PROJECT SELECTION AND EVALUATION

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PROJECT SELECTION AND EVALUATION
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Project Selection Methods

• Non-Numeric Models
• Profitability Models
• Decision Theoretic Models
• Comparative Models

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Non-Numeric Models

• Sacred Cow
• Operating Necessity
• Competitive Necessity
• Product Line Extension
• Comparative Benefit Model

4
Profitability Models

• Payback Period
• Average Rate of Return
• Discounted Cash Flow (NPV)
• Internal Rate of Return
• Profitability Index
• Variations
• Pacificos Method
• Deans Profitability Model

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Decision Theoretic Models

• Decisions Under Uncertainty
• Decisions Under Risk
• Decision Trees
• Simulation and Risk Analysis

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Comparative Models

• Rank Ordering Models
• Scoring Models
• Utility Models
• Hierarchical Models
• Optimizations Models

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Profitability Models
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Payback Period

• The Payback Period for a Project is the Initial
  Fixed Investment in the Project Divided by the
  Estimated Annual Cash Inflows from the Project.
  The Ratio of These Quantities is the Number of
  Years Required for the Project to Repay Its
  Initial Fixed Investment. For Example, Assume a
  Project Costs 100,000 to Implement and has
  Annual Cash Inflows of 25,000. Then
• Payback Period 100,000/25,000 4 years

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Average Rate of Return

• Average Rate of Return often mistakenly Taken to
  be the Reciprocal of the Payback Period, the
  Average Rate of Return is the Ratio of the
  Average Annual Profit (Either Before or After
  Taxes) to the Initial or Average Investment in
  the Project. Because Average Annual Profits are
  not Equivalent to Net Cash Inflows, the Average
  Rate of Return does not Equal the Reciprocal of
  the Payback Period. Assume, in the Previous
  Example, that the Average Annual Profits are
  15,000
• Average Rate of Return 15,000/100,000 0.15

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Discounted Cash Flow

• Also Referred to as the Present Value Method, the
  Discounted Cash Flow Method Determines the Net
  Present Value of All Cash Flows by Discounting
  Them by the Required rate of Return (Also Known
  as the Hurdle Rate, Cutoff Rate, and Similar
  Terms) as Follows,
• NPV (Project)
• Where Ft The Net Cash Flow in Period t
• k The Required Rate of Return, and
• A0 Initial Cash Investment
• (Because This is an Outflow,
  It will be Negative)
• To Include the Impact of Inflation (or Deflation)
  Where pt is the Predicted rate of Inflation
  During Period t, We have
• NPV (Project)

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Internal Rate of Return (IRR)

• The IRR is the Discount Rate that Equates the
  Present Value of Expected Cash Inflows to the
  Present Value of Expected Cash Outflows. IF At is
  the Expected Cash Outflow in Period t, and Rt is
  the Expected Cash Inflow for Period t, the IRR is
  the Value of (k) that Satisfies the Following
  Equation.
• The Value of k is found by Trial and Error

Where At and Rt are Positive Values
A0A1/(1k)A2/(1k)2 .. An/(1k)n
R1/(1k)R2/(1k)2 .. Rn/(1k)n
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Profitability Index

• Also Known as the Benefit-Cost Ratio, the
  Profitability index is the Net Present Value of
  All Future Expected Cash Flows Divided by the
  Initial Cash Investment. If this Ratio is Greater
  than 1.0, the Project may be Accepted.

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Other Profitability Models

• Pacificos Method
• Deans Profitability Method

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Pacificos Methos

• PI is the Profitability Index of Acceptability
  Where
• PI rdpc SP vL /C
• r Probability of Research Success
• d Probability of Development Success, Given
  Research Success
• p Probability of Process Success, Given
  Development Success
• c Probability of Commercial Success, Given
  Process Success
• The Investment, C, is the Estimated Total Cost of
  the RD Effort for the Project. Risk is
  Incorporated in the rdpc term.
• The Cash Flow is SP vL where
• S Estimated Average Annual Sales Volume in
  Units of Product
• P Estimated Average Annual Profit per Unit
• L Estimated Life of the Product Extension in
  Years.
• (Note that Although the Profits are not Formally
  Discounted, They are devalued
• over Time by Multiplying Them by vL rather
  than by L)

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Deans Profitability Method

• Deans Model Contains a Term that Subtracts the
  Unit Manufacturing Cost and the Unit Selling and
  Administrative Costs from the Unit Price,
  Multiplies the Remainder by the Expected Number
  of Units Sold per Years, and then Subtracts
  Tooling and Development Costs (a Project Risk
  Factor is also Included.) All Costs and Revenues
  are Time-Indexed and Discounted to the Present.
  Dean Modifies His Model to Deal with Three
  Distinct Cases (1) Where the Product Extension
  has no Significant Impact on the Existing System,
  (2) Where the Product Extension may Affect the
  Profitability or the Sales of Existing Products,
  or Both, and (3) Where the Product Extension is a
  Replacement for an Existing Product.

