period

Duration/Payback time
• Duration/payback time of a project is a measure of
how long on average the one has to wait before
receiving cash payments from the project.
• Hence a project paying no payments and that
matures in n years has a duration of n years.
• However we can say that a project paying some
returns maturing in n years has a duration LESS
than n.

• Duration of a project that provides cash flow c i at time t i
is n
 ci e  yt i

 ti 
B 

i 1 
where B is its price of the project and y is its yield
(continuously compounded).
• Note the term in the bracket is the ratio of the present
value of the payment of project at time ti to the project
price/cost.

• This leads to
B
  D y
B
Assignment # 04: This is an
assignment and for the proof check
any good book in finance

Return on investment (ROI)
· The concept of return on investment (ROI)

is a sort of calculating the efficiency of the
investment, i.e., ROI=(O/P)/(I/P).
· ROI= {C0/(1+r0)0 + C1/(1+r1)1 + ….. +
CT/(1+rT)T}/I0
· ROI = [{-C0/(1+r0,C)0 + R0/(1+r0,R)0}+
{-C1/(1+r1,C)1 + R1/(1+r1,R)1} + ……. +
{-CT/(1+rT,C)T + RT/(1+rT,R)T}]/I0
Discounted return on investment (DROI)
· The concept of discounted return on investment

(DROI) is a sort of calculating the efficiency of the
investment, i.e., ROI=(O/P)/(I/P) based on the fact that
the discounting factor is considered
· DROI= {C0/(1+r0)0 + C1/(1+r1)1 + ….. + CT/(1+rT)T}/I0
· DROI = [{-C0/(1+r0,C)0 + R0/(1+r0,R)0}+ {-C1/(1+r1,C)1 +
R1/(1+r1,R)1} + ……. + {-CT/(1+rT,C)T + RT/(1+rT,R)T}]/I0
· Here the interest are discounted considering the tax,
interest payment, risk free interest (rf), etc.

Risk Analysis
For an outcome (be it financial or a project), if
we are assured that it is sure to give us a tangible
benefit then we are not concerned about the
chance that it will not happen and the
corresponding probability that we will be denied
any benefit from that outcome. But in reality we
know that in maximum of the cases we have to
face the game of chance and hence be aware of
the probabilistic return of the outcome.
Risk Analysis
For an outcome, which is random or probabilistic
we denote it by X. Corresponding to this r.v. we
have an average/mean of this outcome, which is
termed as the expected value, denoted by E[X].
Simultaneously along with the average return we
are also concerned about the cost involved in the
outcome. This cost or the uncertainty we face
regarding the outcome is know as the risk

Risk Analysis
Risk is usually denoted by the variance, 2=E[(X -
E(X))2]. There are other quantifiable ways of denoting
this risk but for all practical purposes the second moment
of a r.v. suffices to quantify this risk. Other measures of
risk may be the skewness and kurtosis, which are found
out by using the third and fourth moment respectively,
i.e., E[X - E(X)]3 and E[X - E(X)]4

Risk Analysis
If we have X as a discrete variable then we have
E[ X ]   xi f ( xi ) V [ X ]   {xi  E[ X ]}2 f ( xi )
i i
If we have X as a continuous variable then we have

 
E[ X ]   xf ( x) dx V [ X ]   {x  E[ X ]}2 f ( x) dx
 

Risk Analysis
Project C
Project B
Return
Project A+B+C+D Project D
Project A
Risk(Standard deviation)

Risk Analysis
We discuss the portfolio theory as applied to managing financial assets.
This concept will be utilized when we consider the idea of managing a
conglomeration of projects. According to Markowitz’s theory we know
that riskness can be characterized by the variance. This variance along
with covariances determines the return from the portfolio (a set of
assets/securities or a set of different projects). We know the general form
of the optimization problem.
Now the question is how do we reduce/minimize the collective risk of
the set of assets/projects. The method of reducing risk is known as
diversification which can be highlighted by a very simple example.
For ease of understanding, consider a hypothetical example, where we
have n number of assets/projects, denoted by i =1, 2,….., n, such that
1) The prices of assets/projects are moving in such a way that their
respective prices are almost uncorrelated or the correlation is very low.
2) The return of each asset/project has an average value (mean) of m.
3) The variance (risk) of each asset/project is 2.
4) Weights of each asset/project considered in the portfolio (the set of
projects) is assumed to be of equal proportion, i.e.,w i = 1/n for each i.
Risk Analysis
1 n 2
1 n 
rP   ri  r  m  P2  2   2 
n i 1 n i 1 n
2
P

Introduction to Project Portfolio approaches
In order for diversification to be most

effective we must assume:
 Projects in the same industry tend to be
correlated.
 Projects in different industries are not
correlated.

CAPM
In order to do away with the enormous
amount of calculation which is required
when you are combining a large number of
financial assets, we use a proxy which
subsumes that the expected value of any
particular financial asset can be replicated
by the market. By market we mean the
market index.
CAPM
Considering that there is only one variable which
regulates the price movement of any particular asset we
consider that risk to be denoted by i (i = 1, 2,…., n) for
any particular ith asset, such that.
ri  r f   i (rm  r f )   i
Assuming normal distribution for the returns and also
considering i ~ N(0,2,i), we have, after taking
expectation
ri  r f   i (rm  r f )

CAPM
n
Few results
 P   wi  i  i2   i2 m2   2,i
i 1
The first term (in the second formulae) is the systematic risk, i.e.,
the risk associated with the market as a whole, while the second
term is the nonsystematic risk or specific risk. The first risk cannot
be diversified but the second risk can be diversified.
Similarly for the portfolio we have the following form for the
variance in terms of systematic risk and unsystematic risk.
n
2
P   P2 m
2
  wi2 2,i
i 1

CAPM
Assumptions
1) No transaction costs or administrative costs
2) Projects/assets are infinitely divisible
3) Absence of personal tax
4) Project managers/Investors make decisions based on return and risk of
projects/portfolios
5) Investors transaction cannot affect the price of any single project/asset
6) Unlimited short selling is allowed
7) Unlimited riskless lending and borrowing is allowed
8) Investors define relevant period in exactly the same manner
9) Investors have identical expectation wrt necessary inputs to the
project/portfolio decision
10) All projects/assets are marketable

CAPM
CAPM can be used as a pricing model. Consider we have the initial

investment in the project as P0 (known) and the future value as Pt
(unknow). Then we immediately have
Pt  P0
 r f   (rm  r f )
P0
Pt
Thus P0 
1  r f   (rm  r f )
It is interesting to compare the second equation (for the probabilistic case)

with the deterministic case. For the deterministic case we have to discount
the future payments at an interest rate rf, using the factor 1/(1+rf). In the
probabilistic case we have the equivalent factor as 1 /{1  r f   (rm  r f )}

Linearity of Pricing
The price of two assets/projects is the linear sum of those two
assets/projects. Thus if we have
Pt , A Pt , B
P0, A  P0, B 
1  r f   A (rm  r f ) 1  r f   B (rm  r f )
Then we must have
Pt , A  Pt , B
P0, A  P0, B  
1  r f   A B (rm  r f )
Remember:  A B   A   B

Certainty Equivalent Form
Given an/a asset/project with initial invest of P0 (known) and final return
of Pt (unknown), we have
cov[{(Pt / P0 )  1}, rm ]
  2
m
Then with simple substitution we have

1 cov(Pt , rm )(rm  r f )
P0  [ Pt  ]
(1  r f ) m2
The term in the bracket is known as the certainty equivalent of Q.

Project Choice
A firm can use CAPM as a basis for deciding which projects it should
carry out/execute. Suppose you have a project with an initial investment of
P0 (known) and the final return as Pt (unknown). Then NPV is given by
1 cov(Pt , rm )(rm  r f )
NPV   P0  [ Pt  ]
(1  r f ) m2
Now if we have a set of different projects and we have to choose one from
that set then how do we decide which project to choose.
Just find the project for which NPV is maximum.
For an investor he/she can either select a firm based on the NPV of the
project that the particular firm has under taken or consider the project (i.e.,
the firm) which results in maximum expansion of the efficient frontier.
Note: These two selection criterion are equivalent.

Markowitz Model
Assume the portfolio has n number of assets, each with a
expected return of R and covariance of i,j  i, j = 1, 2,
i
……,n. Also suppose wi are the weights that sum up to 1.
Then to find a minimum variance portfolio, we fix the
mean portfolio return
*
at some arbitrary value
Note
R
• One can refer to the paper Markowitz, H.M. Portfolio
Selection, The Journal of Finance, 1952, 7 (1), 77–91
• Harry Markowitz <
https://en.wikipedia.org/wiki/Harry_Markowitz>

Investment Process
Thus 1 n
min  wi w j i , j
2 i , j 1
n
subject to
 i i
w R
i 1
 R *
w
i 1
i 1
wi  0

Investment Process
In the previous optimization problem we

have considered that there is no short
selling, hence the weights have to be greater
than 0.

Investment Process
Now if we consider that SS is

present, then the optimization
problem becomes

Investment Process
Thus 1 n
2 i , j 1
n
subject to
 i i
w R
i 1
 R *
w
i 1
i 1
are unbounded
w 's i

Investment Process
The problem could also have been solved as (SS not
considered) n
max  wi Ri
i 1
subject to
n n
w w  i j i, j  2*
w
i 1
i 1 wi  0
i , j 1

Investment Process
The problem could also have been solved as (SS allowed)
n
max  wi Ri
i 1
subject to n
w w 
i , j 1
i j i, j  2*
 w 1
unbounded
i 1
i
wi ' s

Investment Process
After solving the optimization minimization
problem (considering SS is allowed), we have
n
  w  R * i = 01, 2,….., n

i, j j
j 1
n
w R
i 1
i i R *
w
i 1
i 1

Investment Process
Example # 01: Suppose there are three (3)
uncorrelated assets with variances of 1 and mean
values of 1, 2 and 3 respectively. Solving the
equations we have
*
4 R * 1 R 2
w1   w2  w3  
3 2 3 2 3

Investment Process
Moreover the mean and risk (standard deviation) for
the portfolio thus formed are:
RP ( n 3)  R *
*2
7 R
 P ( n  3)   2* R 
*
3 2

Investment Process
R
MVP( RMVP ,  MVP )

Investment Process
Suppose we have two portfolios (after solving the
optimization problem) corresponding to two
*
R
different starting values and
1 R2
*
Now combining them in some proportions such

that the respective weights adds up to 1 we can
have an infinite number of combinations, each of
which is a solution to the optimization problem.
This gives us the idea of the two fund theorem.

Investment Process
Two fund theorem

Two efficient funds (portfolios) can be
established so that any efficient portfolio
can be duplicated in terms of mean and
variance, as a combination of these. In other
words all investors seeking efficient
portfolios need only invest in a
combinations of these portfolios.
Investment Process
B ( RB ,  B )
A( R A ,  A )
R

Investment Process
The optimization problem under the consideration
that no SS is allowed was as follows
1 n
subject to 2 i , j 1
n n
 i i
w R  R *
w
i 1
i 1 wi  0
i 1

Investment Process
This is a non-linear optimization problem

and cannot be solved as shown before for
the case when SS is allowed.

Investment Process
Example # 02: We have the following data (variance covariance and
returns) which is given below
Security # Variance-Covariance Values Returns
1 2.300.930.620.74-0.23 15.10
2 0.931.400.220.560.2612.50
3 0.620.221.800.780.2714.70
4 0.740.560.783.40-0.56 9.02
5 -0.23 0.26-0.27 -0.56 2.6017.68

Investment Process
For solving consider two sets of

solution:
 =0 and =1 (gives MVP)

 =1 and =0

Investment Process 5
For =0 and =1 we solve

j 1
 i, j j  1
 v1
solving we have v =(0.141,0.401,0.452,0.166,0.440).

1
Normalizing the v1is so that the sum is 1 we obtain the

1
weights v
w1  ii 5
 j
v 1
j 1
w1=(0.088,0.251,0.282,0.104,0.275)
Thus we finally have R 1  14.413  1  0.791

Investment Process 5
For =1 and =0 we solve j 1

 i, j j  Ri
 v 2
solving we have v2=(3.652,3.583,7.248,0.874,7.706)

Normalizing the v2is so that the sum is 1 we obtain the
2
weights v
w2  i
i 5
 j
v 2
j 1
w2=(0.158,0.155,0.314,0.038,0.334)
Thus we finally have R 2  15.202  2  0.812

Investment Process
Assignment/Quiz # 01: There are two efficient
portfolios denoted by A and B respectively. The return
and risk of the two portfolios are as follows: E(rA) =20%
and A = 10%; E(rB) =10% and B = 5%. Assume that
the correlation coefficient between the portfolios is +0.5.
(a) What will the efficient frontier look like? Show it
very clearly and legibly. (b) What is the risk of the
efficient portfolio, which has a return of 15%? (c) Can
you find out the minimum variance point if you know
that short selling is allowed.
Investment Process
As already explained we are aware of the

concept of risk free interest rate (Rf). The
question we are interested in knowing
immediately is how does the feasible set,
minimum variance set and efficient frontier
look like when we include the risk free
interest rate along with n risky assets.

