Chapter 3
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1. Explain six criteria for a useful project
selection/screening model.
2. Understand how to employ checklists and simple
scoring models to select projects.
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.
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.
2
Firms are inundated with project opportunities
 No organization has unlimited resources to work on these
opportunities
 Screening models help managers pick winners from a pool of
projects
 Screening models can be qualitative and simple or
quantitative and complex
 When considering a project selection model, look for:
Realism (provides a realistic result?)
Capability, Comparability (works for ST/LT projects?)
Flexibility (adjustable?)
Ease of use (understandable?)
Cost effectiveness (cheap to use)

see “Prioritizing Spreadsheet”
3

A list of factors to be considered when evaluating
project alternatives
◦ Risk – unpredictability to the firm, technical, safety,
financial, legal
◦ Commercial Impact – reflects market potential, ROI,
payback
◦ Impact to internal operations – employee training, safety
issues, equipment needs
◦ Additional factors – impact on image, patent, strategic fit

Strategic direction of the company will highlight
certain criteria over others
All models only partially reflect reality and have both
objective and subjective factors imbedded
4
Checklist
 Simple scoring models
 Analytic hierarchy process
 Profile models
 Financial models

Let’s look at each of these…
5
A checklist is a list of criteria applied to
possible projects.
A fairly simple device
 Requires agreement on criteria
 Assumes all criteria are equally important

Checklists work best in a group setting and
are valuable for recording opinions and
encouraging discussion
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Performance on Criteria
Project
Criteria
Project Alpha
Cost
Profit Potential
Time to Market
Development Risks
Project Beta
Project Gamma
Project Delta
Cost
Profit Potential
Time to Market
Development Risks
Cost
Profit Potential
Time to Market
Development Risks
Cost
Profit Potential
Time to Market
Development Risks
High
Medium
Low
(3)
(2)
(1)
Which do you
choose?
X
X
X
X
Why?
X
X
X
X
X
X
X
X
X
X
X
X
* good place to make
use of a rubric
7


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)
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(A)
Project
(B)
(A) x (B)
Importance
Weight
Score
Cost
1
3
3
Profit Potential
2
1
2
Development Risk
2
1
2
Time to Market
3
2
6
Criteria
Weighted
Score
Project Alpha
Total Score
Which do you
choose?
Why?
13
Project Beta
Cost
1
2
2
Profit Potential
2
2
4
Development Risk
2
2
4
Time to Market
3
3
9
Total Score
19
9
Developed to address the technical and
managerial problem with scoring models
Similar to simplified scoring model except these
scores are comparable due to ranking of
importance


The AHP is a four step process:
1.
2.
3.
4.
Construct a hierarchy of criteria and subcriteria
Allocate weights to criteria through pairwise
comparison
Assign numerical values to qualitative characteristics
with a Likert scale
Scores determined by summing the products of
numeric evaluations and weights
Analytic Hierarchy Process/Example Car
http://en.wikipedia.org/wiki/Talk:Analytic_Hierarchy_Process/Example_Car
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


Allows one to plot risk vs. return options for
various projects.
Select the project with the maximum return
and minimum acceptable risk.
Makes use of a financial management
concept called the efficient frontier.
◦ A set of options that offers the maximum return for
a given level of risk or the minimum risk for a level
of return.
11
10
Maximum
Desired
Risk
X6
9
8
X2
7
Risk
6
X4
5
X5
4
X3
3
Efficient frontier
2
X1
1
0
0%
20%
40%
Minimum
Desired
Return
60%
80%
100%
120%
Return
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Based on the time value of money principal –
comparing what a dollar is worth today to
another time period
o
o
o
o
Discounted cash flow analysis
Payback period
Net present value
Internal rate of return
All of these models use discounted cash flows
13



The discounted cash flow (or DCF) describes a
method of valuing a project using the time value
of money.
All future cash flows are estimated and
discounted to give their present values.
The discount rate reflects two things based on
risk:
◦ the time value of money – projecting a future value to
today’s dollars.
◦ a cost of capital – a corporate charge for using cash.