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Advantages of Profitability Models

• The Undiscounted Models are Simple to Use and
  Understand
• All Use Readily Available Accounting Data to
  Determine the Cash Flows
• Model Output is in Terms Familiar to Business
  Decision Makers
• With a Few Exceptions, Model Output is on an
  Absolute Profit-Profitability Scale and Allows
  Absolute Go/No-Go Decisions
• Some Profit Models Account for Project Risk
• Deans Model Incorporates the Impact of the
  Project on the Rest of the Organization

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Disadvantages of Profitability Models

• These Models Ignore All Nonmonetary Factors
  Except Risk
• Models that do not Include Discounting Ignore the
  Timing of the Cash Flows and the Time Value of
  Money
• Models that Reduce Cash Flows to Their Present
  Value are Strongly Biases toward the Short Run
• Payback-Type Models Ignore Cash Flows beyond the
  Payback Period
• All are Sensitive to Errors in the Input Data for
  the Early Years of the Project
• All Discounted Models are Nonlinear, and the
  Effects of Changes (or Errors) in the Variables
  or Parameters are Generally not Obvious to Most
  Decision Makers
• Those Models Incorporating the Risks of Research
  and/or Development and/or Process (the Commercial
  Success Risk Factor is Excluded from this
  Comment) Mislead the Decision Maker. It is not so
  such that the research-Development-Process
  Success is Risky as It is that the Time and Cost
  Required to Ensure Project Success is Uncertain.
  The Application of These Risk Terms Applies
  Mainly to RD Projects
• Some Models, Deans and Pacificos, for Example,
  are Oriented Only toward Evaluation of Projects
  that Result in New Products
• All These Models Depend for Input on a
  Determination of Cash Flows, But It is not Clear
  Exactly How the Concept of Cash Flow is Properly
  Defined for the Purpose of Evaluating Projects

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Decision Theoretic Models
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General Simulation Analysis
Probability Distributions for Elements of Project
Cost for a Utility
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Risk Analysis
Probability Distributions for Decision Variables
Probability Distribution for NPV, IRR, and Payback
Single Capital Investment Proposal
Managerial Review and Judgment
Information
DECISION
Intangibles, Other Decision Parameters
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Probability Density for Three Alternatives
Note Alternative 3 has the Lowest Mean, but
Alternative 1 has a Smaller Variance
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Risk Analysis Software

• _at_Risk for Excel
• Crystal Ball

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Comparative Models for Project Selection

• Rank Ordering Methods
• Simple Rank Ordering
• Q-Sorting
• Weighted Ordering
• Scoring Models
• Unweighted 0-1 Scoring Model
• Unweighted Factor Scoring Model
• Weighted Factor Scoring Model
• Constrained Weighted Factor Scoring Model
• Probabilistic Scoring Model
• Utility Models
• Simple Utility Model
• Probabilistic Utility Model
• Hierarchical Models
• Optimization Models
• Integer Programming Model
• Goal Programming Models

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Simple Rank Ordering
Number of Pluses
2
1
4
3
0
Number of Minuses
2
3
0
1
4
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Q-Sorting
Step 1
Least Desirable
Most Desirable
Midpoint
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Q-Sorting (Continued)
Step 2
Least Desirable
Most Desirable
Midpoint
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Q-Sorting (Continued)
Most Desirable
Least Desirable
Midpoint
Step 3
Step 4
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Weighted Ordering
P6 55 P3 45
P3 60 P9 40
P9 70 P8 30
P8 51 P4 49
P4 75 P10 25
P10 60 P2 40
P2 65 P1 35
P1 55 P5 45
P5 52 P7 48
P7 1.00 P5 1.08 P1 1.08
1.32 P2 1.32 2.46 P10 2.46
3.69 P4 3.69 11.07 P8 11.07 11.52 P9
11.52 26.87 P3 26.87 40.31 P6
40.31 49.27
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Scoring Models