Investment Process
Feasible set, minimum variance set and efficient frontier considering risk free interest
rate
Borrowing
Lending
Lending Borrowing

Investment Process
One fund theorem
Q ( RQ ,  Q )
F ( R f ,0)
R

Investment Process
One fund theorem

There is a single fund Q of risky assets such
that any efficient portfolio can be
constructed as a combination of the fund Q
and the risk free interest rate F.

Investment Process
Assignment/Quiz # 02
The correlation coefficient between assets A and B is 0.1 and their
returns and standard deviations are as follows
Asset # SD Return
A 10.0% 15.0%
B 18.0% 30.0%
Find
 The proportion of A and of B that define a portfolio (consisting of A
and B only) having minimum standard deviation
 What is the value of minimum SD for the portfolio
 What is the corresponding mean return of the portfolio thus formed at
the minimum SD point
Investment Process
Take two scripts say TATA STEEL and SBI (from NSE) <
https://www.nseindia.com/> for the time period 01-01-2015
(dd-mm-yyyy) to 31-12-2015 (dd-mm-yyyy). Use the end of
the day price and then find the return (r). Using this
information and then find
 The proportion of TATA STEEL and SBI that define a
portfolio (consisting of TATA STEEL and SBI only) having
minimum standard deviation
 What is the value of minimum SD for the portfolio formed
with TATA STEEL and SBI only.
 What is the corresponding mean return of the portfolio thus
formed at the minimum SD point
Investment Process
Assignment /Quiz # 04
There are three (03) assets and their covariances and returns are given below
Asset # Variance Covariance Return
1 2 1 0 0.4
2 1 2 1 0.8
3 0 1 2 0.8
Questions
 Find the MVP
 Find another efficient portfolio
 Draw the efficient frontier considering correlation coefficient between the two
funds is 0.5
 If risk free interest rate is 0.2, find the efficient portfolio of risky assets
 Draw the efficient frontier when there is risk free interest rate

Investment Process
There are three (03) scripts (Reliance, ONGC, SBI from NSE <
https://www.nseindia.com/>for the time period 01-01-2016 (dd-
mm-yyyy) to 30-12-2016 (dd-mm-yyyy). Use the end of the day
price and then find the return (r). Using this information and
then find
 The MVP.
 Find another efficient portfolio.
 Draw the efficient frontier considering correlation coefficient as
calculated by you in this time period.
 Take the value of risk free interest rate as found by you from the
data and then find the efficient portfolio of risky assets.
 Draw the efficient frontier when there is risk free interest rate.

Investment Process
Techniques for calculating the efficient frontier
We will discuss here the following
 SS allowed along with Rf lending/borrowing possible
 SS allowed but Rf lending/borrowing not permitted
 SS disallowed along with Rf lending/borrowing possible
 SS disallowed nor is Rf lending/borrowing allowed
 Incorporation of other constraints/assumptions

Investment Process
SS allowed along with Rf lending/borrowing possible
Q ( RQ ,  Q )
F ( R f ,0)

Investment Process
For SS allowed along with Rf lending/borrowing
possible we should have the ray such that it is
furthest in the counter clockwise direction. The
efficient frontier is the entire length of the ray
extending from F to Q and beyond. Remember the
loci F-Q is tangent to the point Q. Different point
on the line represent different amounts of risk less
lending and/or borrowing in combination with the
optimum portfolio of risky assets.
Investment Process
Thus we have:
RQ  R f
max  
Q
such that n
 wi  1
i 1
There are two solution methods and one is using
Lagrangian. We will discuss that only

Investment Process
Thus we have:
n
 wi ( Ri  R f )
max   i 1
n 1
(  wi w j i. j ) 2
i 1
n
such that  wi  1
i 1

Investment Process
The solution is as given below (for k = 1, 2,
….., n)
n
/
 w j k , j  Rk  R f
j 1
wi/
wi 
n
/
 wj
j 1

Investment Process
Example # 03
There are three (03) assets and their covariances
and returns are given below. Also the risk free
interest rate is 5
Asset # Variance Covariance Return
1 036 009 036 14
2 009 009 009 08
3 036 009 225 20
Find the optimum portfolio thus formed with these
assets
Investment Process
Using the solution methodology we have
R1  R f  w1/12  w2/ 12  w3/13
/ / 2 /
R2  R f  w1 21  w2 2  w3 23
R3  R f  w1/ 31  w2/  32  w3/ 32

Investment Process
Thus
14 – 5 = w/1*36 + w/2*9 + w/2*36
8 – 5 = w/1*9 + w/2*9 + w/3*9
20 - 5 = w/1*36 + w/2*9 + w/3*225
Finally: w/1 = 14/63; w/2 = 1/63; w/3 = 3/63
w1 = 14/18; w2 = 1/18; w3 = 3/18
Note as a cross validation you can check that
the weights add up to 1.
Investment Process
SS allowed along but Rf lending/borrowing not permitted
Q1 ( RQ ,  Q1 )
1
Q2 ( RQ ,  Q2 )
R 2
Q3 ( RQ ,  Q3 )
F1 ( R f1 ,0) 3
F2 ( R f 2 ,0)
F3 ( R f 3 ,0)

Investment Process
Assume that a certain risk less interest rate for
lending/borrowing exits and using that
particular interest rate we find the
corresponding optimum portfolio and thus the
corresponding point Q. Continue doing that till
we are able to draw the entire portfolio shown
by the dotted curve

Investment Process
SS disallowed along with Rf lending/borrowing possible
Thus we have RQ  R f
max  
Q
n
such that  wi  1 wi  0
i 1
For this we have to use quadratic formulation and we would not
discuss it here.

Investment Process
SS disallowed nor is Rf lending/borrowing allowed
Thus we have n n
min{  wi2 i,i   wi w j i j }
i 1 i  j 1
such that n
 wi Ri  RP*
i 1
n
 wi  1
i 1
wi  0

Investment Process
Recall that we specify the return from the
portfolio at some level and minimize the
portfolio risk, which gives us a point on the
efficient frontier. This is a simple solution
which we have already discussed. Now varying
the specified portfolio return from MVP to
some point we get different values of the
optimum portfolio on the efficient frontier, thus
helping us to trace the efficient frontier

Investment Process
Incorporation of other constraints/assumptions
We can other constraints like depending on the practical situation a person
faces.
Few examples are:
n
 wi d i  D*
i 1
wimax  wi  wimin

Investment Process
Alternative definition of SS (Lintners definition)
As SS involves putting an amount of money equal to SS (for security
reasons), thus SS is use of fund rather than a source of fund (as we have
seen till now). The total fund that the broker-dealer invests short, plus
the fund invested long, must add up to the original value of the
investment. Since for SS wi0 , the proportion of the fund invested in
the SS is |wi|. Thus we have to use an important condition which is
n
 | wi |  1
i 1

Investment Process
The two important points about which we
should be concerned while implementing the
portfolio theory are
 Simplification of the amount and type of input
data needed to perform portfolio analysis
 Simplification of the computational procedure
needed to calculate the optimal portfolio

Investment Process
To solve the above mentioned
problems we can use
 Index models
 Single index model
 Multi index model
 Averaging techniques

Investment Process
Single index models
Under this method the most important
assumption is that the co-movement between
stocks is due to a single common influence or
index (which we will later call as the market
index). These models are not only used to
estimate the correlation matrix, but also used in
efficient market tests and in equilibrium tests

Investment Process
Ri   i   i Rm   i
Assumptions
E[ i ]  0  i=1,2,…..,n
E[ i ( Rm  Rm )] 0i=1,2,…..,n
 ij, i,j=1,2,…..,n
E[ i j ]  0
2  i=1,2,…..,n
V [ i ]    (i )
2
V [ Rm ]   m

Investment Process
Results
1) Ri   i  i Rmi=1,2,…..,n
2 2 2 2
2) i  i  m   i=1,2,…..,n
 (i )
2
3)  i, j  i  jm ij, i,j=1,2,…..,n

Investment Process
Example # 04
Assume  = 3 and  = 2.0 for Ri   i   i Rm   i
Month Return(i) Return(m)
1 14 5 2*5
2 10 4 2*4
3 25 10 2*10
4 16 7 2*7
5 4 1 2*1
Hence the errors are: +1, -1, +2, -1, -1 which adds up to 0 as the case should be

Investment Process
Results
n n
RP   wi i   wi  i Rm
i 1 i 1
n n n n
 P2   wi2 i2 m2   wi 2(i )   wi w j  i  j m2
i 1 i 1 i 1 j 1(i  j )
n
 P   wi  i
i 1
n
 P   wi i
i 1
Investment Process
RP   P   P Rm
Thus if the portfolio P is taken to be the market

portfolio (i.e., all stocks held in the same
proportion as they are in Rm), then the
expected return on P must be Rm

Investment Process
Risk of the portfolio
n n n n
 P2   wi2 i2 m2   wi   (i )    wi w j  i  j m2
2 2
i 1 i 1 i 1 j 1(i  j )
n
2
P   P2 m
2
  wi2 2(i )
i 1

Investment Process
From this equation (i.e., the variance of the
portfolio) we can have some feel of how
diversification takes place. Assume for the
time being that we invest in equal proportions
in the n number of stocks,
n
then
1
 P2   P2 m
2
   2(i )
n 2 i 1

Investment Process
n
2 2 2 2 2
For the risk P 
of i 1Pm  i   (i )
 portfolio
anyw
we have the first term known as non-

diversifiable/market/systematic risk.
While the second term is the
diversifiable/non-
market/nonsystematic risk

Investment Process
For the stock prices/indices (assuming
they are log-normally distributed) we
have r=ln(SP2/SP1). In place of R we
can use r and do all the calculation we
have done so far.

Investment Process
 In India we have the BSE and the NSE
 The most well known indices are BSE30 [
http://www.bseindia.com] and S&P CNX Nifty [
http://www.nseindia.com]
 The BSE30 has 30 companies, while S&P CNX Nifty
has 50 companies as the constituent scripts in the
portfolio/basket

Investment Process
BSE30 companies (as on March 2016)
Adani Ports Asian Paints
Axis Bank Bajaj Auto Ltd
Bharti Airtel Ltd Cipla Ltd
Coal India Ltd Dr. Reddy's Laboratories Ltd
GAIL HDFC
HDFC Bank Hero Motocorp
Hindustan Unilever Limited ICICI Bank
Infosys ITC
Larsen Lupin Ltd.
M&M Maruti Suzuki
NTPC Oil and Natural Gas Corporation Ltd
Power Grid Corporation of India Reliance Industries Ltd
State Bank of India Sun Pharmaceutical Industries Ltd
Tata Motors Ltd Tata Steel Ltd
Tata Consultancy Services Ltd Wipro Ltd

Investment Process
S&P CNX Nifty (as on 31-March-2016)
ABB India Ltd. Apollo Hospitals Enterprises Ltd. Ashok Leyland Ltd.
Bajaj Finance Ltd. Bajaj Finserv Ltd. Bharat Electronics Ltd.
Bharat Forge Ltd. Britannia Industries Ltd. Cadila Healthcare Ltd.
Castrol India Ltd. Colgate Palmolive (India) Ltd. Container Corporation of India
Ltd.
Cummins India Ltd. DLF Ltd. Dabur India Ltd.
Divi's Laboratories Ltd. Emami Ltd. GlaxoSmithkline Consumer
Healthcare Ltd.
Glaxosmithkline Pharmaceuticals Ltd. Glenmark Pharmaceuticals Ltd. Godrej Consumer Products
Ltd.
Havells India Ltd. Hindustan Petroleum Corporation Ltd. Hindustan Zinc Ltd.
Indiabulls Housing Finance Ltd. Indian Oil Corporation Ltd. InterGlobe Aviation Ltd.
JSW Steel Ltd. LIC Housing Finance Ltd. Marico Ltd.
Motherson Sumi Systems Ltd. NHPC Ltd. NMDC Ltd.
Oil India Ltd. Oracle Financial Services Software Ltd. Pidilite Industries Ltd.
Piramal Enterprises Ltd. Power Finance Corporation Ltd. Procter & Gamble Hygiene &
Health Care Ltd.
Punjab National Bank Shree Cement Ltd. Shriram Transport Finance Co.
Ltd.
Siemens Ltd. Steel Authority of India Ltd. Titan Company Ltd.
Torrent Pharmaceuticals Ltd. UPL Ltd. United Breweries Ltd.
United Spirits Ltd. Vedanta Ltd.

