PROJECT
EVALUATION/SELECTION
Project Management
M.Tech – III Sem
Steps in project evaluation
Estimate project cash – flows.
 Establish the cost of capital.
 Apply a suitable decision or appraisal
criterion.
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PROJECT CASH FLOW
Project Cash Flow
Basic principles
 Components
 Example
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Basic Principles
Incremental principles
 Long-term funds principles
 Exclusion of financial cost principles
 Post-tax principle.
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Incremental principles
Project cash flow for ith year
= {cash flow of the firm with the project for ith year }
– {cash flow of the firm without the project for ith year }
 Guidelines:
 Consider all incidental effects – profitability/loss due to
the project on other activities.
 Ignore sunk costs – already spent for preliminary works,
but not directly connected to the project.(R&D, Market
Research, Consultant’s Fees)
 Include Opportunity cost – resources already available
with the firm like land, equipment can be used for project
with opp. Cost.
 Allocation of Overhead: indirect expenses.
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Net Working Capital
Change in Net Working Capital--Net
working capital is defined as current
assets minus current liabilities.
 Investment in working capital is a cash
outflow during the year in which
investment takes place
 Any investment in working capital is a
cash inflow during the last year of the
project and must be treated accordingly

Long – term funds principle
Focused on the profitability of long term
funds like equity stockholders, preference
stockholders, debentures etc.,
 The sacrifice made by suppliers of long
term funds is equal to the outlays on fixed
assets and net working capital.
 Benefits: Operational cash inflows after
taxes and salvage value of fixed assets and
net working capital.

Exclusion of Financial Costs
The interest on long term debt is ignored,
while computing profit.
 The expected dividends are deemed
irrelevant in cash flow analysis.

Post-tax principle
Tax must be properly deducted in
deriving the cash flow.
 Cost of capital is also included in post-tax
terms.
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Components of cash flow
Initial Investment
 Operating cash inflows
 Terminal Cash flow

Initial Investment
New Project
Cost of capital assets +
Installation costs + working
capital Margin + preliminary
and pre-operative expenses
– Tax shield on capital assets
* Usually NA for replacement projects
Replacement Project
Cost of replacement capital
assets + Installation costs –
post tax proceeds from the
sale of old capital assets +
change in working capital
Margin + preliminary and
pre-operative expenses* –
Tax shield on replacement
capital assets
Operating cash inflows
New Project
Profit after Tax +
Depreciation + Other
non-cash charges
+Interest on long term
debt(1-tax rate)
Replacement Project
Change in Profit after
Tax + Change in
Depreciation + Change
in Other non-cash
charges + Change in
Interest on long term
debt(1-tax rate)
Terminal Cash flows
New Project
Replacement Project
Post tax proceeds from
the sale of capital assets
+ Net recovery of
working capital margin
Post tax proceeds from
the sale of replacement
capital assets + Net
recovery of working
capital margin- Post-tax
proceeds from the sale
of present capital assets.
Developing Project Cash Flow Statement
Cash flow statement
+ Net income
+Depreciation
Income statement
Revenues
Expenses
Cost of goods sold
Depreciation
Debt interest
Operating expenses
Taxable income
Income taxes
Net income
-Capital investment
+ Proceeds from sales of
depreciable assets
- Gains tax
- Investments in working
capital
+ Working capital recovery
+ Borrowed funds
-Repayment of principal
Operating
activities
+
Investing
activities
+
Financing
activities
Net cash flow
15
EXAMPLE
COST OF CAPITAL
Cost of Capital

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Rate of return on investments for the market
value of the firm to remain unaffected.
Components:
Equity capital
Preference capital
Long-term debt capital

Firm’s cost of capital is the weighted
arithmetic average of the post tax cost of
various sources of long term finance used by
it.
Conditions to evaluate new
investments
Risk of new investment proposal is the
same as the risk of existing investments.
 Capital structure of the firm will not be
affected by the investment proposal.
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Miscoceptions
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This concept is too academic or impractical.
Cost of equity is equal to dividend rate or
return on equity.
Retained earnings are cost free/lesser than
external equity.
Depreciation has no cost.
Cost of capital can be defined in terms of an
accounting based measure.
If a project is heavily financed by debt , its
weighted average cost of capital is low.
PROJECT SELECTION
Strategic Management and Project
Selection
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Maturity of Project Management
Criteria for PS Models
Nature of PS Models
Types of PS Models
Uncertainty Analysis and Risk Management
Information Base for PS Models
Project Portfolio Process (PPP)
Project Proposal
Overview of PS Process
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Project Management Office (PMO):
Aligning corporate needs and project goals
Project Selection: Choose candidate project
using Evaluation Criteria
Dealing with Uncertainty: Risk Analysis
Strategically selecting best Projects:
Project Portfolio Process (PPP)
Locking up the deal: Writing a Project
Proposal
PS Models
Idealized view of reality
 Representing the STRUCTURE of the
problem, not the detail
 Deterministic or stochastic
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Criteria for Project Selection models
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Realism (technical-, resource-, market-risk)
Capability (adequately sophisticated)
Flexibility (valid results over large domain)
Ease of Use (no expert needed to run model)
Cost (much less than project benefit)
Easy Computerization (use standard software)
Nature of PS models: Caveats

Project decisions are made by PM --- NOT
by PS model!

