AD642
Sources: Gray / Larson | Alan Probst, Uwisc | Rodney Noehme

•
Changes in the organization ’ s mission and strategy
–
Project managers must respond to changes with appropriate decisions about future projects and adjustments to current projects.
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Project managers who understand their organization ’ s strategy can become effective advocates of projects aligned with the firm ’ s mission.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
McGraw-
Hill/Irwin 2 –2

•
Strategic Management
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Provides the theme and focus of the future direction for the firm.
•
Responding to changes in the external environment — environmental scanning
•
Allocating scarce resources of the firm to improve its competitive position —internal responses to new action programs
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Requires strong links among mission, goals, objectives, strategy, and implementation.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
McGraw-
Hill/Irwin 2 –3

 Four of Activities of the Strategic Management Process
1.
Review and define the organizational mission.
2.
Set long-range goals and objectives.
3.
Analyze and formulate strategies to reach objectives.
4.
Implement strategies through projects
McGraw-
Hill/Irwin 2 –4
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.

Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
Strategic
Management
Process
FIGURE 2.1
Hill/Irwin 2 –5

S
Specific
Characteristics of Objectives
Be specific in targeting an objective
M
Measurable Establish a measurable indicator(s) of progress
A
Assignable Make the objective assignable to one person for completion
R
Realistic State what can realistically be done with available resources
T
Time related
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
EXHIBIT 2.1
McGraw-
Hill/Irwin 2 –6

•
The Implementation Gap
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The lack of understanding and consensus on strategy among top management and middle-level (functional) managers who independently implement the strategy.
•
Organization Politics
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Project selection is based on the persuasiveness and power of people advocating the projects.
•
Resource Conflicts and Multitasking
–
The multiproject environment creates interdependency relationships of shared resources which results in the starting, stopping, and restarting projects.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –7

Benefits of Project Portfolio Management
•
Builds discipline into project selection process.
•
Links project selection to strategic metrics.
•
Prioritizes project proposals across a common set of criteria, rather than on politics or emotion.
•
Allocates resources to projects that align with strategic direction.
•
Balances risk across all projects.
•
Justifies killing projects that do not support organization strategy.
•
Improves communication and supports agreement on project goals.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
EXHIBIT 2.2
McGraw-
Hill/Irwin 2 –8

Portfolio of Projects by Type
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
FIGURE 2.2
McGraw-
Hill/Irwin 2 –9

 Selection Criteria
 Financial: payback, net present value (NPV), internal rate of return (IRR)
 Non-financial: projects of strategic importance to the firm.
 Multi-Weighted Scoring Models
 Use several weighted selection criteria to evaluate project proposals.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
10

•
The Payback Model
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Measures the time it will take to recover the project investment.
–
Shorter paybacks are more desirable.
–
Emphasizes cash flows, a key factor in business.
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Limitations of payback:
•
Ignores the time value of money.
•
Assumes cash inflows for the investment period (and not beyond).
•
Does not consider profitability.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
11

•
The Net Present Value (NPV) model
–
Uses management ’ s minimum desired rate-of-return
(discount rate) to compute the present value of all net cash inflows.
•
Positive NPV: the project meets the minimum desired rate of return and is eligible for further consideration.
•
Negative NPV: project is rejected.
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
12

Net Present Value (NPV) and Internal Rate of Return (IRR):
Example Comparing Two Projects
EXHIBIT 2.3

• Money ’ s value changes over time
• A dollar today is worth more than a dollar tomorrow
• When time value is considered, the cost-effectiveness of a project can change

• Interest rates
$100 you invest at a 4% interest rate today will be worth $104 in 1 year, thus making today ’ s money worth more
• Inflation
You purchase 20 items today at $1.00 each for $20.00
After one year, due to inflation, those same items cost $1.50 each and you can only purchase 13.33 of that same item with our $20.00. Thus, today ’ s money is worth more.