Investment Process (Assignment/Quiz # 06)
 Draw the scatter plot of S&P CNX Niftyt vs. S&P CNX Niftyt-1
 For each of the script draw the graph of script price with S&P CNX
Nifty
 For each of the script draw the graph of script return with S&P CNX
Nifty return
 For each script draw the volatility of the script price with volatility of
S&P CNX Nifty
 For each script draw the volatility of the script return with volatility of
S&P CNX Nifty return
 For each script draw the total volumes traded against the day
 For each script draw the total value traded against the day
Note: For this set of assignment the time frame is 01-Jan-2014 to 31-
Dec-2016
Investment Process
S&P CNX Nifty Price <
https://www.nseindia.com/products/content/equities/indices/historical_index_data.htm>

Investment Process
S&P CNX Nifty price returns
Date Close Rate=ln(Pt/Pt-1)
01-Nov-2016 8626 N/A
02-Nov-2016 8514 ln(8514/8626)=-0.013
03-Nov-2016 8484 ln(8484/8514)=-0.004
04-Nov-2016 8433 ln(8433/8484)=-0.006
07-Nov-2016 8497 ln(8497/8433)=+0.008
08-Nov-2016 8543 ln(8543/8497)=+0.005
09-Nov-2016 8432 ln(8432/8543)=-0.013
10-Nov-2016 8525 ln(8525/8432)=+0.011
Investment Process
Month A B C S&P
1 12.05 25.20 31.67 12.28
2 15.27 2.86 15.82 5.99
3 -4.12 5.45 10.58 2.41
4 1.57 4.56 -14.43 4.48
5 3.16 3.72 31.98 4.41
6 -2.79 10.79 -0.72 4.43
7 -8.97 5.38 -19.64 -6.77
8 -1.18 -2.97 -10.00 -2.11
9 1.07 1.52 5.63 6.16
10 12.75 10.75 -4.67 2.47
11 7.48 3.79 -4.67 2.47
12 -0.94 1.32 7.94 -1.15
Given the above data find the mean return and variance for each stock

Investment Process
For the five (05) individual scripts (ABB, Bharat
Electronics Ltd., JSW Steel Ltd., LIC Housing
Finance Ltd., Steel Authority of India Ltd. From
NSE) find their respective returns for the time
period 01-01-2016 to 30-06-2016. Also find the
corresponding S&P CNX Nifty returns.
Calculate the respective values of is for the five
companies considering S&P CNX Nifty as the
market index.

Investment Process
For five (05) individual scripts (the first five (05)) taken
from DAX <https://en.wikipedia.org/wiki/DAX> find
their respective returns for the time period 01-01-2016 to
30-06-2016. Also find the corresponding DAX returns.
Calculate the respective values of is for the five
companies considering DAX as the market index. For
this you need to get the EURO/GERMAN 91 days T-bill
value to find the corresponding risk free interest rate
pertaining to EUROPE/GERMANY

Investment Process
Assignment/Quiz # 09 (continued)
The DAX components are: Adidas, Allianz, BASF,
Bayer, Beiersdorf, BMW, Commerzbank, Continental,
Daimler, Deutsche Bank, Deutsche Börse, Deutsche
Lufthansa, Deutsche Post, Deutsche Telekom, E.ON,
Fresenius, Fresenius Medical Care, Heidelberg Cement,
Henkel, Infineon Technologies, K+S, Linde, Merck,
Munich Re, RWE, SAP, Siemens, Thyssen Krupp,
Volkswagen Group, Vonovia

Investment Process
The next question is how do we estimate the values of
betas. We can use the historical beta values as an
estimate of the future beta values.
The equation Ri   i isgenerally
i Rm   inot the same with
respect to time, in the sense the values of i, 2(i) and i
all change with respect to time. In case we consider
them to be independent with respect to time then we
have some straight forward procedure for calculating
these values.

Investment Process
Ri.t
i
i
Rm,t

Investment Process
T
 [( Ri,t  Ri,t )( Rm,t  Rm,t )]
 i, m
i   t 1
 m2 T
 2
 m , t m, t
( R R )
t 1
 i  Ri,t   i Rm,t
1 T
 2(i )   [ Ri ,t  ( i   i Rm,t )]2
T t 1

Investment Process
We may also be interested in determining the following
 i, m m
coefficient which is i, m   i
 i m i
Remember for all the calculation above we have
assumed i, 2(i) and i are independent of time. Having
said that, values we calculate using the above three
equations gives us an estimate of the true values of i,
2(i) and i and they may be subject to errors. In general
these calculated values are not equal to their respective
true values.

Investment Process
Multi index models
Using this methodology we try to capture some of the
non-market influences that cause securities to move
together. Searching for the non-market influences is
akin to searching for corresponding economic
factors/influences or structural groups (industries) that
account for common movement in stock prices, beyond
that accounted for by the market index itself. This
model introduces extra indices with the hope of
capturing additional information.

Investment Process
The basic use of multi index model is to predict the
correlation coefficients. Some other uses are:
 To form expectations about returns and study the
change in return due to impact of events.
 Method of tailoring the return distribution of a portfolio
to the specific needs of the investor.
 Method of attributing the cause of good or bad
performance of a portfolio.

Investment Process
Ri   i  bi (1) I1  bi ( 2) I 2  .....  bi ( L) I L   i
Assumptions
E[ i ]  0  i=1,...,n
V [ i ]   2(i )  i=1,...,n
V [ I j ]   I2( j )  j=1,…,L
E[( I j  I j )( I k  Ik )]  0j,k=1,...,L
jk,
E[( i   i )( I j  I  i=1,...,n & j=1,…,L
j )]  0

Investment Process
Ri   i  bi (1) I1  bi ( 2) I 2  .....  bi ( L ) I L
2 2 2 2 2 2 2 2
i  bi (1) I (1)  bi ( 2) I ( 2)  .....  bi ( L) I ( L)    (i )
 i, j  bi (1)b j (1) I2(1)  bi ( 2)b j (2) I2(2)  .....  bi ( L)b j ( L) I2( L)   I2( L)

Investment Process
Some variables which are used in multi index model are
(this is not an exhaustive list)
1) Economic growth
2) Business cycle
3) Long-term interest rates
4) Short term interest rates
5) Inflation, i.e., CPI
6) Foreign currency rates, like Rs. vs US$, Rs. vs Yen, Rs.
vs UK Pound, etc.

Investment Process
Prepare a 3 page page (A4 size) write up about how
multi index models are implemented in the
industry. Follow the norm of font size 11, Times
New Roman, margins of 1” on all sides and
paragraph space of 1 unit. Do a thorough search on
the net or in the book and do a comprehensive work.
This assignment have to submitted in hard copy,
typed and printed. Do not forget to write your full
name, roll #, page numbers and assignment number

Investment Process
Taking the index of one (01) company, e.g.,
Reliance from NSE (time period 01-01-2016 (dd-
mm-yyyy) to 31-12-2016 (dd-mm-yyyy)) model a
multi index model. You are free to choose the
variables which you think are appropriate. This is
just a rudimentary exercise to check the working
principle of the multi index model. This work
may not yield you an exact answer but would give
you an idea about the working principle of multi
index model.

Investment Process
Average techniques
Average (smoothing) of the historical
correlation data as a forecast of the future.
Note for multi normal distribution we can
assume that S is the best estimate of .

Investment Process
A better averaging model would be to assume that there was a
common mean correlation within and between groups of stocks. This
is to say that if we have one group as steel stocks and the other as
cement stocks, then the past correlation structure between the steel
stocks would be the best predictor of the future correlation structure
between steel stocks. Similarly for cement stocks. Moreover the past
correlation between the steel stocks group and the cement stocks
group would also be the best predictor of the future correlation
structure between the steel stocks group and cement stocks group.

Investment Process
Moreover the correlation between any steel
stock and any cement stock is assumed to be
same. To make this calculation simple we take
this value to the average of all the correlations
between each steel and cement stock taken in
pairs.

Investment Process
Simple techniques for determining the efficient
frontier
We will describe here the methods for selecting the
optimal portfolio considering
1) Single index model
2) Constant variance-covariance matrix

Investment Process
Using the single index model
We would be interested in finding a single number
that measures the desirability of including a stock in
the optimal portfolio. The desirability of any stock
to be included in the portfolio depends on the excess
return to beta ratio
Ri  R f
This meansi the additional return over and above the
risk free interest rate divided by the risk (in this case
the beta of the stock)

Investment Process
Now if there is no SS then if this ratio is –ve or zero
we would not include the particular stock in the
portfolio. For SS if this ratio is –ve it means that we
SS this stock, i.e., borrow this stock so that it is
included in our portfolio.

Investment Process
Without SS
Ri  R f include
 C*
i
Ri  R f * include
do
 Cnot
i
With SS
Ri  R f include
*
C
i
Ri  R f include with SS
 C*
i

Investment Process
The problem has the condition
 SS being not allowed
 Risk less lending and borrowing
being allowed

Investment Process
The rule works as follows
 Find the excess return to beta ratio for each
stock under consideration and rank them from
the highest to the lowest
 The optimal consists of investing in all stocks
with Ri  R f
 C*
i
 And not investing in any stock with
Ri  R f
 C*
i
Investment Process
Example # 05
We assume Rf=5% and 2m=10%
Ri  R f
Ri  R f i  2(i )
i Ri i
1 15.0 10.0 01.0 50 10.0
2 17.0 12.0 01.5 40 08.0
3 12.0 07.0 01.0 20 07.0
4 17.0 12.0 02.0 10 06.0
5 11.0 06.0 01.0 40 06.0
6 11.0 06.0 01.5 30 04.0
7 11.0 06.0 02.0 40 03.0
8 07.0 02.0 00.8 16 02.5
9 07.0 02.0 01.0 20 02.0
10 05.6 00.6 00.6 06 01.0

Investment Process
Ri  R f Ri  R f  i2 i Ri  R f i  2j
i ( ) i ( ) j 
i  2(i )  2(i ) j 1  2( j ) 2
j 1   ( j )
1 10 2/10 2/100 2/10 2/100

2 8 4.5/10 5.63/100 6.5/10 7.63/100
3 7 3.5/10 5/100 10/10 12.63/100
4 6 24/10 40/100 34/10 52.63/100
5 6 1.5/10 2.5/100 35.5/10 55.13/100
6 4 3/10 7.5/100 38.5/10 62.63/100
7 3 3/10 10/100 41.5/10 72.63/100
8 2.5 1/10 4/100 42.5/10 76.63/100
9 2 1/10 5/100 43.5/10 81.63/100
10 1 0.6/10 6/100 44.1/10 87.63/100

Investment Process
2
i Ri  R f
i m  ( ) j
j 1  2( j )
Ci 
2
i  2j
1  m  2
j 1   ( j )
1 1.67
2 3.69
3 4.42
4 5.43
5 5.45
6 5.30
7 5.02
8 4.91
9 4.75
10 4.52

Investment Process
This C* implies that for all assets above
(in the sense ) Ri  R f
 C*
i
will be included in the portfolio. And for
assets with they
Ri  R f *
C
i
would not be included. This is due to the
fact that SS is not being allowed

Investment Process
Remember one important thing. The summation is being done
from j to i. This is true for this case when SS is not being allowed
2
i Ri  R f
m  ( ) j
j 1  2( j )
Ci 
2
i  2j
1  m  2
j 1   ( j )

Investment Process
i Ri  R f
wi  [  C* ]
 2(i ) i
2
n Ri  R f
m ( ) j
* 2
n j 1  2( j )
C m   jwj 
j 1 2
n  2j
1  m  2
j 1   ( j )
The n here does not mean the whole set of assets given to you, but only the set of assets which
you have included in your portfolio. Here in this example it is 5.

Investment Process
2
n Ri  R f
m ( ) j
i Ri  R f j 1  2( j )
wi  [  ]
2
  (i )  i n  2j
2
1  m  2
j 1   ( j )
i w(i) w*(i)
(non-normalized wghts) (normalized wghts)
1 0.166667 0.284769
2 0.161702 0.276287
3 0.129006 0.220421
4 0.114172 0.195075
5 0.013724 0.023448
6
7
8
9
10

Investment Process
 SS being allowed (normal definition)
being allowed

Investment Process
with Ri  R f
 C*
i
 And also investing in stocks (SS) with
Ri  R f
 C*
i
Investment Process
2
We assume R fand 5% m  10%
Ri  R f
Ri Ri  R f i  2(i ) i
i
1 15 10 1 50 10
2 17 12 1.5 40 8
3 12 7 1 20 7
4 17 12 2 10 6
5 11 6 1 40 6
6 11 6 1.5 30 4
7 11 6 2 40 3
8 7 2 0.8 16 2.5
9 7 2 1 20 2
10 5.6 0.6 0.6 6 1

Investment Process
Ri  R f Ri  R f  i2 n Ri  R f n  2j
i ( ) i ( ) j 
i  2(i )  2(i ) j 1  2( j ) 2
j 1   ( j )
1 10 2/10 2/100 44.1/10 87.63/100

2 8 4.5/10 5.63/100 44.1/10 87.63/100
3 7 3.5/10 5/100 44.1/10 87.63/100
4 6 24/10 40/100 44.1/10 87.63/100
5 6 1.5/10 2.5/100 44.1/10 87.63/100
6 4 3/10 7.5/100 44.1/10 87.63/100
7 3 3/10 10/100 44.1/10 87.63/100
8 2.5 1/10 4/100 44.1/10 87.63/100
9 2 1/10 5/100 44.1/10 87.63/100
10 1 0.6/10 6/100 44.1/10 87.63/100

Investment Process
2
n Ri  R f
i m ( 2
) i
i 1   (i )
Ci 
n 2
2
1   m  2i
i 1  (i )
1 4.52
2 4.52
3 4.52
4 4.52
5 4.52
6 4.52
7 4.52
8 4.52
9 4.52
10 4.52

Investment Process
Now there is no C* which is maximum. As
we are considering all the assets (due to
SS), hence we have only one value (which
we, for our convenience will also denote
here by C*).
Assets with Ci>C* will be included in the
portfolio and for those with Ci<C* would
be included considering SS

Investment Process
There is no C* which is maximum. We are considering all the
assets (due to SS), hence we have only one value (which we, for
our convenience will also denote here by C*). Assets with
Ri  R f
 C*
i
Ri  R f
will be included in the portfolio and for those  C*
i
with would be included considering SS

Investment Process
Remember one important thing. The summation is being done from j to n (i.e., all assets
you have been provided with).
2
n Ri  R f
m ( 2
) i
i 1   (i )
Ci 
n 2
2
1  m  2i
i 1  (i )

Investment Process
i Ri  R f
wi  [  C* ]
 2(i ) i
n Ri  R f
2
m  ( 2 )i
* 2
n i 1   (i )
C m   i wi 
i 1 n 2
2
1  m  2i
i 1  (i )
The n here means the whole set of assets given to you. Here in this example it is 10.