• Identify Relevant Criteria. For Most Project
  Selection Situations, Five to Ten Criteria are
  Sufficient
• Define a Range for Each Criterion. The Range
  Could be from Very Good to Very Bad for
  Qualitative Criteria, and from the Highest
  Measurable Value to the Lowest for Quantitative
  Criteria, such as Return on Investment (ROI)
• Divide the Range of Each Criterion into
  Intervals. The Recommended Number of Intervals is
  Between Five and Nine
• Rank the Criteria in the Order of Their Relative
  Importance and Assign Weights to Them

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Scoring Models(Continued)

• Assign a Numerical Value to Each Interval
• Evaluate Each Project, One at a Time, According
  to the Criteria by Indicating the Interval to
  Which It Belongs
• Calculate the Product of the Criterion Weights
  and the Criterion Intervals. The Sum of These
  Products is the Project Score
• Repeat Steps Six and Seven for Each Project
• Rank the Projects According to Their Scores

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Possible Project Criteria

• Technical Aspects
• Availability of Qualified Technical Personnel
• Availability of Technical Know-How
• Changes of Technical Success
• Alternatives to Project
• Adequacy of Support Personnel
• Adequacy of Facilities and Equipment
• Compatibility with Existing Projects
• Completion Time Relative to Need

• Utilization Aspects
• Requirements for Results
• Availability of Funding for Implementation of
  Results
• Risk of Early Obsolescence of Results
• Effect on Present Operations
• Compatibility with Present Operations
• Compatibility with Corporate Goals
• Value-to-Cost Ratio
• Impact on Safety, Reliability, and Pollution
  Problems

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Unweighted 0-1 Factor Model
Project
Rater
Date
Does Not Qualifies
Qualifies
No Increase in Energy Requirements x Potential
Market Size, Dollars x Potential Market
Share, Percent x No New Facility
Required x No New Technical Expertise
Required x No Decrease in Quality of Final
Product x Ability to Manage Project with
Current Personnel x No Requirement for
Reorganization x Impact on Work Force
Safety x Impact on Environmental
Standards x Profitability Rate of Return
more than 15 after Tax x Estimated Annual
Profits more than 100,000 x Time to
Break-Even less than 3 Years x Need for
External Consultants x Consistency with
Current Line of Business x Impact on Company
Image With Customers x With Our
Industry x
Totals
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5
Sample Project Evaluation Form
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Unweighted Factor Scoring Model

• Score Performance Level
• 5 Above 1,0000,000
• 4 750,000 to 1,000,000
• 3 500,000 to 750,000
• 2 200,000 to 500,000
• 1 Less than 200,000
• Score Performance Level
• The Quality of the
• Final Product is
• 5 Significantly and Visibly Improved
• 4 Significantly Improved, but not Visible to
  Buyer
• 3 Not Significantly Changed
• 2 Significantly Lowered, but not Visible to
  Buyer
• 1 Significantly and Visibly Lowered

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Weighted Factor Scoring Model

• When Numeric Weights Reflecting the Relative
  Importance of Each Individual Factor are Added,
  We have a Weighted Factor Scoring Model. In
  General, It Takes the Form

j 1,2,3 . n

• Where Si The Total Score of the i th Project
• Sij The Score of the i th Project on the j th
  Criterion
• Wj The Weight of the j th Criterion

The Weights wj may be generated by any technique
that is acceptable to the organizations policy
makers. (The Delphi Technique is both effective
and acceptable.) When numeric weights have been
generated, it is helpful (but not necessary) to
scale the weights so that
0 Wj 1
j 1,2,3 . n
n
? Wj 1
j 1
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Simple Scoring Model for a project

• Criterion Interval Values (C )
• 1.0 0.8 0.6 0.4 0.2
• Criterion Criterion Very Very Rating
• Weight (W ) Good Good Medium Poor Poor W x C
• Use of Available
• Personnel 0.15 x (0.15)(0.8) 0.12
• Growth Potential 0.20 x (0.20)(0.6) 0.12
• Profitability 0.30 x (0.30)(0.8) 0.24
• Competitive Advantage 0.05 x (0.05)(0.4)
  0.02
• Consistence with
• Technical Competence 0.20 x (0.20)(0.8)
  0.16
• Compatibility with
• Existing Project 0.10 x (0.10)(1.0) 0.10

