CHAPTER 2

PROJECT SELECTION AND

PROJECT PORFOLIO PROCESS

2-1
CHAPTER OUTLINE
 2.1 Project selection
 2.2 Project portfolio process (PPP)

2-2
2.1 PROJECT SELECTION

2-3
PROBLEMS WITH MULTIPLE PROJECTS
 Delays in one project delays others
 Inefficient use of resources
 Bottlenecks in resource availability or lack of required
technological inputs

2-4
CHALLENGES
 Making sure projects are closely tied to goals and
strategy
 How to handle the growing number of projects?

 How to make these projects successful?

2-5
PROJECT SELECTION
 Project selection is the process of evaluating individual
projects or groups of projects, and then choosing to
implement some set of them so that the objectives of the
parent organization will be achieved
 Managers often use decision-aiding models to extract the
relevant issues of a problem from the details in which the
problem is embedded
 Models represent the problem’s structure and can be useful
in selecting and evaluating projects
 PROJECT SELECTION AND CRITERIA
OF CHOICE
 Project selection…
 Evaluating
 Choosing
 Implementing

 Same process as other business decisions

2-8
MODEL CRITERIA
 Realism
 Capability
 Flexibility
 Ease of Use
 Cost
 Easy Computerization

2-10
 THE NATURE OF PROJECT
SELECTION MODELS
 Models turn inputs into outputs
 Managers decide on the values for the inputs and
evaluate the outputs
 The inputs never fully describe the situation
 The outputs never fully describe the expected
results
 Models are tools
 Managers are the decision makers

2-11
TYPES OF PROJECT SELECTION MODELS
2 Basic Types of Models
 Numeric

 Nonnumeric

 Two Critical Facts:

 Models do not make decisions

 All models, however sophisticated, are only partial

representations of the reality the are meant to

reflect

2-12
APPROACHES TO PROJECT SELECTION

Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
Financial models

2-13
1. CHECKLIST MODEL
A checklist is a list of criteria applied to possible projects.
 Uses a list of questions to review potential projects and to
determine their acceptance or rejection.
 Requires agreement on criteria
 Assumes all criteria are equally important
Fails to answer the relative importance or value of a potential
project and doesn’t to allow for comparison with other
potential projects.

Checklists are valuable for recording opinions and

encouraging discussion
2-14
MULTI-CRITERIA SELECTION MODELS
 Checklist Model
 Uses a list of questions to review potential projects and to determine their
acceptance or rejection.
 Fails to answer the relative importance or value of a potential project and
doesn’t to allow for comparison with other potential projects.
 Multi-Weighted Scoring Model
 Uses several weighted qualitative and/or quantitative selection criteria to
evaluate project proposals.
 Allows for comparison of projects with other potential projects

2–15
2. SIMPLIFIED SCORING MODELS
 Uses several weighted qualitative and/or quantitative
selection criteria to evaluate project proposals.
 Allows for comparison of projects with other potential
projects
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) 2-16

SCORING MODELS
 Unweighted 0–1 factor model
 Unweighted factor model

 Weighted factor model

2-17
 UNWEIGHTED 0-1 FACTOR
MODEL EXAMPLE

2-18
UNWEIGHTED FACTOR SCORING
MODEL
 Replaces X’s with factor score
 Typically a 1-5 scale
 Column of scores is summed
 Projects with high scores are selected

2-19
UNWEIGHTED FACTOR MODEL
 Each factor is weighted the same
 Less important factors are weighted the same as
important ones
 Easy to compute

 Just total or average the scores

2-20
WEIGHTED FACTOR MODEL

FIGURE 2.3
2–21
WEIGHTED FACTOR MODEL EXAMPLE

2-22
WEIGHTED FACTOR MODEL EXAMPLE

2-23
ADVANTAGES OF SCORING MODELS
 Allow multiple criteria
 Structurally simple
 Direct reflection of managerial policy
 Easily altered
 Allow for more important factors
 Allow easy sensitivity analysis

2-24
DISADVANTAGES OF SCORING MODELS
 Relative measure
 Linear in form
 Can have large number of criteria
 Unweighted models assume equal importance

2-25
3. 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

2-26
 4. PROFILE MODELS
Show risk/return options for projects.

X6 Criteria
Maximum
selection as
Desired Risk X4 X5 axes
X2
R
Rating each
i X1 X
3 Efficient Frontier
project on
s Minimum
criteria

k Desired Return
Return
2-27
5. FINANCIAL MODELS

Based on the time value of money principal

 Payback period

 Net present value

 Internal rate of return

 Options models

 Profitability Index

All of these models use discounted cash flows

2-28
PAYBACK PERIOD

Determines how long it takes for a project to

reach a breakeven point
Investment
Payback Period 
Annual Cash Savings

2-29
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
0 ($200,000) ($200,000)
1 $75,000 ($125,000)
2 $75,000 ($50,000)
3 $75,000 $25,000

2-30
PAYBACK PERIOD DRAWBACKS
 Does not consider time value of money
 More difficult to use when cash flows change over
time
 Less meaningful for longer periods of time (due to
time value of money)

2-31
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
Ft = net cash flow for period t
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t 2-32
 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.