Investment Process
2
n Ri  R f
m ( 2
)i
 Ri  R f i 1   (i )
wi  i [  ]
2
  (i ) i 2
n  2
1  m  2i
i 1  (i )
i w(i) w*(i)
1 0.10965 6.15451
2 0.13060 7.33022
3 0.12414 6.96730
4 0.29654 16.64391
5 0.03707 2.08049
6 -0.02586 -1.45167
7 -0.07586 -4.25799
8 -0.10086 -5.66116
9 -0.12586 -7.06432
10 -0.35173 -19.74129

Investment Process
 SS being allowed (Lintners
definition)
being allowed

Investment Process
with Ri  R f
 C*
i
 And also investing in stocks (SS) with
Ri  R f
 C*
i
Investment Process
2
We assume R fand 5% m  10%
Ri  R f
Ri Ri  R f i  2(i ) i
i
1 15 10 1 50 10
2 17 12 1.5 40 8
3 12 7 1 20 7
4 17 12 2 10 6
5 11 6 1 40 6
6 11 6 1.5 30 4
7 11 6 2 40 3
8 7 2 0.8 16 2.5
9 7 2 1 20 2
10 5.6 0.6 0.6 6 1

Investment Process
Ri  R f Ri  R f  i2 n Ri  R f n  2j
i ( ) i ( ) j 
i  2(i )  2(i ) j 1  2( j ) 2
j 1   ( j )
1 10 2/10 2/100 44.1/10 87.63/100

2 8 4.5/10 5.63/100 44.1/10 87.63/100
3 7 3.5/10 5/100 44.1/10 87.63/100
4 6 24/10 40/100 44.1/10 87.63/100
5 6 1.5/10 2.5/100 44.1/10 87.63/100
6 4 3/10 7.5/100 44.1/10 87.63/100
7 3 3/10 10/100 44.1/10 87.63/100
8 2.5 1/10 4/100 44.1/10 87.63/100
9 2 1/10 5/100 44.1/10 87.63/100
10 1 0.6/10 6/100 44.1/10 87.63/100

Investment Process
2
n Ri  R f
i m ( 2
) i
i 1   (i )
Ci 
n 2
2
1   m  2i
i 1  (i )
1 4.52
2 4.52
3 4.52
4 4.52
5 4.52
6 4.52
7 4.52
8 4.52
9 4.52
10 4.52

Investment Process
Ri  R f
 C*
i
Ri  R f
i

Investment Process
Remember one important thing. The summation is being done from j to n (i.e., all assets
you have been provided with).
2
n Ri  R f
m ( 2
) i
i 1   (i )
Ci 
n 2
2
1  m  2i
i 1  (i )

Investment Process
i Ri  R f
wi  [  C* ]
 2(i ) i
n Ri  R f
2
m  ( 2 )i
* 2
n i 1   (i )
C m   i wi 
i 1 n 2
2
1  m  2i
i 1  (i )
The n here means the whole set of assets given to you. Here in this example it is 10.

Investment Process
2
n Ri  R f
m ( 2
)i
 Ri  R f i 1   (i )
wi  i [  ]
2
  (i ) i 2
n  2
1  m  2i
i 1  (i )
i w(i) w*(i)
1 0.10965 0.07956
2 0.13060 0.09476
3 0.12414 0.09007
4 0.29654 0.21517
5 0.03707 0.02690
6 -0.02586 -0.01877
7 -0.07586 -0.05505
8 -0.10086 -0.07319
9 -0.12586 -0.09133
10 -0.35173 -0.25521

Investment Process
Using the constant variance-covariance
matrix
Here we consider the correlation coefficient
between asset i and j as always equal and constant,
no matter what is the asset number, i.e., i,j=ij
The ranking criteria is considered to be the excess
return to the standard deviation. i.e.,
Ri  R f
i
Investment Process
Without SS
Ri  R f include
 C*
i
Ri  R f * include
do
 Cnot
i
With SS
Ri  R f include
*
C
i
Ri  R f include with SS
 C*
i

Investment Process
 SS not being allowed
being allowed

Investment Process
 Find the excess return to SD for each stock
under consideration and rank them from the
highest to the lowest
with Ri  R f
 C*
i
 And not investing in any stock with
Ri  R f
 C*
i
Investment Process
We assume R f  5%
i R R
Ri  R f 
Ri Ri  R f i
 j
1    i j 1  j
f
Ci
i i
1 29 24 3 8 ½ 8 4
2 19 14 2 7 1/3 15 5
3 29 24 4 6 ¼ 21 5.25
4 35 30 6 5 1/5 26 5.2
5 14 9 2 4.5 1/6 30.5 5.08
6 21 16 4 4 1/7 34.5 4.93
7 26 21 6 3.5 1/8 38 4.75
8 14 9 3 3 1/9 41 4.56
9 15 10 5 2 1/10 43 4.3
10 9 4 2 2 1/11 45 4.09
11 11 6 4 1.5 1/12 46.5 3.88
12 8 3 3 1 1/13 47.5 3.65

Investment Process
This C* implies that for all assets above
(in the sense ) Ri  R f
 C*
i
will be included in the portfolio. And for
assets with they
Ri  R f *
C
i
would not be included. This is due to the
fact that SS is not being allowed

Investment Process
Remember one important thing. The

summation is being done from j=1 to
i. This is true for this case as SS is not
allowed

Investment Process
 n Ri  R f
C*  
1    n i 1  i
1 Ri  R f
wi  [  C*]
(1   ) i  i
This C* is different from the C*s we have considered under the single index mode. Also the n
is different for the case when SS is not allowed and for the case when SS is allowed

Investment Process
Remember one important thing. The summation is being done
from j to i. This is true for this case when SS is not being allowed
0.5
C1  *8  4
1  0.5  1* 0.5
0.5
C2  *[8  7]  5
1  0.5  2 * 0.5
0.5
C3  *[8  7  6]  5.25
1  0.5  3 * 0.5

Investment Process
i w(i) w*(i)
1 44/24 0.463
2 42/24 0.442
3 9/24 0.095
4
5
6
7
8
9
10
11
12

Investment Process
 SS being allowed (normal definition)
being allowed

Investment Process
with Ri  R f
 C*
i
 And also investing in any stock (SS) with
Ri  R f
 C*
i
Investment Process
We assume R f  5%
n R R
Ri  R f 
Ri Ri  R f i
 j
1    n j 1  j
f
Ci
i i
1 29 24 3 8 1/13 47.5 3.65
2 19 14 2 7 1/13 47.5 3.65
3 29 24 4 6 1/13 47.5 3.65
4 35 30 6 5 1/13 47.5 3.65
5 14 9 2 4.5 1/13 47.5 3.65
6 21 16 4 4 1/13 47.5 3.65
7 26 21 6 3.5 1/13 47.5 3.65
8 14 9 3 3 1/13 47.5 3.65
9 15 10 5 2 1/13 47.5 3.65
10 9 4 2 2 1/13 47.5 3.65
11 11 6 4 1.5 1/13 47.5 3.65
12 8 3 3 1 1/13 47.5 3.65

Investment Process
Ri  R f
 C*
i
Ri  R f
i

Investment Process

n. This is true for this case as SS is
allowed

Investment Process
 n Ri  R f
C*  
1    n i 1  i
1 Ri  R f
wi  [  C*]
(1   ) i  i

Investment Process
i w(i) w*(i)
1 1.45 0.88
2 1.68 1.02
3 0.59 0.36
4 0.23 0.14
5 0.43 0.26
6 0.09 0.06
7 -0.03 -0.02
8 -0.22 -0.13
9 -0.33 -0.21
10 -0.83 -0.51
11 -0.54 -0.33
12 -0.88 -0.54

Investment Process
 SS being allowed (Lintners
definition)
being allowed

Investment Process
with Ri  R f
 C*
i
 And also investing in any stock (SS) with
Ri  R f *
C
i
Investment Process
Ri  R f
 C*
i
Ri  R f
i

Investment Process
We assume R  5%
f
n R R
Ri  R f 
Ri Ri  R f i
 j
1    n j 1  j
f
Ci
i i
1 29 24 3 8 1/13 47.5 3.65
2 19 14 2 7 1/13 47.5 3.65
3 29 24 4 6 1/13 47.5 3.65
4 35 30 6 5 1/13 47.5 3.65
5 14 9 2 4.5 1/13 47.5 3.65
6 21 16 4 4 1/13 47.5 3.65
7 26 21 6 3.5 1/13 47.5 3.65
8 14 9 3 3 1/13 47.5 3.65
9 15 10 5 2 1/13 47.5 3.65
10 9 4 2 2 1/13 47.5 3.65
11 11 6 4 1.5 1/13 47.5 3.65
12 8 3 3 1 1/13 47.5 3.65

Investment Process

n. This is true for this case as SS is
allowed

Investment Process
 n Ri  R f
C*  
1    n i 1  i
1 Ri  R f
wi  [  C*]
(1   ) i  i

Investment Process
i w(i) w*(i)
1 1.45 0.20
2 1.68 0.23
3 0.59 0.08
4 0.23 0.03
5 0.43 0.06
6 0.09 0.01
7 -0.03 -0.01
8 -0.22 -0.03
9 -0.33 -0.05
10 -0.83 -0.11
11 -0.54 -0.07
12 -0.88 -0.12

Investment Process
Capital Asset Pricing Model (CAPM)
We are mainly concerned with two important
problems
 To determine the best course of action in the
investment process, i.e., how to device the portfolio.
 To determine the correct, arbitrage free or fair or
equilibrium price of any asset/security (we will be
mainly concerned with this question)

Investment Process
In answering the second question we
come across the CAPM which was
developed by Sharpe, Lintner and
Gossain

Investment Process
Assumptions
1) No transaction costs
2) Assets are infinitely divisible
3) Absence of personal tax
4) Investors transaction cannot affect the price of an
asset
5) Investors make decision based on return and risk
criterion

Investment Process
Assumptions
6) Unlimited SS is allowed
7) Unlimited risk less lending and borrowing is allowed
8) Investors define relevant period in exactly the same
manner
9) Investors have identical expectations with respect to
the necessary inputs for the portfolio decision
10) All assets are marketable

Investment Process
For the one fund theorem which we
had studied, a natural question arises
what would be the fund Q (risk
assets) which everyone would
purchase. Is it the market index or
something else.

Investment Process
That fund is the market index
portfolio, i.e., it is the fund that
contains share of every stock in
proportion to the stocks
representation in the entire market.
An assets weight is defined as the
proportion of the portfolio capital that
is allocated to the asset.

Investment Process
Hence the weight of the asset in the
market portfolio is equal to the
proportion of that assets total capital
value to the total market capital value.
This weight is called the market
capitalization weights and is denoted
by wi, as we already have seen.

Investment Process
Capital market/Pricing line
The capital market/pricing line shows the
relation between the expected rate of return and
the risk. Thus as risk increases so does the
expected return. Mathematically we can define
this as a linear regression, given by
RM  R f
RP[efficient(i )]  R f   P[efficient(i )]
The slope of the capital market/pricing
M line is
the price of risk

Investment Process
Capital market/Pricing line
M ( RM ,  M )
F ( R f ,0)
R

Investment Process
The capital market/pricing line relates
the expected rate of return of an efficient
portfolio to its standard deviation.
Remember it does not show how the
expected rate of return of an individual
asset is related to its corresponding risk.