Future Value
Measures what today ’ s money would be worth at a specified time in the future assuming a certain discount rate
Present Value
Measures what money at a specified period of time in the future would be worth if valued in terms of today ’ s money

• The rate used in calculating the present value of expected yearly benefits and costs
• Used to reflect the time value of money
• The higher the discount rate, the lower the present value of future cash flows

 A nominal discount rate that reflects expected inflation should be used to discount nominal benefits and costs
 Market interest rates are nominal interest rates

 The nominal rate is the real discount rate adjusted to eliminate the effect of expected inflations should be used to discount constant-dollar or real benefit benefits and costs
 A real discount rate can be approximated by subtracting expected inflation from a nominal interest rate

(1+ Nominal Interest Rate) = (1 + Real Interest Rate) * (1 +
Inflation rate)

• Future Value = Present Value X (1+discount rate) raised to a power of the number of years
• Present Value = Future Value/ (1+discount rate) raised to a power of the number of years

100 X (1.0 + .04) 5 = 121.67 where .04 is the discount rate.

5

18 = $

Understanding the time value of money can help you identify misconceptions about real costs and benefits of projects or courses of action

• Future value, present value, and discount rates are used to determine Net Present Value
• Net Present Value is a component of Cost Benefit Analysis
• Net Present Value is a criterion for deciding whether a government program can be justified on economic principles.

• NPV is the future stream of benefits and costs converted into equivalent values today
• Programs with a positive NPV are generally cost effective
• Programs with negative NPV are generally not cost effective

• Assign monetary values to benefits and costs
• Discount future benefits and costs using an appropriate discount rate
• Subtract the sum total of discounted costs from the sum total of discounted benefits

 Project A produces $5,000 of revenue in 2006
 Project B produces $5,200 of revenue in 2007
 Which is the more fiscally sound project?

• You cannot directly compare two different years without discounting
• 2006 is Present Value
• 2007 is Future Value


You must find the PRESENT VALUE of Project B in 2006 to compare
 Since this is a government project, we ’ ll use 4.5% interest on a US Treasury Bond as the Discount Rate

• The PRESENT VALUE of Project B is determined by:
$5,200 / (1+ 0.045) = $4,976
NPV = $4,976

After discounting, the present value of :
Project A = $5,000
Project B = $4,976
Choose Project A

New County Historical Society & Museum
 Construction cost:
 Visitor ticket:
$10,000,000
$15
 Annual expected visitors
 Expected growth of visitors horizon)
 Annual maintenance costs
56,700
12% (for 10 year
$10,000 w/7% growth
 Annual repair expenses
 Discount rate
$5,000 w/7% growth
Bond Rate)
4.85% (10 yr Treasury
 Depreciation
 Capital Expenditure
 Inventory, etc.
$300,000
$285,714 w/5% growth
$5,000 w/5% growth

For each year of payback of 10 year project:
 Projected revenues – annual maintenance and repair expenses =
Benefits
 Add benefits + depreciation
 Subtract capital expenditure for the year and change in working capital to get Free Cash Flows
 Free Cash Flows/(1+.0485) to the power of the year number (1-10) for
Present Value of Cash Flows (PVCF)
 Total of ten year ’ s PVCF – Cost of Construction = NPV
 NPV this project is $249,758; generally cost effective

HOWEVER, if you decrease the expected growth rate in paying visitors from 12% to only 5% the entire picture changes
With only a 5% expected increase, using the same formula, our NPV result is a negative ($2,698,349), a major loss and commonly viewed as not costeffective

 Traditional NPV analysis usually does not address the decisions that managers have after a project has been accepted.
 In reality, capital budgeting and project management is typically dynamic, rather than static in nature.
 Real options exist when managers can influence the size and riskiness of a project ’ s cash flows by taking different actions during the project ’ s life.
 Real option analysis incorporates typical NPV budgeting analysis and also incorporates opportunities resulting from managers ’ decisions.
8-39

 A new proposed project would cost $500 now (t=0) in order to explore the project ’ s feasibility.
 Next year, it will cost an additional $1500 at t=1 upon final acceptance, and is expected to produce cash flows in years 2 through 6 (from t=2 to t=6).
 Our current (t=0) forecast for cash flows CF
2
 70% probability of $1000 per year
 30% probability of $400 per year through CF
6 is:
 Next year (t=1), we will know cash flows CF
2 through CF certainty; they will be either $1000 or $400 per year.
6 with
8-40

 Calculate the expected cash flows CF
2 through CF
6
 E(CF) = (0.70)(1000) + (0.30)(400) = $820 per year
 A time line of expected cash flows is shown below.
t=0 t=1 t=2
CF
0
= -500 CF
1
= -1500 CF
2
= 820 t=3
CF
3
= 820 t=4
CF
4
= 820 t=5
CF
5
= 820 t=6
CF
5
= 820
8-41