Year Net flow Discount NPV

0 -$60,000 1.0000 -$60,000.00
1 $15,000 0.9009 $13,513.51
2 $15,000 0.8116 $12,174.34
3 $15,000 0.7312 $10,967.87
4 $15,000 0.6587 $9,880.96
5 $15,000 0.5935 $8,901.77
2-33
PROJECTS WITH UNEQUAL LIVES
 Suppose a firm chooses between two machines of
unequal lives. They are mutually exclusive. How do you
decide which one to purchase?
 In this case, if you use NPV, you will ignore the fact that
you need to buy a new machine sooner in one case than
the other!

2-34
 EXAMPLE
Two machines have the following maintenance expenses during
their lives: (r=10%)

0 1 2 3 4
Machine A -500 -120 -120 -120
Machine B -600 -100 -100 -100 -100
METHODS TO HANDLE THIS…
 Use replacement chains
 Matching Cycle Approach

 Annualized NPV approach or The Equivalent Annual

Cost Method (EAC)

2-36
REPLACEMENT CHAINS
Calculate PV (costs) for the same time horizon.
In this example, Machine A has a lifetime of 3
years, and Machine B has a lifetime of 4 years.
If we repeat the analysis over a period of 12 years,
A would have 4 replacement cycles and B would
have 3.

2-37
MATCHING CYCLE APPROACH
 Repeat projects until they end at the same time
 Assumption: the projects can be repeated
 The easiest: repeat the projects forever

 Compare NPV of the “repeated projects”

 NPV(T) : NPV of the original project of T years
 NPV(T,∞) = NPV(T) / (1 – (1+R)-T) : NPV of the original project
replicated at const scale to ∞

2-38
 ANNUALIZED NPV APPROACH
(OR EQUIVALENT ANNUAL COST – EAC)

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

2-39
 ANNUALIZED NPV APPROACH
(OR EQUIVALENT ANNUAL COST – EAC)

Idea: Amortize the cash flows to get a per-year cost for each
piece of equipment. This gives the Equivalent Annual Cost of
each machine.
0 1 2 3 4
Machine A -500 -120 -120 -120
EACa EACa EACa
Machine B -600 -100 -100 -100 -100
EACb EACb EACb EACb

2-40
EXERCISE:

 Consider a factory which must have an air cleaner.

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

2-41
SOLUTION:

 At first glance, the cheap cleaner has lower NPV:

 NPV (Cadillac) =
 NPV (Cheap) =
 This overlooks the fact that the Cadillac cleaner lasts twice
as long => choose the Cadillac cleaner

2-42
SOLUTION: MATCHING CYCLE
APPROACH
 Repeat projects until they end at the same time
 Assumption: the projects can be repeated
 The easiest: repeat the projects forever
 Compare NPV of the “repeated projects”
 NPV(T) : NPV of the original project of T years
 NPV(T,∞) = NPV(T) / (1 – (1+R)-T) : NPV of the
original project replicated at const scale to ∞

2-43
APPLICATION: EXAMPLE OF REPLACEMENT
PROJECTS
A Belgian Dentist needs an autoclave to sterilize his
instruments. He has an old one that is in use, but the
maintenance costs are rising. So he is considering replacing
it.
New Autoclave
 Cost = $3,000 today,
 Maintenance cost = $20 per year
 Resale value after 6 years = $1,200
 NPV of new autoclave (at r = 10%):

EAC of new autoclave =

2-44
Year 0 1 2 3 4
5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600
500
Total Annual Cost

2-45
INTERNAL RATE OF RETURN
A project must meet a minimum rate of return before it is
worthy of consideration.

t
ACFt Higher IRR values
IO  
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
2-46
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
1 $14,000 0.9009 $12,173.91
2 $14,000 0.8116 $10,586.01
3 $14,000 0.7312 $9,205.23
4 $14,000 0.6587 $8,004.55

2-47
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?

2-48
OPTIONS MODELS EXAMPLE
 A construction firm is considering whether or not to upgrade an
existing chemical plant. The initial cost of the upgrade is $5,000,000
and the company requires a 10% return on its investment. The plant
can be upgraded in one year and start earning revenue the following 5
years. The best forecast promises cash flows of $1 million per year, but
showed adverse economic and political conditions prevail, the
probability of realizing this amount drops to 40%, with a 60%
probability that the investment will yield only $200,000 per year.
 If the company decides to wait a year, its investment will have a 50%
likelihood of paying off at the higher value of $1 million per year.
Does it make sense to wait for a year before making the investment?

