Chapter 3

Project Selection and

Portfolio Management

03-01
 Chapter 3 Learning Objectives
After completing this chapter, students will be able to:
Explain six criteria for a useful project-
selection/screening model.
Understand how to employ checklists and simple
scoring models to select projects.
Use more sophisticated scoring models, such as the
Analytical Hierarchy Process.
Learn how to use financial concepts, such as the
efficient frontier and risk/return models.

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 Chapter 3 Learning Objectives
After completing this chapter, students will be able to:
Employ financial analyses and options analysis to
evaluate the potential for new project investments.
Recognize the challenges that arise in maintaining an
optimal project portfolio for an organization.
Understand the three keys to successful project
portfolio management.

Copyright © 2013 Pearson Education 03-03

 Project Selection
Screening models help managers pick winners from a
pool of projects. Screening models are numeric or
nonnumeric and should have:
Realism
Capability
Flexibility
Ease of use
Cost effectiveness
Comparability

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 Screening & Selection Issues
Risk – unpredictability to the firm
Commercial – market potential
Internal operating – changes in firm operations
Additional – image, patent, fit, etc.

All models only partially reflect reality and

have both objective and subjective factors
imbedded

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 Approaches to Project Screening
Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
Financial models

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 Checklist Model
A checklist is a list of criteria applied to possible
projects.

 Requires agreement on criteria

 Assumes all criteria are equally important

Checklists are valuable for recording opinions and

encouraging discussion

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 Simplified Scoring Models
Each project receives a score that is the weighted sum
of its grade on a list of criteria. Scoring models require:
 agreement on criteria
 agreement on weights for criteria
 a score assigned for each criteria
Score   (Weight  Score)
Relative scores can be misleading!

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 Analytic Hierarchy Process
The AHP is a four step process:
1. Construct a hierarchy of criteria and subcriteria
2. Allocate weights to criteria
3. Assign numerical values to evaluation dimensions
4. Scores determined by summing the products of
numeric evaluations and weights
Unlike the simple scoring model, these scores can be
compared!

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 FIGURE 3.1  Sample AHP with Rankings for Salient Selection Criteria
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 Profile Models
Show risk/return options for projects.
X7
X6
Maximum
Desired Risk

Criteria
X2 selection as
axes
Risk

X4 X5

Efficient Frontier
X3
Rating each
project on
X1
criteria
Minimum Return
Desired Return
Figure 3.4 03-11
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 Efficient Frontier

Figure 3.5
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 Financial Models
Based on the time value of money principal

Payback period
Net present value
Internal rate of return
Options models

All of these models use discounted cash flows

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 Payback Period
Determines how long it takes for a project
to reach a breakeven point

Investment
Payback Period 
Annual Cash Savings

Cash flows should be discounted

Lower numbers are better (faster payback)

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 Payback Period Example
A project requires an initial investment of $200,000 and
will generate cash savings of $75,000 each year for the next
five years. What is the payback period?
Year Cash Flow Cumulative Divide the
0 ($200,000) ($200,000) cumulative amount
by the cash flow
1 $75,000 ($125,000) amount in the third
2 $75,000 ($50,000) year and subtract
from 3 to find out
3 $75,000 $25,000
the moment the
25, 000 project breaks
3  2.67 years even.
75, 000
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 Net Present Value
Projects the change in the firm’s stock value if a project
is undertaken.

Ft
NPV  I o  
(1  r  pt )t
where Higher NPV
Ft = net cash flow for period t values are better!
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t

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 Net Present Value Example
Should you invest $60,000 in a project that will return $15,000
per year for five years? You have a minimum return of 8% and
expect inflation to hold steady at 3% over the next five years.
The NPV
Year Net flow Discount NPV
column total
0 -$60,000 1.0000 -$60,000.00
is negative,
1 $15,000 0.9009 $13,513.51
so don’t
2 $15,000 0.8116 $12,174.34
invest!
3 $15,000 0.7312 $10,967.87
4 $15,000 0.6587 $9,880.96
5 $15,000 0.5935 $8,901.77
-$4,561.54
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 Internal Rate of Return
A project must meet a minimum rate of return
before it is worthy of consideration.
t
ACFt
IO   Higher IRR values
n 1 (1  IRR )t
are better!
where
ACFt = annual after tax cash flow for time period t
IO = initial cash outlay
n = project's expected life
IRR = the project's internal rate of return

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 Internal Rate of Return Example
A project that costs $40,000 will generate cash flows of
$14,000 for the next four years. You have a rate of return
requirement of 17%; does this project meet the threshold?

Year Net flow Discount NPV

0 -$40,000 1.0000 -$40,000.00
This table
has been
1 $14,000 0.9009 $12,173.91
calculated
2 $14,000 0.8116 $10,586.01
using a
3 $14,000 0.7312 $9,205.23
discount
4 $14,000 0.6587 $8,004.55
rate of
-$30.30
15%

The project doesn’t meet our 17% requirement

and should not be considered further.
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 Options Models
NPV and IRR methods don’t account for failure to
make a positive return on investment. Options
models allow for this possibility.

Options models address:

1. Can the project be postponed?
2. Will future information help decide?

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 Project Portfolio

Copyright © 2013 Pearson Education FIGURE 3.6  GE’s Tollgate Process 03-21

 GE Tollgate Review Process Flow Map

Figure 3.7 03-22

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 Project Portfolio Management
The systematic process of selecting, supporting, and
managing the firm’s collection of projects.
Portfolio management requires:
decision making,
prioritization,
review,
realignment, and
reprioritization of a firm’s projects.

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 Pharmaceuticals Development Process

Copyright © 2013 Pearson Education Figure 3.8 03-24

 Keys to Successful
Project Portfolio Management
Flexible structure and freedom of
communication

Low-cost environmental scanning

Time-paced transition

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 Problems in Implementing
Portfolio Management
 Conservative technical communities

 Out of sync projects and portfolios

 Unpromising projects

 Scarce resources

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 Summary
1. Explain six criteria for a useful project-selection
screening model.
2. Understand how to employ checklists and simple
scoring models to select projects, including the
recognition of their strengths and weaknesses.
3. Use more sophisticated scoring models, such as the
Analytical Hierarchy Process.
4. Learn how to use financial concepts, such as the
efficient frontier and risk/return models.

Copyright © 2013 Pearson Education 03-27

 Summary
5. Employ financial analyses and options analysis to
evaluate the potential for new project investments.
6. Recognize the challenges that arise in maintaining
an optimal project portfolio for an organization.
7. Understand the three keys to successful project
portfolio management. 

Copyright © 2013 Pearson Education 03-28

Copyright © 2013 Pearson Education 03-29