Investment Process
CAPM
If the market portfolio M is efficient, then the
expected return for any efficient portfolio is
given by
RP[efficient(i )]  R f   P[efficient(i )] ( RM  R f )
 P[efficient(i )], M
RP[efficient(i )]  R f  ( RM  R f )
2
M

Investment Process
Beta is the normalized version of the
covariance of the asset with the market
portfolio. Hence we can say that the CAPM
formula states that the expected excess return
of an asset is directly proportional to its
covariance with the market. It is this
covariance that determines the expected
excess rate of return. CAPM changes our
concept of the risk of an asset from that of 
to .

Investment Process
Security market line
The CAPM can be expressed in
graphical form by regarding the
formula as a linear relationship. This
relationship is termed as the security
market line (as shown in the next
slides)

Investment Process
2
M ( RM ,  M )
F ( R f ,0)
R
cov( R, RM )
Investment Process
M ( RM ,1)
F ( R f ,0)
R

Investment Process
In both the graphs we have different variables in
the x-axis. Remember the essence of CAPM
emphasizes that any asset/portfolio should fall on
the security market line. Thus this line expresses
the risk reward structure of an asset/portfolio
according to the CAPM and emphasizes that the
risk of an asset/portolio is a function of its
covariance with the market or equivalently a
function of its beta

Investment Process
We know the systematic risk is given by i2M
and the nonsystematic risk as 2(i).
The systematic risk is the risk associated with
the market and cannot be reduced with
diversification, while nonsystematic risk can
be made zero with diversification.

Investment Process
Consider an asset on the capital market line
and in that case it would be an efficient
portfolio which is formed by investing some
proportion in the market portfolio and the rest
in the risk free interest rate. If nonsystematic
risk is zero then the portfolio is exactly on the
capital market line. So more the
nonsystematic risk greater is the shift towards
the right.

Investment Process
M ( RM ,  M )
F ( R f ,0)
R Portfolio with
systematic risk Portfolios with systematic
only and nonsystematic risks

Investment Process
For performance evaluation we have the CAPM
model as
Rî  R f  î ( Rˆ M  R f )  J
J is the error term and is the Jensens index

Investment Process
According to CAPM, the value of J should be zero
when the true expected returns are used. Hence J
measures approximately how much the performance of
any index/stock has deviated from the theoretical value
of zero. A positive J implies the stock did better and a
negative J implies it did worse. The value of J tells us
nothing about the fund, but instead it is a measure of
the volatility of the CAPM. If CAPM is valid then
every security/fund must satisfy CAPM exactly. If we
find a so called efficient portfolio security with non
zero J then the market is itself inefficient.

Investment Process
i ( Ri , i )
M ( RM ,1)
Jensens Index
F ( R f ,0)

Investment Process
In order to measure the efficiency of a
security or the market we use, S, the
Sharpe index and the formula is given by
ˆR  R  Sˆ
i f i

Investment Process
M ( RM ,  M )
i ( Ri ,  i )
F ( R f ,0)
R Theta

Investment Process
CAPM model with stochastic price would
be
E[ Pi (t T2 ) ]  Pi (t T1 ) E[ PM (t T2 ) ]  PM (t T1 )
 R f  i {  Rf }
Pi (t T1 ) PM (t T1 )
The factor given below is the risk adjusted

interest rate
E[ PM (t T2 ) ]  PM (t T1 )
1  R f  i {  Rf }
PM (t T1 )

Investment Process
 Linearity of pricing (means no
arbitrage)
 Certainty equivalent form

Investment Process
In the CAPM model we have considered the
returns are normally distributed. In case they
are log-normally distributed then the modified
CAPM is E ( Ri )  R f E ( RM )  R f
 i
E ( Ri ) E ( RM )
exp( i , M  i M )  1
where i  2
exp( M ) 1

Work Breakdown Structure in
Project Management
 Work Breakdown Structure (WBS) is a process
that sets a project’s scope by breaking down its
overall mission into a cohesive set of
synchronous, increasingly specific tasks.
 Any project is just a collection of a number of
discrete steps, or activities, that collectively add
up to the overall deliverable.

Work Breakdown Structure in
Project Management
 The WBS lays out the individual building blocks
that will construct the project.
 This process is critical because for most of us,
planning a project can be an intimidating
experience.
 The WBS helps us create a necessary structure to
the project by outlining the individual steps
needed to succeed.

Schematic Expression of WBS
 Stage 1: Give a detailed list of work which are
primary
 Stage 2: Break down all the primary work into
secondary
 Stage 3: Break down all the secondary work in to
tertiary

Schematic Diagram of WBS

Cost Estimation in Project
Management
 A cost estimate is a forecast for the total final cots of executing
the project.
 The main purpose of the cost estimate is to provide a baseline
or reference for cost control, i.e., to control that the resource
spending in the project is kept within the cost frame used for
assessing the feasibility of the project.
 Cost estimation involves two important aspects:
 The estimate is an approximate calculation
 The estimate contains uncertainty

Cost Estimation Methods
 There are, in principle, two types of estimating methods:
 Synthetic methods: In this method we estimate the costs
without break down, and only use the characteristics of the
system. This means that synthetic methods may be used in
the early phases for ball park estimates, and that analytical
methods find their application in developing control
estimates.
 Analytical methods: In this method we estimate the resource
consumption by breaking the total system down on
subsystems and estimating the resources for each of these.

Cost structure and contingency
allowance

Project Management Scheduling
 It is the process of converting project goals into an
achievable methodology for their completion.
 It creates a timetable and the network logic that relates
project activities to each other in a coherent fashion.
 Scheduling is critical because the goal of project
management is to complete a set of goals in a specified
time frame.
 The more efficient we are at creating a project schedule,
the more likely we are to satisfy this key success
criterion.
Activity Duration in Project
Management
 Typically, there are two ways to determine
activity durations:
 Deterministic: Assumes that sufficient knowledge is
available to develop a reasonably accurate time
estimate for project activities, refer to CPM
 Stochastic: Assumes that knowledge is insufficient to
develop any reasonably accurate time estimate for
project activities, refer to PERT

 There are three terms connected to scheduling
that we need to define:
 Activity – which is a set of work items requiring
resources to be executed
 Event – which is a point in time when an activity starts
or finishes
 Milestone – which is a planned observable event
connected to a defined result

 There are two ways to represent a
schedule:
Gantt chart (bar chart)
Network

GANTT Chart in Project
Management

GANTT Chart in Project
Management
 The main advantage of a Gantt chart is that it is
easy to read and understand.
 It communicates well, even to persons not
familiar with schedules.
 Originally, it did not show precedence
relationships between the activities, but modern
software packages have corrected this deficiency.

Precedence Diagram in Project
Management
 Precedence diagramming is a schematic
display of the project sequential
activities and the logical relationships
between them.

Precedence Diagram in Project
Management
 Creating a precedence diagram, or network, is crucial for several
reasons, including:
 Networks clearly illustrate the interdependence of all tasks or
work packages to each other and to the overall project.
 Networks help us identify those tasks that are dependent on other
activities. This information tells us which activities must be
highly coordinated to ensure smooth completion.
 Networks allow us to determine when the project will be
completed.
 Networks help with overall master scheduling of organizational
resources because they show us times when personnel must be
fully committed to project activities.

Project planning
Initial planning
Job Alternative Job Dept. Time
Identification description (Days)
A (1,2) Forecasting sales Sales 14
B (2,4) Pricing Sales Sales 03
C (2,3) Preparing Production Production 07
Schedule
D (3,4) Costing the Accouting 04
Production
E (4,5) Preparing the budget Treasurer 10

Project Graph
Depending on the nomenclature we have two different
ways of depicting an/a activity/job/task, i.e., either using
a node or an arc.
Node Arc
Hence we have Activity on Arc (AOA) and Activity on

Node (AON) depiction of projects.

PERT Example (AON Network Diagrams)
A C
edge or arc
Node A represents Activity A Node C represents Activity C
The edge or arc represents the precedence relationship

between the two activities

PERT Example (AOA Network Diagrams)
Activity A
1 2
edge or arc
Node 1 represents the Node 2 represents the

beginning of Activity A ending of Activity A
The edge or arc represents Activity A

AOA and AON Diagram (Shown together)

A B C
E
A C
F

A B
1 2 3 D
C 4
B
A 3
1 2
C 4

A
F
C
H
B E
D G

B G
2 3 K
7 Q
C H 8
A
A F L O
D 11
4 6 10
1 R
I P
J M S
E
5 9
N

The project network began on more than one node and ended on a
single node. Other variants are:
B Beginning with one

E node and ending with
A D more than one node
C F
Beginning with more

A E than one node and
C D ending with more
than one node
B F

The Start and Finish boxes tie the network off at its ends and give one a
sense that the network has defined points in time at which the project
begins and ends. The use of such a convention is not necessary and will
generally be avoided.
A E
Start C D
Finish
B F

A C
1 2 A 2 4
1 E
A 2 D
B 3 5
1 B
3

C
2 4
A F
1 H
E 6 7
B
3 D G
5

• Note that in the problem the work begins on a single node and ended on a single node.
• When constructing Network diagrams using the AOA approach, this convention is
followed--network diagrams begin on a single node and end on a single node.
• Note also a second convention in AOA Network diagram construction. Two nodes are
connected by one and only one activity (edge or arc). Thus,
Act. I.P.
A __ No, and why not? Rather, this is preferred and why?
B __ A C
A C
C A,B
D B
B d1
B D
D

Finally, a third convention. An arc cannot emanate from or terminate at more
than one node.
Act. I.P. No, and why not?
A __
B __ D
C A,B A
D A C
NO!
E B
B
E
D
A d1
Rather, this is preferred and why?
C
d2
B
E

PERT Example (AON and AOA Network Diagrams)
Immediate Description Predecessor

Activity
A build internal components ___
B modify roof and floor ___
C construct collection stack A
D pour concrete and install frame B
E build hi-temp burner C
F install control system C
G install air-pollution control device D,E
H inspect and test F,G

Rule for AOA
 Based on our discussion so far, we can indicate some of
the rules for drawing an AOA network:
 The network should be connected without any cycle
 It should have unique start and finish events
 Events should be numbered so that for any activity the
finish event has a higher number than the start event
 An activity may be represented by one arc only
 Two activities may not have identical start and finish
events

Important Points Regarding
Activity Network
 Prior to constructing an activity
network, there are some simple rules of
thumb you need to become familiar
with as you develop the network
diagram. These rules are very helpful in
understanding the logic of activity
networks
Activity Network
1. Some determination of activity precedence ordering must
be done prior to creating the network. That is, all activities
must be logically linked to each other; those that precede
and other, subsequent activities.
2. Network diagrams usually flow from left to right.
3. An activity cannot begin until all preceding connected
activities have been completed.
4. Arrows on networks indicate precedence and logical flow.
Arrows can cross over each other, although it is helpful for
clarity’s sake to limit this effect when possible.

Activity Network
5. Each activity should have a unique identifier associated
with it (number, letter, code, etc.). For simplicity, these
identifiers should occur in ascending order; each one
should be larger than the identifiers of preceding
activities.
6. Looping, or recycling through activities, is not permitted.
7. Although not required, it is common to start a project
from a single beginning node, even in the case when
multiple start points are possible. A single node point
also is typically used as a project end indicator.

Simple Example of Precedence
Diagram (Network)
 A–B–F–H–J
 A–C–E–H–J
 A–C–E–G–J
 A–D–I–J
 Similarly for others starting with B, C,
E, F, G, H, I, J

Diagram (Network)

Diagram (Network)
 We also know the estimated duration for each of the
activities in the project network and can apply them to
determine the time necessary to complete each path.
Thus:
Path A – B – F – H – J = 4 + 4 + 4 + 2 + 4 = 18 days
Path A – C – E – H – J = 4 + 2 + 2 + 2 + 4 = 14 days
Path A – C – E – G – J = 4 + 2 + 2 + 2 + 4 = 14 days
Path A – D – I – J = 4 + 5 + 3 + 4 = 16 days

Diagram (Network)

Diagram (Network)
 Once we have completed the backward pass, we can determine
individual activity float, for each task as well as for each path through
the network.
 Again, float informs us of the amount of time an activity can be
delayed and still not delay the overall project.
 To illustrate the implications of float, suppose that Activity C is
delayed and cannot start until 3 days after the original schedule.
 What are the implications of this delay on the overall project? None!
With 4 days of float for Activity C, a delay of 3 days will not affect
the overall length of the project or delay its completion.

Diagram (Network)
 One other important point to remember about activity float is that it is
determined as a result of performing the forward and backward
passes through the network.
 Until we have done the calculations for ES(early start), EF(early
finish), LS(late start), and LF(late finish), we cannot be certain which
activities have float associated with them and which do not.
 Using this information to determine the project critical path suggests
that the critical path is the network path with no activity float
associated with it.

Diagram (Network)
 In our project example, we can determine the
critical path by linking the nodes with no float:
A – B – F – H – J. We can also determine the
float for individual path float; that is, the
linkage of each node within a noncritical path.
For example, the path A – D – I – J has 4 days
of float.