2-49
PROFITABILITY INDEX
 Benefit cost ratio
 NPV divided by initial cash investment

 Ratios greater than 1.0 are good

2-50
PROFITABILITY INDEX (PI)

 With the constraints of budgets/resources, the Profitability Index

can be used
 The highest weighted average PI becomes a criterion for selecting
a project.

2-51
PROFITABILITY INDEX (PI)

NPV
Profitability Index 
Investment

Example
We have maximum $300,000 for investment
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D162,000 150,000 1.08 2-52
PROFITABILITY INDEX (PI)

Example
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

2-53
ADVANTAGES OF PROFITABILITY
MODELS
 Easy to use and understand
 Based on accounting data and forecasts
 Familiar and well understood
 Gives a go/no-go indication
 Can be modified to include risk

2-54
 DISADVANTAGES OF PROFITABILITY
MODELS
 Ignore nonmonetary factors
 Some ignore time-value of money
 Biased toward the short-term
 Payback ignores cash flow after payback
 IRR can have multiple solutions
 All are sensitive to errors
 Nonlinear
 Dependent on determination of cash flows
2-55
RISK CONSIDERATIONS IN PROJECT
SELECTION
 Both costs and benefits are uncertain
 Benefits are more uncertain
 Thereare many ways of dealing with risk
 Can make estimates about the probability of
outcomes
 Subjective probabilities
 Uncertainty about:
 Timing
 What will be accomplished?
 Side effects
 Pro forma documents
2-56
2.2 PROJECT PORTFOLIO PROCESS
(PPP)

2-57
THE PROJECT PORTFOLIO PROCESS
(PPP)
 Links projects directly to the goals and strategy of the
organization
 Means for monitoring and controlling projects

2-58
SYMPTOMS OF A MISALIGNED
PORTFOLIO
 More projects
 Inconsistent determination of benefits
 Projects that don’t contribute to the strategy
 Competing projects
 Costs exceed benefits
 No risk analysis of projects
 Lack of tracking against the plan
 No client for project

2-59
\\
PURPOSE OF PROJECT PORTFOLIO
PROCESS
 Identify nonprojects
 Prioritize list of projects

 Limit number of projects

 Identify the real options for each project

 Identify projects with good fit

 Identify co-dependent projects

2-60
PURPOSE OF PROJECT PORTFOLIO
PROCESS CONTINUED
 Eliminate risky projects
 Eliminate projects that skip the formal selection process
 Keep from overloading the organization
 To balance the resources with needs
 To balance returns
 To balance short-, medium-, and long-term returns

2-61
PROJECT PORTFOLIO PROCESS STEPS
1. Establish a project council
2. Identify project categories and criteria
3. Collect project data
4. Assess resource availability
5. Reduce the project and criteria set
6. Prioritize the projects within categories
7. Select the projects to be funded and held in
reserve
8. Implement the process
2-62
STEP 1: ESTABLISH A PROJECT COUNCIL
 Senior management
 The project managers of major projects
 The head of the Project Management Office
 Particularly relevant general managers
 Those who can identify key opportunities and risks
facing the organization
 Anyone who can derail the PPP later on

2-63
 STEP 2: IDENTIFY PROJECT
CATEGORIES AND CRITERIA
 Derivate projects
 Platform projects
 Breakthrough projects
 R&D projects

2-64
STEP 3: COLLECT PROJECT DATA
 Assemble the data
 Document assumptions

 Screen out weaker projects

 The fewer projects that need to be compared and

analyzed, the easier the work of the council

2-65
STEP 4: ASSESS RESOURCE
AVAILABILITY
 Assess both internal and external resources
 Assess labor conservatively

 Timing is particularly important

2-66
STEP 5: REDUCE THE PROJECT AND
CRITERIA SET

 Organization’s goals  Use strengths

 Have competence  Synergistic

 Market for offering  Dominated by another

 How risky the project is  Has slipped in desirability

 Potential partner

 Right resources

 Good fit

2-67
STEP 6: PRIORITIZE THE PROJECTS
WITHIN CATEGORIES
 Apply the scores and criterion weights
 Consider in terms of benefits first and resource costs
second
 Summarize the returns from the projects

2-68
STEP 7: SELECT THE PROJECTS TO BE
FUNDED AND HELD IN RESERVE
 Determine the mix of projects across the categories
 Leave some resources free for new opportunities

 Allocate the categorized projects in rank order

2-69
STEP 8: IMPLEMENT THE PROCESS
 Communicate results
 Repeat regularly

 Improve process

2-70
PROJECT PROPOSALS
 The project proposal is essentially a project bid
 Putting together a project proposal requires a detailed
analysis of the project
 Project proposals can take weeks or months to complete

 A more detailed analysis may result in not bidding on the

project

2-71
PROJECT PROPOSAL CONTENTS
 Cover letter
 Executive summary

 The technical approach

 The implementation plan

 The plan for logistic support and administration

 Past experience

2-72