Very similar to net present value.
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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)
15
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
Divide the cumulative
amount by the cash
flow amount in the
third year and subtract
from 3 to find out the
moment the project
breaks even.
25, 000
3
 2.67 years
75, 000
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
Advantage
◦ Easy to understand and use
◦ Emphasizes the early recovery of capitol
◦ Cashflow beyond the payback period are uncertain,
so they are ignored

Disadvantage
◦ Ignores timing of the cash flow within the payback
period
◦ Emphasis is on the recovery of capital, not on
profitability
◦ Does not provide a decision criterion for acceptance
How do you decide on the maximum allowable
payback period?
17



Needs to be accounted for in the capital
investment decision
Main reason: capital could be used for
something else
Capital has an opportunity cost in any given
use
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


One of the most common project selection metrics.
Predicts the change in the firm’s value if a project is
undertaken.
We attempt to equate all cash flows to current dollars.
Ft
NPV  I o  
(1  r  pt )t
where
Ft = net cash flow for period t
R
r = required rate of return
I o= initial cash investment
Higher NPV
values are
better!
A positive
value indicate
the firm will
make money
Pt = inflation rate during period t
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

NPV takes into account a discount factor
The discount factor is simply the reciprocal of
the discount rate
1
discount factor 
(1  r  p)t
r  rate of return
p  inflation rate
t  time period
20
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
0
1
Net flow Discount
-$60,000 1.0000
$15,000 0.9009
2
3
4
$15,000
$15,000
$15,000
0.8116
0.7312
0.6587
5
$15,000
0.5935
The NPV
NPV
-$60,000.00 column total is
negative, so
$13,513.51
don’t invest!
$12,174.34
$10,967.87
$9,880.96
$8,901.77
-$4,561.54
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



Answers the question: What rate of return will this project
earn?
It is the interest rate at which the NPV of the cash flows is
equal to zero.
A project must meet a minimum rate of return before it is
worthy of consideration.
Need to be solved with MSExcel or a financial based
calculator – by hand is an iterative (guessing) process
t
ACFt
IO  
n 1 (1  IRR )t
where
Higher IRR
values are
better!
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
22
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
0.8696
$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%
Actual IRR is
14.9625%
The project doesn’t meet our 17% requirement and should
not be considered further.
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The systematic process of selecting,
supporting, and managing the firm’s
collection of projects.
Portfolio management requires:
◦ Decision making on continued support of
projects
◦ Prioritization of resources
◦ Review of potential projects
◦ Realignment with strategic fit
◦ Reprioritization of a firm’s projects
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
Flexible structure and freedom of
communication
◦ Cannot be constrained by bureaucracy, poor
communication, rigid processes

Low-cost environmental scanning

Time-paced transition
◦ Finding a way to “test the waters” before full
commitment
◦ Market testing a number of experimental product
prototypes
◦ Having a process to transition from one project to
another
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
Conservative technical communities
◦ Technical reps holding onto projects too long

Out of sync projects and portfolios
◦ Projects must stay aligned with the current strategic
direction of the firm

Unpromising projects
◦ Willing to “kill” a project when it is necessary?

Scarce resources
◦ No one has unlimited resources
◦ Resources need to be allocated where they are most
beneficial
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Eclipse 500
Airbus A380
Tiny? 6 passengers
Boeing 787 Dreamliner
Jumbo? between 550 to 800 passengers
Midsize? between 290 to 330 passengers
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1.
2.
3.
4.
5.
If you were to prioritize the criteria for a successful
screening model, which of those criteria do you
rank at the top of your priority list? Why?
What are the benefits and drawbacks of project
checklists for screening alternatives?
How does use of the Analytical Hierarchy Process
(AHP) aid in project selection? In particular, what
aspects of the screening process does the AHP
seem to address and improve directly?
What are the benefits and drawbacks of the profile
model for project screening? Be specific about the
problems that may arise in identifying the efficient
frontier.
How are financial models superior to other
screening models? How are they inferior?
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6.
7.
8.
9.
10.
How does the options model address the problem
of non-recoverable investment in a project?
What advantages do you see in the GE Tollgate
screening approach? What disadvantages do you
see? How would you alter it?
Why is project portfolio management particularly
challenging in the pharmaceutical industry?
What are the keys to successful project portfolio
management?
What are some of the key difficulties is successfully
implementing portfolio management practices?
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

GoodAnswers’ controller, Sal Reigh, has
negotiated a four-year lease agreement with
Columbia Management.
Included in the agreement is
◦ Option #1, a lump sum payment of $40,000 upon
signing the four-year lease to pay for the cost of
configuring the office to meet the needs of
GoodAnswers.
-or ◦ Option #2, to pay nothing up front, but to incur an
annual lease in the amount of $11,000 paid at the end
of each year for the four-year term of the lease.

Assuming GoodAnswers has a cost of capital of
10%, which option should Sal choose?
30