Project Graph
4
B, 3 days E, 10 days
4
A, 14 days
1 2 D, 4 days 5
5
C, 7 days
3

Project Graph
(Critical Path)
4
4
A, 14 days
1 2 D, 4 days 5
5
C, 7 days
3

Project planning
Main drawbacks of CPM, PERT
1) They do not consider any feedback loop
or re-evaluation loop which is very
essential for any projects.
2) They only consider end to start (E to S)
relationship between any two consecutive
tasks or activities which are dependent on
one another.

Project planning
Looping not allowed

Precedence Relationship
E to E, E to S, S to E and S to S relationship
E to E
E to S
A B
S to S
S to E


 Finish-to-start relationship (FS): The Activity B may not
start until x days after activity A has finished. By letting
x = 0, the precedence relationship becomes “B may start
as soon as A is finished”.
 Start-to-start relationship (SS). The Activity B may not
start until x days after the start of activity A.
 Finish-to-finish relationship (FF). The Activity B may
not finish earlier than x days after activity A is finished.
 Start-to-finish relationship (SF). The Activity B may not
finish earlier than x days after activity A has started.
 In order to perform a forward scheduling

we have to “normalize” the FS, FF and SF
time relationships to a SS relationship.
Correspondingly, to perform a backward
scheduling we “normalize” the time
relationships FS, SS and SF to a FF
relationship.

Rules for calculating Precedence
Relationship
Type Forward Backward
FS dA+x dB+x
SS x dB+x-dA
FF dA+x- dB x
SF x- dB x-dA

Relationship
 The time relationships (a time intervalfor
example number of days) can both be a lower
bound or an upper bound on the time that
separates the start/finish of two next following
activities.
 Furthermore, time points and time relationships
can both be positive or negative depending on
we calculate forward or backward in time or
reverse the time axis.
Relationship
 There may be two approaches to assign time
interval to networks:
 Time interval is a lower or upper bound on event times
of activities, i.e. a time relationships
 Time interval is the duration of an activity, i.e. an
attribute.

PERT
 PERT was originally conceived in the late 1950’s
as a joint venture of the U.S. Navy and Booz
Allen Hamilton for the Polaris missile program.
 This technique uses probabilistic estimation; that
is, it assigns likely probabilities to a range of
estimates for each activity that reflect the
uncertainties inherent in the estimation process.

PERT
 PERT estimates recognize that for any activity duration, there are
three important estimates:
 Optimistic time (a) – the time an activity will take if everything
happens as planned. In estimating the duration for a, there should
be only a 1% chance (1/100) that the activity time will be <a.
 Most likely time (m) – the most realistic time to complete the
activity.
 Pessimistic time (b) – the time an activity will take if nothing
happens as planned; that is, if everything goes wrong or conditions
are most unfavorable. In estimating the duration for b, there
should be only a 1% chance (1/100) that the activity time will be
>b.
PERT
 The logic for this assumption is based on the
understanding that to achieve a probability
distribution with a 99% confidence interval,
observations should lie within three standard
deviations of the mean in either direction.
 A spread of six standard deviations from tail to
tail in the probability distribution, then, accounts
for 99.7% of the possible activity duration
alternatives.
PERT Distribution

Beta Distribution (v/s Triangular distribution)

PERT Calculation
 The beta distribution suggests that the formulae for deriving
E(T) and Var(T) are:
 ET = (a + 4m + b)/6
 Var(T) = {(tb-ta)/6}2
Where
 ET= Expected time for activity

 a= Most optimistic time to complete the activity
 m= Most likely time to complete the activity, the mode of
the distribution
 b= Most pessimistic time to complete the activity
PERT Calculation
 The expected number of days required to finish a project is the sum of
the number of days required for each activity/job/task. Remember here
the time required for each activity/job/task must be its respective E(ti),
where i=1,…..,m (the number of the activity/job/task)
 The critical path length is also calculated using the respective expected
time for each activity/job/task, i.e., E(CP) = {E(t1) + E(t2) + …….
+E(tK)}, where 1, 2, …, K are the jobs/activities/tasks on the critical
path.
 Remember for finding out the variance of the total project we simply
add the variances of the activities/jobs/tasks and not the standard
deviation. The important assumption which helps us to add the
variances, is that the activities/jobs/tasks are independent. Thus
Var(CP) = {Var(t1) + Var(t2) + ….. + Var(tk)}, where 1, 2, …, K are the
jobs/activities/tasks on the critical path.
PERT
 Remember we can have multiple critical paths
for a project.
 Then also the question arises which
activities/jobs/tasks should we concentrate on so
as to reduce the project time.
 Definitely the easiest method is to reduce the
timing for a common activity/job/task. But there
are methods by which we can find the best
combination of activities/jobs/tasks.

PERT
5
5
3
2
2
5
4 6 8 9
1 3 2
2
1
3
3 4 7
2 3

PERT
For the project illustrated above we can reduce any one

of the following
 8-9
 1-2 and 1-3
 5-8, 6-7 and 4-7
 1-2, 3-5, 3-6 and 3-4
 2-5, 3-5, 3-6, 4-6 and 4-7

PERT
 We must find the amount of slack which is available for
each activity/job/task.
 For the critical path slack is not available for any of the
activity/job/task.
 For the non-critical path slacks may be available for an/a
activity/job/task. This means, if due to unavoidable
circumstances we face some problem we can absorb the
delay by utilizing these slacks. It may not affect the over
all duration of the job, but will definitely increases the
cost of the project.
Critical Path and slack available
4
4
A, 14 days
1 2 D, 4 days 5
5
C, 7 days
3

Critical Path and slack available
Slack available for activities/jobs/tasks are as

follows:
1) A: 0
2) B: 8
3) C: 0
4) D: 0
5) E: 0

Early and late start for an activity/job/task
Given the early and late start date of any activity/job/task we can
find the amount of slack for that activity/job/task, as LS-ES or LF-
EF, i.e.,
 TS = LS –ES or TS = LF- EF
 FS(i)=earliest of all ES(j)-EF(i); here j is the set of all
activities/jobs/tasks which are immediate successors to the
activity/job/task i.
 Thus the total slack (TS) for the path would simply be the addition
of the slacks of the corresponding activities/jobs/tasks.
 Free slack (FS) is the actual number of days which we may have for
us to use as a cushion in case of emergencies.
 Remember we always have {FS  TS}, and there may be cases
where an/a activity/job/task can have TS but no FS.

PERT
We have briefly mentioned about early start, late
start, early finish and late finish, but what do
they actually mean
 ES = is the earliest possible time when an
activity/job/task can start
 EF = ES+t
 LS= is the latest possible time when an
activity/job/task can start without pushing the
project duration
 LF=LS+t
PERT (Example # 13)
4
3
3
10 6
3 5
1
4
14
2 3
7

PERT (Forward pass method)
Activity 1-2 (t=14) ES=0; EF=0+14=14
Activity 1-4 (t=3) ES=0; EF=0+3=3
Activity 2-4 (t=3) ES=14; EF=14+3=17
Activity 2-3 (t=7) ES=14; EF=14+7=21
Activity 3-5 (t=4) ES=21; EF=21+4=25
Activity 4-5 (t=3) ES=17; EF=17+3=20
Activity 5-6 (t=10) ES=25; EF=25+10=35

PERT (Backward pass method)
Activity 5-6 (t=10) LF=35; LS=35-10=25
Activity 4-5 (t=3) LF=25; LS=25-3=22
Activity 3-5 (t=4) LF=25; LS=25-4=21
Activity 2-3 (t=7) LF=21; LS=21-7=14
Activity 2-4 (t=3) LF=22; LS=22-3=19
Activity 1-4 (t=3) LF=22; LS=22-3=19
Activity 1-2 (t=14) LF=14; LS=14-14=0

PERT
Activity 1-2 (t=14) TS=0
Activity 5-6 (t=10) ES=0

PERT
4
3
3
10
3 5 6
1 4
14
5 3
7

PERT
Free slack (FS) for any activity/job/task is defined as the cushion
which is available without affecting the early start time of any
other activity/job/slack.
FS(i)=earliest of all ES(j)-EF(i)
Here j is the set of all activities/jobs/tasks which are immediate
successors to the activity/job/task i.
Activity 1-2 (t=14) FS=14-14=0
Activity 1-4 (t=3) FS=17-3=14
Activity 2-4 (t=3) FS=17-17=0
Activity 2-3 (t=7) FS=21-21=0
Activity 3-5 (t=4) FS=25-25=0
Activity 4-5 (t=3) FS=25-20=5
Activity 5-6 (t=10) ES=35-35=0

Forward and Backward
Scheduling

GANTT CHART
 We must know the dependence between
jobs/activities/tasks.
 We must know the respective jobs/activitys/tasks early
start time and late start time, remembering that there are
external factors which may affect the start and end time
of jobs/activities/tasks.
 This chart gives us an over all picture of the number of
days which will be required to finish a project.

GANTT CHART
Early Start Schedule
JOB DESCRIPTION DAYS
Clear for construction
Concrete forms
Reinforcement
Pour concrete
Clear grade
Sewer lines

GANTT CHART
Late Start Schedule
JOB DESCRIPTION DAYS
Clear for construction
Concrete forms
Reinforcement
Pour concrete
Clear grade
Sewer lines

PERT Calculations
 Based on the Central Limit Theorem (CLT) the
project duration may be assumed to follow a
normal distribution.
 This can be used to answer to important
questions:
 What is the probability that the project will finish
within a given deadline?
 What deadline should be set if the probability of
meeting it should be at least x%?

PERT Calculations
• The probability that the total project time, T, will
be less than D can be expressed P(T D)= Ф[{D-
E(T)}/sqrt{V(T)}], where
• E(T) is the expected value of the total project
duration, T
• Var(T) is the variance (s2) of the total project
duration.
• Ф is the normal distribution (0,1).

PERT Calculations
• We want to fix the deadline D that can
be obtained with a probability 
• T~NT{E(T),Var(T)}
• Considering CLT to be true one can use
the following equation Ф[{D-
E(T)}/SD(T)]=, here SD(T)=Var(T)

Project Graph with expected time and standard deviation
4
B, 3, 1 E, 10, 3
A, 14, 4
1 2 D, 4, 2 5
C, 7, 1.5
3

 If we are given the respective expected times and the

standard deviations for the activities/jobs/tasks, can we
know the critical path for certainty? The answer is NO.
 If we are lucky then a simple calculation as we have
done in the earlier case can solve the problem to provide
us with the critical path and the respective critical
activities/jobs/tasks.
 In case we cannot, then we use simulation to find the
critical path and the corresponding critical
activities/jobs/tasks.
Activity Expected time Standard deviation Variance

(1,2) 06 02 04
(1,3) 12 03 09
(2,4) 13 02 04
(3,4) 05 01 01
(4,5) 04 01 01
(3,5) 16 04 16

• The longest path is 1-3-5 and the expected time or the critical path time is
12+16=28 and the corresponding variance is 9+16=25.
• This implies the job may take anything between 28-5=23 to 28+5=33
number of days.
• The next longest path (1-2-4-5) has a length of 23 and the corresponding
variance is 9, which implies that the maximum and the minimum time
required along this path is 23+3=26 and 23-3=20 respectively.
• What if due to some external circumstances the standard deviations for the
paths 1-2, 2-4 and 4-5 are 4, 8 and 3 respectively. Then the new sum of
variances for this path is 16+64+9=89.
• In which case the maximum time required along the path 1-2-4-5 is
32.4333. Now can we say which is the critical path and the corresponding
critical activities/jobs/tasks?

Expected time and standard deviation for project
E(t)-SD(t) E(t) E(t)+SD(t)

1) In maximum of the projects we are first given the due date or

completion date, i.e., at which date we have to complete the job and
then deciding what is the project we decide the activities/jobs/tasks
and the find out the critical path and whether we can finish the
project within that due/completion date.
2) In case we are assume the expected time and variance of each and
every activity/job/task we find what proportion of the project would
be finished within that due/completion date.
3) Criticality index: I say for example we run a simulation study for
1,00,000 times and if an/a activity/job/task is on the critical path
30,000 number of time then we say the criticality index for that
activity/job/task is 0.3.

Project planning
· Remember that we usually plan a project
considering man hour days, hence it is important to
evaluate the cost structure of each individual
activity/job/task and then extrapolate it to find the
total cost of the project
· Simplistically TC = {t1*c1+t2*c2+….+tn*cn}
· Here tis are the time periods for an/a
activity/job/task and we must consider all of them.
Here cis are the corresponding costs per unit time.

Project Graph (Critical Path)
• Critical path is 1-2-3-4-5, which is 14+03+04+10=31 days
• Now if costs per unit day for the paths, 1-2, 2-3, 2-4, 3-4 and 4-5
are 05, 10, 10, 15 and 25 respectively, then the total cost is
14*05+03*10+03*10+04*15+010*25=440
4
4
A, 14 days
1 2 D, 4 days 5
C, 3 days
3

Simple costing methods for a project
Two different scenarios considering there is a penalty of 20 (some

monetary unit) per day for over shooting the stipulated time
duration of the project which is 31 days.
1) Due to some unavoidable circumstances the time duration for
activity B increases to 4 days from 3 days, then the incremental cost
is 1*10 and from this we can find the percentage increase in the cost
of the whole project. As there is no over shooting of the time
duration we only incur an additional cost of 10. Hence % increase
of cost is 10/440=2.3%
2) Due to some unavoidable circumstances the time duration for
activity C increases to 4 days from 3 days, then the incremental cost
is 1*10+1*20 and from this we can find that the percentage increase
in the cost of the whole project is 30/440=6.8%.

