Project Identification and Project Selection

Dr. Ziping WangPROJ 600

Agenda

Project identificationProject selection

Non-financial methodsFinancial methods

Project charterRFP (request for proposal)

Project IdentificationStart of Initiating phaseRecognize need, problem, or opportunityVarious ways for identification

Organizations strategic planning Response to unexpected events Group organized to address a need

Important to clearly identify need to determine if worth pursuingUse decision making process to prioritize and select project with greatest need

Project Selection

Evaluate needs, costs, benefitsSelect project

Develop criteria List assumptions Gather data Evaluate each

opportunity

Combine “gut” feelings and quantitative information to make decision

A Set of Criteria in Project Selection

• Develop a set of criteria against which the opportunity will be evaluated. For example:

• Alignment with company goals• Anticipated sales volume• Increase in market share• Establishment of new markets• Anticipated retail price• Investment required• Estimated manufacturing cost per unit• Technology development required• Return on investment• Human resources impact• Public reaction• Competitors’ reaction• Expected time frame• Regulatory approval• Risks

Project Screening ModelsScreening models help managers pick winners from a pool of projects. Screening models should have:

Realism: An effective model must reflect organizational objectives

Capability: A model should be flexible enough to respond to changes in the conditions under which projects are carried out.

Flexibility: The model should be easily modified if trial applications require changes.

Ease of use: A model must be simple enough to be used by people in all areas of the organization.

Cost effectiveness: The model must be cost effective.

Comparability: The model must be broad enough to be applied to multiple projects.

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

Approaches to Project Screening

Non-financial: projects of strategic importance

to the firm.

Checklist model

Simplified scoring models

Analytic hierarchy process

profile models

Financial: payback, net present value (NPV),

internal rate of return (IRR)

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

Simplified Scoring ModelsEach 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

Relative scores can be misleading!

( )Score Weight Score

Scoring ModelCriteria weight Project 1 Project 2 Project 3 Project 4

Support key business objectives 25% 90 90 50 20Has strong internal sponsor 15% 70 90 50 20Has strong customer support 15% 50 90 50 20Uses realistic level of technology 10% 25 90 50 70Can be implemented in one year or less 5% 20 20 50 90Provides positive NPV 20% 50 70 50 50Has low risk in meeting scope, time, and cost goals 10% 20 50 50 90Weighted Project Scores 100% 56 78.5 50 41.5

Weighted Score by Project

0

20

40

60

80

100

Projects

Project 1

Project 2

Project 3 Project 4

Analytic Hierarchy Process

The AHP is a four step process:1. Construct a hierarchy of criteria and

subcriteria2. Allocate weights to criteria3. Assign numerical values to evaluation

dimensions4. Scores determined by summing the products

of numeric evaluations and weights

Profile Models

Show risk/return options for projects.

Maximum

Desired Risk

Minimum Desired Return

Return

Risk

X1

X3

X5

X6

X4X2

Efficient Frontier

Criteria selection as axes

Rating each project on criteria

Financial Models

Based on the time value of money principal Payback period Net present value Internal rate of return

All of these models use discounted cash flows

Payback Period

Cash flows should be discountedLower numbers are better (faster payback)

InvestmentPayback Period

Annual Cash Savings

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

Payback Period ExampleA project requires an initial investment of $200,000 and will generate cash savings of $75,000 each year for the next three 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

200,0002.67

75,000years

*: the reciprocal of payback yields the average rate of return

1* 37%

2.67rate of return

Net Present Value

Projects the change in the firm’s stock value if a project is undertaken.

0

(1 )

to t

t

t

t

FNPV I

r p

where

F = net cash flow for period t

r = required rate of return

I = initial cash investment

p = inflation rate during period t

Higher NPV values are better!

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

-$4,561.54

The NPV column total is negative, so don’t invest!

ExampleProject A Project B

Cost of project $700,000 $400,000Estimated annaul cash inflow $225,000 $110,000Estimated useful life of project 5 years 5 yearsRequired rate of return 15% 15%

1) Payback Period 3.1 years 3.6 years

2) NPV

Present value of annual net cash inflows

Project A NPV=

5

1 )15.01(

225000000,700

tt

Project B NPV=

5

1 )15.01(

110000000,400

tt

=$54,235

=-$31,283

Internal Rate of ReturnA project must meet a minimum rate of return before it is worthy of consideration.

1 (1 )

nt

tt

t

ACFIO

IRR

where

ACF = 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

Higher IRR

values are better!

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 15%; does this project meet the threshold?

Year Net flow Discount NPV

0 -$40,000 1.0000 -$40,000.00

1 $14,000 0.8696 $12,173.91

2 $14,000 0.7561 $10,586.01

3 $14,000 0.6575 $9,205.23

4 $14,000 0.5718 $8,004.55

-$30.30

This table has been calculated using a discount rate of 15%

The project doesn’t meet our 15% requirement and should not be considered further.

Project Charter

Purpose

Provides sponsor approvalCommits funding for the projectSummarizes key conditions and parameters Establishes framework to develop baseline plan

Possible Elements

Project titlePurposeDescriptionObjectiveSuccess criteria or expected benefitsFundingMajor deliverablesAcceptance criteria

Milestone scheduleKey assumptionsConstraintsMajor risksApproval requirementsProject managerReporting requirementsSponsor designeeApproval signature

PROJECT CHARTER EXAMPLE

Completeness of information Describes the project that needs to

be addressed Lists requirements, constraints,

assumptions, and risks An RFP could be developed from the

charter’s informationPossible evaluation criteria

Meets the purpose Cost Experience Risks Appropriate instructional strategies

Examine the project charter and comment on

•Completeness of the information•Possible evaluation criteria

Preparing a Request for Proposal

Decision made to outsource to external resourceComprehensively describe project requirements Includes need, problem, or opportunity description Allows contractors to develop a thorough proposal Facilitates the development of evaluation criteria

May be communicated informally or formally, in writing or verbally

Guidelines for Developing an RFP

State project objective or purposeProvide a statement of workInclude customer requirementsState deliverables the customer expectsState acceptance criteriaList customer supplied itemsState approvals required

State type of contractState payment termsState schedule and key milestonesList format and content instructionsIndicate due dateInclude evaluation criteriaInclude level of effort or funds available

RFP EXAMPLE

Will AJACKS supply the names of the firms to be surveyed?What manufacturing industries are the target?What marketing information already exists?What are the page limitations for the proposal and supplemental information?What is an acceptable return rate on the survey?

Examine the RFP example. What additional questions need to be answered?

HomeworkQ1:

Project A costs $90,000, will return $25,000 per year for five years. Project B costs $80,000, will return $20,000 per year for five years. You have an expected return of 8% and inflation to hold steady at 3% over the next five years.Which project will you select based on NPV?

Q2 (Chapter 2, Q5): Which elements of a project charter would you use to help plan if you have a project that does not require a project charter? Why?Q3 (Chapter 2, Q13): Develop an RFP for a real-world project such as landscaping the grounds surrounding a nearby business office, building a deck for your house, or holding a big graduation celebration. Be creative in specifying your needs. Fell free to come up with unique ideas for the RFP.