A PS model APPROXIMATES, but does
NOT DUPLICATE reality!
Nature of PS Models: Methodology
Start with detailed list of firm’s goals
 Create list of project evaluation factors (PEF’s)
 Weigh every element in PEF list
 Compute an overall score for project based
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on weighted PEF’s
 Select project that has the closest alignment
with firm’s goals
Project Evaluation Factors (PEFs)
Production Factors
 Marketing Factors
 Financial Factors
 Personnel Factors
 Administrative and Misc. Factors
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Types of PS Models: Nonnumeric
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Sacred Cow
Operating Necessity
Competitive Necessity
Product Line Extension
Comparative Benefit
Model
Numeric PS Models: Profit /
Profitability
Payback Period (PB)
 Average Rate of Return
 Discounted Cash Flow (NPV-net present
value)
 Internal Rate of Return
 Profitability Index
 Other Profitability Models
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Numeric PS Models: Scoring
Unweighted 0-1
Factor Model
 Unweighted Factor
Scoring Model
 Weighted Factor
Scoring Model
 Constrained
Weighted Factor
Scoring Model
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S = ∑(x)
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S = ∑(s)
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S = ∑(s·w)
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S = ∑(s·w) ∏(c)
Choosing the PS Model
Dependent on wishes and philosophy of
management
 80% of Fortune 500 firms choose
“nonnumeric” PS models
 Firms with outside funding often chose
scoring PS models
 Firms without outside funding often chose
profit / profitability PS models
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Management of Risk: Terminology
 Risk: Decision based on complete
information about the probability of each
possible outcome.
 Uncertainty: Decision based on
incomplete or insufficient data.
 Game: Decision based under conditions
of conflict.
Areas of Uncertainty
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Project timing & expected cash flow.
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Direct outcome of project, i.e. what
exactly will the project accomplish
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Side effects and unforeseen consequences
of project
Window-of-Opportunity Analysis
 Estimate IN ADVANCE economic
impact of innovation before R&D is
undertaken
 Set up a baseline of current process as
the sum of all current sub processes
 Compute cost / performance of new
innovation as a multiple of each sub
process in the baseline system
Problems Affecting Data Used in PS
Models
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Accounting: arbitrary assignment of
overhead costs, linear cost and revenue forecasts
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Measurements: (subjective vs. objective),
(quantitative vs. qualitative), (reliable vs.
unreliable), (valid vs. invalid)
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Technology shock: New technology has to
overcome initial resistance threshold.
PROJECT PORTFOLIO
Project Portfolio Process (PPP)
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Step 1: Establish a Project Council
Step 2: Identify Project Categories & Criteria
Step 3: Collect Project Data
Step 4: Assess Resource Availability
Step 5: Reduce Project and Criteria Set
Step 6: Prioritize Projects within Categories
Step 7: Prioritize the projects within categories
Step 8: Implement the Process
Project Proposal: Content
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Cover letter
Executive summary
Description and past experience of project team
Nature of technical problem to be solved
How to approach solution of technical problem
Plan for implementation of project
Plan for logistic support and administration
Project Proposal:
Cover letter & Executive summary
 Compose a cover letter as key
marketing instrument
 Explain fundamental nature and general
benefits of project
 Minimally technical language
Project Proposal:
Past Experience of Project Team
 List all key project personnel with titles
and qualifications
 Include full resume of each principal
 Provide all pertinent references
Project Proposal:
Technical Approach
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General description of problem to be
addressed or project to be undertaken
Major subsystems of problem or project
 Methodology of solving the problem
 Special client requirements
 Test and inspection procedures
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Project Proposal:
Implementation Plan
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Estimates of time, cost and materials for each
subsystem and the whole project
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Establish major milestones to break project
into phases
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List equipment, overhead and administrative
cost
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Develop contingency plans (incl. slack time)
Project Proposal:
Plan for Administration and Logistic Support
Control over subcontractors
 Nature and Timing of all reports (progress,
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budget, audits)
 Change management
 Termination Procedures
 “touch of class” capabilities (artist’s
renderings, meeting facilities, video conferencing,
computer graphics)