Costing methods for a project
We must remember here that we are considering the E to S criteria for

denoting the number of days. If that had not been the case then the
incremental cost structure would have been much more difficult to
calculate.
You can consider different hypothetical cases where we can use a
combination of different depiction of the duration of days for an
activity/job/task, i.e., E to E, E to S, S to E and S to S.
Comment
1) For a E to E depiction of the number of days (only) is it true that the total
number of days for a project would change?
2) For a E to S depiction of the number of days (only) is it true that the total
3) For a S to E depiction of the number of days (only) is it true that the total
4) For a S to S depiction of the number of days (only) is it true that the total

Costing methods for a project
Remember we are considering a linear cost structure,

i.e., an increase in the number of days has a linear
increase in the cost of the activity/job/task and hence the
TC of the project can be considered to be varying
linearly. Calculating the marginal cost function for the
project is relatively easy.
If the cost structure of the activity/job/task varies non-
linearly with the number of days, then we face a lot of
problem and depicting the marginal cost function for the
project is quite complicated.

Some methodologies
1) Strength Weakness Opportunities Threat (SWOT): For

this we analyze the characteristics of the project related
to the four main evaluation criterion stated above.
2) We may be interested in resource allocation and then
concentrate on resource leveling.
3) We may be interested in only resource allocation and not
on resource leveling.

t-SD(t) t D t+SD(t)

Chance of completion of a project with the due date D
 Given the due date say D, we may wish to calculate how probable
is it that the project will be completed within that due date, i.e.,
Pr[X  D] = Pr[{X-E(t)}/SD(t)  {D-E(t)}/SD(t)]. Thus
considering E(t)=50, SD(t)=10 and D=50, we have Pr[Z0]=0.5,
i.e., there is a 50% chance that the project will be completed within
the due date of 50. In other words we can also state that out of 100
cases of the same project being taken up time and again with the
same E(t), SD(t) and due date, D, we will have 50 cases where the
job will be finished within the due date.
 We can also find the change in probability that the job will be
completed within the due dates given by the two values, D1 and D2,
i.e., P[Z  z1] and P[Z  z2], these z1 and z2 are for different values
of D, i.e., z1={D1-E(t)}/SD(t) and z2={D2-E(t)}/SD(t)

Cost or penalty to be paid considering due date D
The penalty structure for a project is as follows,

considering the due date as 60
1) Less than 60% complete penalty is Rs. 15 lakhs
2) Between 61-69% complete penalty is Rs. 6 lakhs

Penalty
% complete

The penalty structure need not be a step wise function as shown in

the precious slide. It can be a continuous function also.
Penalty
% complete

PERT (Example # 14)
Consider the following table of activities and this has immediate predecessor(s)
(I.P.), optimistic, most likely, most pessimistic, E(ti) and var(ti) for each activity
ACT I.P. Optimistic (a) Most Likely (m) Pessimistic(b) E(ti) var(ti)
A __ 01 02 03 02 04/36
B __ 02 03 04 03 04/36
C A 01 02 03 02 04/36
D B 02 04 06 04 16/36
E C 01 04 07 04 36/36
F C 01 02 09 03 64/36
G D,E 03 04 11 05 64/36
H F,G 01 02 03 02 04/36

PERT
F
A C 3
2 2 H
E 2
4
B D G
3 4 5

PERT
A-C-F-H; A-C-E-G-H; and B-D-G-H. Summing the

E(ti) on each path yield time through each path of 9,
15, and 14 weeks, respectively. With an E(t) = 15 for
A-C-E-G-H, this path is defined as the critical path
(CP) being the path that governs the completion time
of the project . Despite the beta distribution of each
activity, the assumption is made that the number of
activities on the CP is sufficient for it to be normally
distributed with a variance equal to the sum of the
variances of its activities only, var(t) = 112/36 = 3.11

PERT
C
4
A 2 F
E H
1 6 7
B 3 5 G
D

PERT
· Given E(t) = 15 weeks and Var(t) = 3.11, what is the
probability of the project requiring in excess of 16 weeks to
complete?
· Pr{X 16} = 1 – Pr{X < 16} = 1 - Pr[Z < {(16 – 15)/1.76} =
(1 - 0.716)
· One should remember that 1.76 is the square root of 3.11, the
standard deviation of the expected completion time
· The assumption is that summing up a sufficient number of
activities following a beta distribution yield a result which
approximates or a approaches a variable which is normally
distributed Xt~N(x,t,2x,t), where x,t = E(t) and 2x,t = Var(t)

Activity Network Diagram


 The critical activities for this project is: A – C – D – F – H.
 For the overall project variance, the value is (σp2) = (1.78 + 1.00
+ 4.00 + 0.69 +0 .25) = 7.72
 Thus the project standard deviation (σp) is found as: 2.78
weeks
 This information is useful for assessing the probability of on-
time project completion because PERT estimates make two
more assumptions:
 Total project completion times follow a normal probability
distribution
 The activity times are stochastically independent
 As a result, the normal, bell curve can be used to represent project
completion dates.
 Normal distribution here implies that there is 50% likelihood that
project completion time will be less than 30 weeks and a 50% chance
that it will be greater than 30 weeks.
 With this information we are able to determine the probability that
our project will be finished on or before a particular time.
 Suppose, for example, that it is critical to our company that project
finishes before 32 weeks. Although the schedule calls for a 30 week
completion schedule, remember that our estimates are based on
probabilities.

 Therefore, if we wanted to determine the probability
that the project would finish no later than 32 weeks, we
would need to determine the appropriate area under the
normal curve that corresponds to a completion date on
or before week 32.
 We can use a standard normal equation to determine this
probability.
 The standard normal equation is represented as Z =
(Due date – Expected date of completion)/ σp= (32 –
30)/2.78 = 0.72
Crashing of Jobs
 Under some circumstances, it may be necessary to find ways to
accelerate the completion of a project. There are a number of reasons
why we may need to speed up the project, including:
 The initial schedule was too optimistic. In order to complete the
project on time, we are forced to find ways to speed the project.
 Market needs change and the project is in demand earlier than
anticipated. Perhaps we learn that a competitor is working on a
similar product and intends to introduce it earlier than our original
schedule. Because profit and market share come to the first
company to get the project to market, it makes sense to accelerate
our project..

Crashing of Jobs
The project has slipped considerably behind
schedule. In order to catch up and meet our
milestones, we have to speed up development.
The contracts provide incentives to avoid schedule
slippage. For example, suppose we were faced with
stiff penalties for every day a project was delayed?
We have a strong motivation to ensure that the
project comes in on time or early.

Time Cost Trade Off

Resource Leveling and Resource
Allocation

Cumulative Resource
Requirement Curve

Resource Constraints
 Resource constraints create two types of problems:
 Resource leveling: The problem is to obtain the best
possible smooth resource profile over time. The project
deadline is fixed, but the resource (capacity) level might
be adjusted.
 Resource allocation: The problem is to obtain the
shortest possible project duration. There is a given limit
for the available resources (capacity limit) which cannot
be exceeded. However, the project duration might be
adjusted to accommodate this.

 The solution algorithms for these types of
problems fall into two major categories:
 Decision based: Which are algorithms where the
solutions are justified because they appear as
reasonable.
 Optimization based: Which are algorithms seeking a
mathematical optimal solution according to given
optimization criteria.

 The classical theory gives two
approaches to scheduling activities in a
resource constrained network:
Serial
Parallel

 Serial
 The serial method ranks the activities according to a chosen
criterion.
 Then they are scheduled one by one in the ranked sequence.
 The resource requirement is compared to the available
resources.
 If there are not sufficient resources available, the activity is
gradually moved to a later position until the resource limit is
not exceeded.
 If necessary, the project deadline will be extended.

 Parallel
The parallel method splits the total project time into
a number of intervals.
Within each interval, the serial method is applied for
scheduling.
If an activity cannot be scheduled due to lack of
resources, it is postponed to the succeeding period.
There may be different priorities criteria for
different periods.

Crashing of Jobs (Example # 15)
Symbol Normal Crash Slope
Time/Cost Time/Cost
A 09/10 06/16 02
B 08/09 05/18 03
C 05/07 04/08 01
D 08/09 06/19 05
E 07/07 03/15 02
F 05/05 05/05 N/A
G 05/08 02/32 08

Crashing of Jobs
Symbol ES EF LS LF Cost
A 00 09 00 09 10
B 00 08 02 10 09
C 09 14 12 17 07
D 09 17 09 17 09
E 08 15 10 17 07
F 14 19 17 22 05
G 17 22 17 22 08

Crashing of Jobs
C (5)
2 4
A (9) F (5)
1
D (8) 6
B (8) G (5)
E 3(7) 5

Crashing of Jobs
Symbol Time TS FS
A 09 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 07 02 02
F 05 03 03
G 05 00 00
 Days: 22 (A-D-G)
 Cost is 55 (A+B+C+D+E+F+G)

Crashing of Jobs
C (5)
2 4
A (8) F (5)
1
D (8) 6
B (8) G (5)
E 3(7) 5

Crashing of Jobs
Symbol Time TS FS
A 08 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 07 02 02
F 05 03 03
G 05 00 00
 Days: 22-1=21 (A ( by 1 day)-D-G)
 Cost is 55+2=57 (A( by 2 units)+B+C+D+E+F+G)

Crashing of Jobs
C (5)
2 4
A (7) F (5)
1
D (8) 6
B (8) G (5)
E 3(7) 5

Crashing of Jobs
Symbol Time TS FS
A 07 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 07 02 02
F 05 03 03
G 05 00 00
 Days: 21-1=20 (A ( by 1 day)-D-G)/(B-E-G)
 Cost is 57+2=59 (A( by 2 units)+B+C+D+E+F+G)

Crashing of Jobs
C (5)
2 4
A (6) F (5)
1
D (8) 6
B (8) G (5)
E 3(6) 5

Crashing of Jobs
Symbol Time TS FS
A 06 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 06 02 02
F 05 03 03
G 05 00 00
 Days: 20-1=19 (A ( by 1 day)-D-G)/(B-E( by 1 day)-G)
 Cost is 59+2+2=63 (A( by 2 units)+B+C+D+E( by 2 units)+F+G)

Crashing of Jobs
C (5)
2 4
A (6) F (5)
1
D (8) 6
B (8) G (4)
E 3(6) 5

Crashing of Jobs
Symbol Time TS FS
A 06 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 06 02 02
F 05 03 03
G 04 00 00
 Days: 19-1=18 (A-D-G( by 1 day))/(B-E-G( by 1 day))
 Cost is 63+8=71 (A+B+C+D+E+F+G( by 8 units))

Crashing of Jobs
C (5)
2 4
A (6) F (5)
1
D (8) 6
B (8) G (3)
E 3(6) 5

Crashing of Jobs
Symbol Time TS FS
A 06 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 06 02 02
F 05 03 03
G 03 00 00
 Days: 18-1=17 (A-D-G( by 1 day))/(B-E-G( by 1 day))

Crashing of Jobs
C (5)
2 4
A (6) F (5)
1
D (8) 6
B (8) G (2)
E 3(6) 5

Crashing of Jobs
Symbol Time TS FS
A 06 00 00
B 08 02 00
C 05 03 00
D 08 00 00
E 06 02 02
F 05 03 03
G 02 00 00
 Days: 17-1=16 (A-D-G( by 1 day)/(B-E-G( by 1 day)/A-C-F)

Crashing of Jobs
C (4)
2 4
A (6) F (5)
1
D (7) 6
B (8) G (2)
E 3(5) 5

Crashing of Jobs
Symbol Time TS FS
A 06 00 00
B 08 02 00
C 04 03 00
D 07 00 00
E 05 02 02
F 05 03 03
G 02 00 00
 Days: 16-1=15 (A-D( by 1 day)-G/(B-E( by 1 day)-G/A-C( by 1 day)-F)
 Cost is 87+1+5+2= (A+B+C( by 1 units)+D( by 5 units)+E( by 2 units)
+F+G)

Project Management
• Suppose we had a project with only eight
activities.
• The table shows our calculated normal activity
durations and costs and crashed durations and
their costs.
• We wish to determine which activities are the
optimal candidates for crashing.
• Assume that the project costs listed include both
fixed and variable costs for each activity.
Project Management
Project activities and costs (normal vs. crashed)
Normal Crashed
Activity
Duration Cost Duration Cost
A 5 days $ 1,000 3 days $ 1,500
B 7 days $ 700 6 days $1,000
C 3 days $ 2,500 2 days $ 4,000
D 5 days $ 1,500 5 days $ 1,500
E 9 days $ 3,750 6 days $ 9,000
F 4 days $ 1,600 3 days $ 2,500
G 6 days $ 2,400 4 days $ 3,000
H 8 days $ 9,000 5 days $ 15,000
Total costs $ 22,450 $ 37,500

Project Management
Fully crashed Activity
B F
6 3
A C E H
3 2 6 5
D G
5 4

Project Management
Project Cost by Duration
Duration Total costs
27 days $ 22,450
26 days $ 22,700
25 days $ 22,950
24 days $ 24,700
23 days $ 26,450
22 days $ 28,200
21 days $ 30,200
20 days $ 32,200
19 days $ 34,200

Project Management
 The fully crashed project network is shown above
 Critical path is unchanged through fully crashing all activities
 The association of costs to project duration is graphed in the
next figure
 As each project activity has been crashed in order, the overall
project budget increases
 Past crashing activities A, E, and H, there is little incentive to
crash any of the other project tasks.
 The overall length of the project cannot shrink below 19 days

Project Management
 Additional crashing merely adds costs to the budget
 Optimal crash strategy for this project is to crash only activities
A, E, and H for a total cost of $11,750 and a revised project
cost of $34,200.
 Decision to crash a project should be carefully considered for
its benefits and drawbacks.
 There is always a significant cost associated with activity
acceleration.
 If the reasons for crashing are sufficiently compelling, the
overall project duration can often be shortened significantly.

