Chapter 3 (Project selection)

• The selection of the right project for future investments is

a crucial decision for the long-term survival of a
company.
• The selection of the wrong project may well precipitate
project failure leading to a company liquidation.
• This chapter on project selection will outline a framework
for evaluating and ranking prospective project using
numeric models.
• The project selection process is developed as a separate
chapter, but it should be recognized as a subsection of
other knowledge areas, namely scope management,
project lifecycle and feasibility study.
 Cont…
• Project selection is making commitment for the
future.
• Project managers operate in a world of finite
resources, and cannot carry out all the projects
they may want or need. Therefore a process is
required to select and rank projects on the basis
of beneficial change to a company.
 Project selection models
• A numeric model is usually financially focused and
quantifies the project in terms of time to repay the
investment (payback) or return on investment.
• When choosing a selection model the points to consider
are realism, capability, ease of use, flexibility and cost
effectiveness.
• However, most importantly the model must evaluate
projects by how well they meet a company's strategic
goals and corporate mission. The following subheadings
indicate the type of questions to ask?
 Cont…
• Will the project maximize profits?
• Will the project maximize the utilization of workforce?
• Will the project maintain market share, increase market share or
consolidate market position?
• Will the project enable the company to enter new markets?
• Will the project improve the company's image?
• Will the project maximize the utilization of plant and equipments?
• Will the project satisfy the needs of the stakeholders and their
political aspirations?
• Is the project risk and uncertainty acceptable?
• Is the project scope consistent with company expertise?
 Cont…
• The relationship between a project expected results and
the company strategic goals, need to be established. In
general, the kind of information required can be
quantified under the following headings (Meredith).
• Production
• Marketing
• Financial
• Personnel
• Administration
 Cont…
• Production considerations
• Methods of implementation
• Time to be up and running
• Other applications of the system
• Learning curve-time until the product is saleable
• Extent of outside consultants required
• Cost of power requirements
• Interfacing equipment required
• Period of disruption
• Safety of the system
 Cont…
• Marketing consideration
• Number of potential users
• Market share
• Time to achieve proposed market share
• Impact on current system
• Ability to control quality of information
• Customer acceptance
• Estimated life of new system
• Enhanced image of company
• Extent of possible new markets
 Cont…
• Financial consideration
• Cost of new system
• Impact on company cash flow
• Borrowing requirement
• Time to breakeven
• Payback period, NPV and IRR
• Size of investment required
• Cost of implementation
• Cost of training
• Cost of mistakes
• Level of financial risk
 Cont…
• Personnel consideration
• Skills requirement and availability
• Training requirements
• Employment requirement
• Level of resistance to change from current workforce
• Impact on working conditions
• Ergonomics, health and safety considerations
• Effects on internal communications
• Effect on job description
• Effects on work unions
• Effects on morale
 Cont…
• Administration considerations
• Compliance with national and international standards
• Reaction from shareholder and other stakeholders
• Cost of maintenance contracts
• Disaster recovery planning
• Cost of upgrading the system to keep pace with new
technology
• Vulnerability of using a single supplier
• Customer service
• Effects of centralized databases
• Extent pf computer literacy
• Legal considerations
 Numeric models
• The numeric selection models presented here
may be subdivided into financial models and
scoring models. The financial models are:
• Payback period
• Net present value
• Return on investment
• Internal rate of return
• Companies tend to prefer financial model and
select solely on profitability
 Payback period
• The payback period is time taken to gain a
financial return equal to the original investment.
This period is usually expressed in years and
months.
• For example, a company wishes to buy a new
machine for a 4 years project. The manager has
to choose between machine A or machine B- a
mutually exclusive situation. Both machines
have the same initial cost (35000) their cash
flow performs differently over the four year
period due to different labor, material and
maintenance costs.
 Payback period cont…
• To calculate the payback period simply
work out how long it will take to recover
the initial outlay.
Years Cash-flow Machine A Cash-flow Machine B

0 (35 000) (35 000)

1 20 000 10 000
2 15 000 10 000
3 10 000 15 000
4 10 000 20 000
Payback period NILL NIL
 Project 1
Years
0 (20 000)
1 10 000
2 10 000
3 5000
4 2500
5 2500
 Project 2
Years
0 (40 000)
1 5000
2 5000
3 5000
4 5000
5 60 000
 Payback period Cont…
• NB. Machine A will recover its outlay one sooner than
machine B. where projects are ranked by the shortest
payback period, machine A is selected in preference to
machine B. the advantages of the payback methods are
that it:
• Is simple and easy to use
• Uses readily available accounting data to determine
cash-flows
• Reduces project exposure to risk by selecting the project
with the shortest payback period
• Reduces the uncertainty of future cash flows.
 Payback cont…
• The disadvantages of payback period are:
• It does not consider time value of money
• It is not a suitable technique to evaluate long term
projects where the impacts of differential inflation and
interest rate could significantly change the results
• Although the payback period would reduce the duration
of the risk, it does not quantify the risk exposure
• The payback period calculation does not look at the total
project-i.e what happens to the cash flow after the
payback period is not considered because other project
build up slowly to give excellent results.
 Net Present Value (NPV)
• The NPV uses a compound interest which accumulates the value of
investment over a period.
• NPV calculates the value of investment over a period of time.
• For example if you were to invest R100, at 20% interest rate, it will
determine the value after a certain period.
• Then the cash flow over a number of years is combined in this manner the
total figure is the net present value.
• The discount factor is derived from the reciprocal of the compound interest
formula
• Discount factor =1/(1+i)*n.
• Where i= the forecast interest rate.
• N= period.
 NPV cont…
• The NPV is a measure of the value or worth added to the
company by carrying out the project.
• The preference should be given to the project with
highest NPV
• The advantages of NPV
• It allows for inflation and escalation
• It looks at the whole project from start to finish
• It gives more accurate profit and loss forecast
 NPV cont…
• Disadvantages of NPV
• It is biased towards short run project
• It uses fixed interest rate over the duration of the
project its accuracy is limited by the accuracy of
the predicted future cash flows and interest rate.
 NPV activity
• Consider the machine selection example again,
this time using NPV. assume the discount factor
is 20%, set up the NPV format. Follow the steps.
• Insert the cash-flows
• Transfer the discount factor from the table
• Calculate the present value by multiplying the
discount factor
• Aggregate the present value to give NPV
 Machine A
Years Project cash-flow Discount factor Present value
0 ($35 000) 20%
1 20 000
2 15 000
3 10 000
4 10 000
Total NPV
 Machine B
years Project cash-flow Discount factor Present value
0 ($35 000) 20%
1 10 000
2 10 000
3 15 000
4 20 000
Total NPV