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Constrained Weighted Factor Scoring Model

• The Temptation to Include Marginal Criteria can
  be Partially Overcome by Allowing Additional
  Criteria to Enter the Model as Constraints rather
  than Weighted Factors. These Constraints
  represent Project Characteristics that must be
  Present or Absent in Order for the Project to be
  Acceptable. In the Example Concerning the Quality
  of the Final Product, We might have Specified
  that We would not Undertake any Project that
  would Significantly Lower the Quality of the
  Final Product (Visible to the Buyer or not)
• We would Amend the Weighted Scoring Model to Take
  the Form

Where Cjk 1 If the j th Project Satisfies the k
th Constraint, and 0 If It does not. Other
Elements in the Model are as Defined Earlier.
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Probabilistic Scoring Model for a project

• Criterion Interval Values
• 1.0 0.8 0.6 0.4 0.2
• Criterion Criterion Very Very Expected
• Weight (W ) Good Good Medium Poor Poor Rating
• Use of Available
• Personnel 0.15 0.3 0.5 0.2 --- --- 0.12
• Growth Potential 0.20 0.1 0.1 0.4 0.2 0.2 0.11
• Profitability 0.30 0.3 0.4 0.1 0.1 0.1 0.22
• Competitive Advantage 0.05 --- 0.1 0.2 0.5 0.2
  0.02
• Consistence with
• Technical Competence 0.20 0.1 0.6 0.2 0.1 ---
  0.15
• Compatibility with
• Existing Project 0.10 0.5 0.3 0.2 --- --- 0.09

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Scoring Models

• Advantages
• Allow for Multiple Criteria
• Easy to Use and Understand
• Direct Reflection of Managerial Policy
• Weighted Models Reflect Importance
• Allow for Easy Sensitivity Analysis

• Disadvantages
• Output is Strictly Relative, not Representative
  of Utility
• Assume Linearity and Independent
• Non-Weighted Models Unrealistically Assume All
  Variables are Equally Important

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Utility Models
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Simple Utility Model
Generation of Risk Attitude in Term of Utility
Function
Probability Distributions for Decision Variables
Expected Monetary Value of Project Using the
Rollback Principle
Single Capital Investment Proposal
Information
Managerial Review and Judgment Availability of
Expected Utility of Project
DECISION
Intangibles, Other Decision Parameters

• Let Ek Expected Utility of Project
  k
• Wi Relative Weight of Criterion i
• Ui Utility Function for Criterion i
• Vijk Level j of the Outcome of Project k for
  Criterion i
• Pijk Probability that the Level Vijk will be
  Achieved
• The Expected Utility of Project k is

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Hierarchical Models
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• Impact Level, Which Deals with Issues Related to
  the Strategic Purpose of the Organization
• Target Level, Which Defines the Project Goals
  that are to be Achieved
• Operational Level, Which Refers to the Project,
  Strategies, and Actions that are Under
  Consideration

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• Where Vi Relative Value of Project i
• Wm Relative Weight of Benefit m
• Pij Relative Contribution of Project i to
  Strategy j
• Sjk Relative Contribution of Strategy j to
  Goal k
• Gkl Relative Contribution of Goal k to
  Objective l
• Olm Relative Impact of Objective l on Benefit m

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Optimization Models
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0-1 Integer Programming Model

• Formulate the Problem with (m) projects and (n)
  factors as Follow
• The Relative Value of Project (i)
• Then Where xi 0 or 1
• Where ri is the Resource
• Requirement for Project (i), and
• R is the Availability Resource

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Goal Programming Model

• Formulation Similar to the 0-1 Integer
  Programming Model Except that the Constraint are
  Expressed as the Goals with Negative and Positive
  Deviations from the Target Values, and the
  Objective Function is Developed to Minimize the
  Deviations.
• This Model Allows the Incorporation of Multiple
  Objectives under Multiple Criteria into the
  Decision Process.
• Variables are, again, Defined as Taking Integer
  Values,
• 0 for the Non-Selected Project,
• and 1 for the Selected Project.

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Goal Programming Models

• Objective Function Min ? D-, D
• Goals Profit D- - D
• Market Share D- - D
• Synergy D- - D
• Manpower D- - D

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Criteria for Project Selection Models

• Realism
• Capability
• Flexibility
• Ease of Use
• Data Requirements
• Cost