Project Management
Cost vs. days saved in a fully-crashed project
Cost ($)
44,000
40,000
Crash all
36,000
Crash A+E+H
32,000
28,000 Crash A+E
24,000 Crash A
All normal
20,000
Duration (days)
16 18 20 22 24 26 28 30

Project Control Techniques
• Volume (resource consumption)
• Time (schedule)
• Number of units completed (bill of quantities
finished)
• Earned person hours
• Earned (monetary) value

• Monitoring the status of a project using S-curves
becomes a simple tracking problem.
• At the conclusion of each given time period (week,
month, or quarter), we simply total the cumulative
project budget expenditures to date and compare
them with the anticipated spending patterns.
• Any significant deviations between actual and
planned budget spent reveal a potential problem area.

Simple S-curve of project status

• The problem with S-Curves is that the interpretation of their visual
information is not always easy or obvious.
• For example, does the USD10,000 shortfall in the example represent
a delay in the project or simply a more efficient process that
artificially deflates the overall project expenditures to date?
• Likewise, positive variance is not always a sign of project progress.
In fact, a team may have a serious problem with over-expenditures
that could be interpreted as strong progress on the project when in
reality it signals nothing more than their inefficient use of project
capital resources.

• The bottom line is this: Simply evaluating a project’s status according
to its performance on time versus budget expenditures may easily
lead us into making inaccurate assumptions about project
performance.
• In short, because S-Curves only link time to budget expenditures, we
have no way of knowing the true status of the project and so must use
dollars spent as a surrogate.
• What we need is a means to determine how the project is actually
doing besides just how much money has been spent.
• We need a way of assessing the value the project has generated to
date.
• Earned Value Management (EVM) is just such a method for assessing
project status.
Earned Value Project
Key concepts related to Earned Value Management
• Earned Value Management (EVM)
• Planned Value (PV)
• Earned Value (EV)
• Actual Cost (AC)
• Schedule Variance (SV)
• Cost Variance (CV)
• Schedule Performance Index (SPI)
• Cost Performance Index (CPI)

Costs: Tools and Techniques
Earned Value Management (EVM)
 Is a commonly used method of performance measurement.
 It integrates project scope, cost, and schedule measures to help the
project management team assess and measure project performance
and progress.
 It is a project management technique that requires the formation of an
integrated baseline against which performance can be measured for
the duration of the project.
 The principles of EVM can be applied to all projects, in any industry.
 EVM develops and monitors three key dimensions for each work
package and control account

Planned Value (PV)
 Is the authorized budget assigned to the work to be accomplished for
an activity or work breakdown structure (WBS) component.
 It includes the detailed authorized work, plus the budget for such
authorized work, allocated by phase over the life of the project.
 The total of the PV is sometimes referred to as the performance
measurement baseline (PMB).
 The total planned value for the project (when completed) is also
known as Budget At Completion (BAC).

Earned Value (EV)
 Is the value of work performed, expressed in terms of the approved budget
assigned to that work for an activity or work breakdown structure component.
 It is the authorized work that has been completed, plus the authorized budget
for such completed work.
 The EV being measured must be related to the PV baseline (PMB), and the
EV measured cannot be greater than the authorized PV budget for a
component.
 The term EV is often used to describe the percentage completion of a project.
 A progress measurement criteria should be established for each WBS
component to measure work in progress.
 Project managers monitor EV, both incrementally to determine current status
and cumulatively to determine the long-term performance trends.

Actual cost (AC)
 Actual Value (AC) is the total cost actually incurred and recorded in
accomplishing work performed for an activity or work breakdown
structure component.
 It is the total cost incurred in accomplishing the work that the EV
measured.
 The AC has to correspond in definition to whatever was budgeted for
in the PV and measured in the EV (e.g., direct hours only, direct costs
only, or all costs including indirect costs).
 The AC will have no upper limit;tgus whatever is spent to achieve the
EV will be measured.

Schedule Variance (SV)
 Schedule variance (SV) is a measure of schedule performance on a
project.
 The EVM schedule variance is a useful metric in that it can indicate a
project falling behind its baseline schedule.
 The EVM schedule variance will ultimately equal zero when the
project is completed because all of the planned values will have been
earned.
 EVM and SV are best used in conjunction with critical path
methodology (CPM) scheduling and risk management and it is
calculated using the following equation which is SV = EV – PV.

Cost Variance (CV)
 It is a measure of cost performance on a project.
 The cost variance at the end of the project will be the difference between the
budget at completion (BAC) and the actual amount spent.
 CV is particularly critical because it indicates the relationship of physical
performance to the costs spent and CV= EV – AC
 Any negative CV is often non-recoverable to the project.
 The SV and CV values can be converted to efficiency indicators to reflect the cost
and schedule performance of any project for comparison against all other projects
or within a portfolio of projects.
 The variances and indices are useful for determining project status and providing a
basis for estimating project cost and schedule outcome.

Schedule Performance Index (SPI)
 Is a measure of progress achieved compared to progress planned on a
project. It is sometimes used in conjunction with the cost performance
index (CPI) to forecast the final project completion estimates.
 An SPI value less than 1.0 indicates less work was completed than
was planned, while if the value is greater than 1.0 then it indicates
that more work was completed than was planned.
 Since the SPI measures all project work, the performance on the
critical path must also be analyzed to determine whether the project
will finish ahead of or behind its planned finish date.
 The SPI is equal to the ratio of the EV to the PV and it is calculated
using the following equation which is SPI = EV/PV.

Cost Performance Index (CPI)
 It is a measure of the value of work completed compared to the
actual cost or progress made on the project.
 It is considered the most critical EVM metric and measures the
cost efficiency for the work completed.
 A CPI value less than 1.0 indicates a cost overrun for work
completed while a CPI value greater than 1.0 indicates a cost
under run of performance to date.
 The CPI is calculated using the following equation which is
CPI = EV/AC.

Earned Value Project (Figure # 01)

Earned Value Project (Figure # 02)

Earned Value Project
Earned value and project status slippage

Graphical Evaluation and Review Technique
(GERT)
 Activity networks employing PERT or CPM are by far the most

common forms of precedence diagram used
 However, they do suffer from some important limitations, particularly
in certain setting such as R&D projects, where their underlying
assumptions reflect the complexities of individual project settings
 For example, situations such as multiple branching (i.e., success or
failure of a project), probabilistic branching, and repeating activities via
feedback loops, which are frequently found in experimental or R&D
project settings cannot be modeled in PERT/CPM networks
Project Management:MBA666 RNSengupta,IME Dept.,IIT Kanpur,INDIA 600

GERT (contd…)
 As a result, Graphical Evaluation and Review

Technique (GERT) was developed to offer an
alternative diagram modeling option for projects that
are faced with these additional complexities
 GERT creates a visual method for rendering network
logic to precedence diagramming with the added
flexibility to demonstrate network complexities

GERT (contd…)
 Hence one uses GERT when one wants to analyze terminal

networks that
 Contains activities that have a probability of occurrence
associated with them, and we intend to find the probability that
the node is realized
 Treats the plausibility that the time to perform an activity is not
a constant but a random variable, and we intend to find the
conditional moment generating function of the elapsed time
required to traverse between any two nodes

GERT (contd…)
 In GERT the branches of the network are

described by two or more parameters which
are:
Probability that the branch is traversed
The time take (or other attribute(s)) to
traverse the branch if it is taken

GERT (contd…)
 Components of Stochastic networks are:

 Directed branches (arcs, edges, transmittances, etc.)
 Logical Nodes (vertices)
 A directed branch has one emanating node (to be described
later) and one terminating node (to be described later).
(pa, ta)

OR and AND statements
 Exclusive OR is a logical operation that outputs true only when inputs differ (one
is true, the other is false)
 The truth table of A XOR B shows that it outputs true (value of 1) whenever the
inputs differ
 I/P (A) I/P (B) O/P
0 0 0
1 0 1
0 1 1
1 1 0

(contd…)
 Inclusive OR (also known as alternation), is a logical operation that outputs true if
and only if one or more of its operands is true
 The truth table of A OR B shows that it outputs true (value of 1) whenever one of
the input is true
 I/P (A) I/P (B) O/P
0 0 0
1 0 1
0 1 1
1 1 1

(contd…)
 AND, is a logical operation that outputs true if and only if both operands are true
 The truth table of A AND B shows that it outputs true (value of 1) whenever both of
the input is true
 I/P (A) I/P (B) O/P
0 0 0
1 0 0
0 1 0
1 1 1

GERT (I/P Logical Relationship)

GERT (I/P Logical Relationship) (contd…)

GERT (contd…)

GERT (contd…): STEPS
1) Convert a qualitative description of the

system/problem to a model in network form
2) Collect the necessary data to describe the branches of
the network
3) Obtain an equivalent one branch function between
two nodes of the network

GERT (contd…): STEPS
4. Convert the equivalent function into the following two

performance measure of the network:
 The probability that a specific node is realized
 The mgf of the time associated with an equivalent
network
5. Make inference concerning the system under study
obtained in 4 above

GERT Diagram/Example

GERT (contd…)
 It is important to note, however, some of the inherent

disadvantages in the use of GERT precedence
diagrams
 First, GERT typically employs AOA formats, which
we have previously noted are not at all common with
modern project management techniques or
nomenclature (e.g., the use of dummy variables)
 Thus, with some few exceptions, GERT is not
supported by common project management software
GERT (contd…)
 Further, GERT networks can become extremely

cumbersome and complicated depending upon the size of
the project, the number of activities, expected feedback
loops, probabilistic conditions that must be modeled, etc.
 Thus, although purporting to offer a more accessible, visual
treatment of project networks, GERT can actually quickly
become unwieldy and obfuscate the visualization of a
project’s network activities

GERT (contd…): Example
 Space mission consisting of two

(02) vehicles
 Both vehicles must be
successfully launched


 Space mission consisting of two

(02) vehicles
 At least one of the vehicle must
be successfully launched


 One of the niceties of GERT is its

usefulness at many level within a problem
area


GERT (contd…): Example (Discussion
of diagram)
 AND node plays a predominant role in the

activities up to and including the terminal
countdown
 This is due to the fact that all activities must be
performed before lift off
 After the terminal count down either
possibilities are presented

of diagram)
 Successful node is an EXCLUSIVE OR node due to the reason

that successful launch can happen in two mutually exclusive
ways which are:
 Proper operation during boost phase
 Unsuccessful orbit after boost phase with orbit correction
achieved
 The dotted lines represents the process where it signifies
activities that do not contribute to the successful launch

of diagram)

GERT (contd…): Example (Basic
Network Analysis)
 All six nodes behave in the same manner if only one

branch is received at the I/P side and one branch is
emitted at the O/P side
 Thus if two branches are in series and they are being
considered then the node type have no effect on the
equivalent one branch network

Network Analysis)

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Network Analysis)

Network Analysis)

Network Analysis)

Network Analysis)

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Network Analysis)

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Network Analysis)

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Network Analysis)

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Network Analysis)

(Topographical equation)

Network Analysis)

Queuing Graphical Evaluation Review Technique (Q-GERT)
 Q-GERT is a modification of the traditional GERT approach in that it

recognizes special circumstances where multiple numbers of the
project teams or activities must be taken into consideration
simultaneously
 Q-GERT gets its name from special queuing options which it has
available for modeling situations in which queues build up prior to
project activities
 Q-GERT allows the modeler to assign unique network “attributes”
(i.e., activity times, nodal branching probabilities) to each individual
projects and then process these projects through a single generalized
network

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PROJECT MANAGEMENT

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Control Organizational Organization

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Introduction Growth Maturity Stagnation Decline

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