Now calculate the NPV of the project ’ s timeline.
This project ’ s NPV consists of the following items:
–
$500 spent today
–
$1500 spent at t=1
–
Five expected cash flows of $820 each from t=2 to t=6
(a n=5 year annuity). The PV annuity formula produces a value for t=1, which must be discounted by n=1 years from t=1 to t=0.
NPV
0

500 
1
1500

0.15


820


1
0.15


1

0.15

0.15
1

1

0.15

5


NPV
0

585.884
8-42

 This estimated NPV of $585.884 is incomplete. It assumes the continuation of the project from t=0 to termination at t=6 if the project is accepted today.
 All we have is the NPV of expected future cash flows, ignoring the option to abandon the project.
 In reality, if $500 is spent today, then next year at t=1, the firm has the option to either spend $1500 to continue, or abandon the project.
 The decision at t=1 to continue or abandon depends on whether
CF
2 to CF
6 are then known to be $1000 or $400 per year. If the project is believed to be negative NPV at t=1, then it will be cancelled at that time .
8-43

 When the $1500 expenditure is made at t=1, we know if
CF
2 through CF
6 is either $1000 or $400 per year.
 We first calculate the project ’ s NPV
1
, for CF
1 through CF being $1000 per year. We deem this as the success NPV.
6
 From today ’ s (t=1) perspective, this success NPV has a p=70% chance of occurring.
NPV
1

1500

1000


1
0 .
15

0 .
15

1
1

0 .
15

5


NPV
1

1500

(1000)(3.3
52155)

$1852.155
8-44

 Next we calculate the project ’ s NPV
1
, for CF
1 through CF
6
$400 per year. We deem this as the failure NPV.
being
 From today ’ s (t=1) perspective, this failure NPV has a p=30% chance of occurring.
NPV
1

1500

400


1
0 .
15

0 .
15

1
1

0 .
15

5


NPV
1

1500

(400)(3.35
2155)

$159.138
8-45

 What is today ’ s (t=0) decision, based on this new scenario analysis of next year ’ s likelihood of p=70% success and p=30% failure?
 NPV
NPV
0
= -500 + (0.7)[success NPV
1
/(1+r)]
1
/(1+r)] + (0.3)[ failure
 We will not go forward next year with negative NPV therefore the failure NPV
1 just be cancelled at t=1 if CF
2 known to be $400 per year.
through CF
6 are then
1
, is ZERO, as the project will
 PV
0
= -500 + (0.7)[1852/(1+0.15)] + (0.3)[ 0 ] = $627.399
8-46

 Note that this dynamic NPV=$627.399 is greater than the earlier static NPV=$585.884. The $41.52 difference is the value of the option to abandon.
 A decision tree of the project is shown below.
success, p=70%
ACCEPT,
NPV
1
=$1852 conduct
$500 study failure, p=30%
REJECT,
NPV
1
=$0 do nothing
8-47

 A project has a k=10% cost of capital. If accepted, the project costs $1100 today at t=0.
 Next year, at t=1, we will know whether or not the project is actually a success or failure. Today at t=0, all we know are the
probabilities of future success or failure.
 Success: probability=50% , and the project will generate cash flows of
$180 per year forever (perpetuity) if a success.
 Failure: probability=50% , and the project will generate cash flows of $30 per year forever (perpetuity) if a failure.
 Project X can be abandoned at t=1 for $500 salvage value.
 CFs here are perpetuities. The PV of a perpetuity is always
PV=CF/r
8-48

 Expected annual CF = (p success)(180) + (p failure)(30) =
(0.5)(180) + (0.5)(30) = $105
 The expected cash flow is $105 per year forever.
 NPV
0
= -1100 + 105/0.1 = -1100 + 1050 = -$50
 If treated as a project that is allowed to continue forever after t=0 acceptance, the expected NPV is negative.
 Under this type of analysis (ignoring the abandonment option), the project should be rejected.
8-49

 A tree diagram of the project is shown below. There are really two NPVs for this project; one for success and one for failure, each with a probability of 50%.
Success, p=50%
CF = $180/year, forever,
PV
0
= 180/0.1 = $1800
Investment costs
$1100 today
Failure, p=50%
CF = $30/year, forever,
PV
0
= 30/0.1 = $300
Or abandon at t=1 for $500
8-50

•
The first timeline shows the project, if successful and, of course, never abandoned.
•
The second timeline shows the project, if an eventual failure and not abandoned.
•
The third timeline shows the project, if known to be a failure at t=1 and abandoned at t=1 for $500 (the project ’ s t=1 cash flow will be earned).
t=0 t=1
CF
0
= -1100 CF
1
= 180 t=2
CF
2
= 180 t=0 t=1
CF
0
= -1100 CF
1
= 30 t=2
CF
2
= 30 t=0 t=1
CF
0
= -1100 CF
1
= 30
+ 500 salvage
8-51

 NPV
$700
0
(if success) = -1100 + 180/0.1 = -1100 + 1800 =
 NPV
0
(if failure) : this issue must be further addressed in detail. Either the project can be continued at t=1 or it can be abandoned and the assets sold for $500 salvage value.
 First, calculate the NPV cash flows:
0 if as though the project is
continued in operation as a failure with the $30 annual
 Failure NPV
0
= -1100 + 30/0.1 = -1100 + 300 = -$800
8-52

 Now investigate abandoning the project at t=1 if we realize it is a failure. At t=1 one cash flow (the only project cash flow since the project is then cancelled) of $30 is received and then the assets are sold for $500. This abandon upon failure NPV
0 is thus:
 NPV
0
= -1100 + 30/(1+0.1) + 500/(1+0.1) = -1100 + 481.18 = -
$618.18 if abandoned at t=1.
 If a failure at t=1, the abandonment NPV is higher than the
NPV if allowed to continue.
8-53

 If accepted today, at t=0, there is a 50% chance that the project will be allowed to operate forever, and a
50% chance that it will be abandoned for a $500 salvage value.
 Dynamic NPV
0
NPV
0
]
 Dynamic NPV
0
$40.91.
= (0.5)[success NPV
0
] + (0.5)[failure
= (0.5)[700] + (0.5)[-618.18] =
 The project should now be accepted since the NPV becomes positive when we allow for project abandonment.
8-54

 The NPV
0
= –$50 if the project is treated as continuing forever after acceptance.
 The NPV
0
= $40.91 when we include the decision to abandon at t=1 when the project becomes a failure.
 The difference between these two NPVs is called the value of the option to abandon.
 Value of option = 40.91 – (–50) = $90.91
8-55

 Investment timing options
 Often, the option to delay investment is valuable if market or technology conditions are expected to improve.
 Abandonment/shutdown options
 Two example were previously shown
 Growth/expansion options
 May be valuable if the demand turns out to be greater than expected
 Flexibility options
 Projects may be more valuable if an allowance is made for greater future modifications.
8-56

Project Screening Matrix
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
FIGURE 2.3
McGraw-
Hill/Irwin 2 –
57

•
Project Classification
–
Deciding how well a strategic or operations project fits the organization ’ s strategy.
•
Selecting a Model
–
Applying a weighted scoring model to bring projects to closer with the organization ’ s strategic goals.
•
Reduces the number of wasteful projects
•
Helps identify proper goals for projects
•
Helps everyone involved understand how and why a project is selected
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
58

•
Sources and Solicitation of Project Proposals
–
Within the organization
–
Request for proposal (RFP) from external sources (contractors and vendors)
•
Ranking Proposals and Selection of Projects
–
Prioritizing requires discipline, accountability, responsibility, constraints, reduced flexibility, and loss of power.
•
Managing the Portfolio
–
Senior management input
–
The priority team (project office) responsibilities
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
59

•
Senior Management Input
–
Provide guidance in selecting criteria that are aligned with the organization ’ s goals
–
Decide how to balance available resources among current projects
•
The Priority Team Responsibilities
–
Publish the priority of every project
–
Ensure that the project selection process is open and free of power politics.
–
Reassess the organization ’ s goals and priorities
–
Evaluate the progress of current projects
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved. McGraw-
Hill/Irwin 2 –
60

Project Screening
Process
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
FIGURE 2.5
McGraw-
Hill/Irwin 2 –
61

Project Portfolio Matrix
Copyright
© 2006 The McGraw-Hill Companies. All rights reserved.
FIGURE 2.7
McGraw-
Hill/Irwin 2 –
62

 Bread-and-butter projects
 Involve evolutionary improvements to current products and services.
 Pearls
 Represent revolutionary commercial advances using proven technical advances.
 Oysters
 Involve technological breakthroughs with high commercial payoffs.
 White elephants
 Projects that at one time showed promise but are no longer viable.