Chapter 2

1. Chapter 2 Strategic Management and Project Selection

2. Strategic management • Why project manager need to understand strategy? • To make appropriate decisions and adjustments. • To make them effective project advocates.

3. Problems With Multiple Projects • Delays in one project delays others (because of common resource needs or technological dependencies.) • Inefficient use of resources (results in peaks and valleys of resource utilization.) • Bottlenecks in resource availability (or lack of required technological inputs result in project delays that depend on those scarce resources or technology.)

4. Project Results • 30 Percent cancelled midstream • Over half of completed projects-190 percent over budget • Over half of completed projects- 220 percent late

5. Challenges • Making sure projects closely tied to goals and strategy • How to handle growing number of projects • How to make projects successful

6. Project Selection and Criteria of Choice • Project selection is the process of evaluating proposed projects or groups of projects, and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. • E.g. A manufacturing firm can use evaluation/selection techniques to choose which machine to adopt in a part-fabrication process; a TV station can select which of several syndicated comedy shows to rerun in its 7:30 p.m. weekday time-slot; a construction firm can select the best subset of a large group of potential projects on which to bid. • Each project will have different costs, benefits, and risks.

7. Models • Models are used to select projects • All models simplify reality • That is, they only look at the key variables involved in a decision • The more variables included in a model, the more complex it becomes • Simpler models usually work better

8. Why Project Selection Models? Companies only want to undertake successful projects Projects that fail waste resources and hurt profitability and competitiveness Projects that succeed improve profitability and competitiveness No model can predict with absolute certainty

9. Selection Models- Criteria • Realism • Capability • Flexibility • Easy to use • Inexpensive • Easy to implement(computerisation)

10. Realism • Needs to include all objectives of the firm • Needs to include the firms expertise as well as its limitations • Should reflect the real situation • Include factors like project risks, implementation risks and technical risks of performance, cost and time.

11. Capability • Model needs to be sophisticated enough to deal with all projects • Varying resource requirements • Varying time periods • Varying probabilities of success • Needs to be able to select the optimum projects among all contenders

12. Flexibility • Needs to be able to work with all projects • Needs to be updated as the firm and its environment evolves

13. Easy to Use • Needs to be quick to gather the data and easy to use • Easy to be able to “fit” the project in the model

14. Inexpensive • Do not want the model to eat up all the savings that result from using the model • Expenses include the cost of writing and maintaining the model • Also includes the expense of gathering the data needed by the model

15. Easy to Implement(computerisation) • A model to be used to evaluate all the firm’s projects should be centrally maintained

16. The Nature of Project Selection Models • Models turn inputs into outputs • Managers decide on the values for the inputs and evaluate the outputs • The inputs never fully describe the situation • The outputs never fully describe the expected results • Models are tools • Managers are the decision makers

17. Types of Project Selection Models • Numeric models • Nonnumeric models

18. Numeric Models • Models that return a numeric value for a project that can be easily compared with other projects • Two major categories: • Profit/profitability • Scoring

19. Profit/Profitability Models • Models that look at costs and revenues • Payback period (PBP) • Discounted cash flow (NPV) • Internal rate of return (IRR) • Profitability index (PI) • NPV and IRR are the more common

20. Payback Period (PBP) • It is defined as the number of years required for recovering the original cash outlay invested in a project. • The length of time until the original investment has been recouped by the project.

21. Payback Period Example • A project costs $100,000 to implement and has annual net cash inflows of $ 25,000. Then calculate the payback period of the project.

22. Payback Period Example

23. Payback Period-Decision rule • It has to be pre-determined the acceptable min. pay back period. • If the project PBP is shorter than acceptable PBP, the project is acceptable. • A shorter payback period is better.

24. Payback Period

25. Example Calculation of the payback period for a given investment proposal. a) Prepare End of Year Cumulative Net Cash Flows b) Find the First Non-Negative Year c) Calculate How Much of that year is required to cover the previous period negative balance d) Add up Previous Negative Cash Flow Years Initial Annual Net Cash Flows Investment 1 2 3 4 5 6 7 8 9 10 Alternative A (45,000) 10,500 11,500 12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500 a End of Year Cummulative Net Cash Flow (45,000) (34,500) (23,000) (10,500) 3,000 16,500 30,000 43,500 57,000 70,500 84,000 b Pay Back Period Fraction of First Positive Year Pay Back Period 0.78 c) 0.78 = 10,500/13,500 3.78 d) 3 + 0.78

26. Payback Period Drawbacks • Does not consider time value of money • Less meaningful over longer periods of time (due to time value of money) • Ignores the life of the project beyond the PBP. • More difficult to use when cash flows change over time

27. Discounted Cash Flow (NPV Method) • This method determines NPV of all cash flows by discounting them by the required rate of return • The value of a stream of cash inflows and outflows in today’s dollars • Widely used to evaluate projects • Includes the time value of money • Includes all inflows and outflows, not just the ones through payback point • Requires a percentage to use to reduce future cash flows - discount rate

28. NPV Formula A0 :Initial cash investment (negative because this is an outflow) Ft :The cash flow in time period t k :The discount rate T :The number of years of life

29. NPV Formula Terms • A higher NPV is better. • The higher the discount rate, the lower the NPV. • A project is acceptable if the sum of the NPV of all estimated cash flows over the life of the project is positive. Decision rule: • Accept if NPV is greater than 0. • Reject if NPV is lesser than 0.

30. NPV Example • A project has $ 100,000 investment with a net cash inflow of $ 25,000 per year for a period of 8 years, a required rate of return of 15%, and an inflation rate of 3 % per year. Calculate NPV of the project.

31. NPV Example Because the present values of the inflows is greater than the present values of the outflow- that is, NPV is positive- the project is deemed acceptable.

32. Internal Rate of Return [IRR] • IRR is calculated with trial & error. • Start with any discount rate and calculate NPV for a project. • If the NPV is positive, try a higher discount rate and go on trying out different rates till a rate is found at which NPV is exactly zero. • The higher the IRR, the better • While it is technically possible for a series to have multiple IRR’s, this is not a practical issue

33. Example Given an investment project having the following annual cash flows; find the IRR. Year 0 1 2 3 4 5 6 7 8 9 Cash Flow (30.0) (1.0) 5.0 5.5 4.0 17.0 20.0 20.0 (2.0) 10.0 Solution: Step 1. Pick an interest rate and solve for the NPV. Try r =15% NPV = -30(1.0) -1(P/F,1,15%) + 5(P/F,2,15) + 5.5(P/F,3,15) + 4(P/F,4,15) + 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15) = + $5.62 Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a higher interest rate in order to reduce the NPV value. Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high. Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%

34. IRR using Excel Using Excel you should insert the following function in the targeted cell C6:

35. Profitability Index (PI) • a.k.a. Benefit/cost ratio • PV of future cash inflows divided by initial cash investment • Ratios greater than 1.0 are good

36. Profitability Index (PI) PI= B/C ratio = PV of Cash Inflow PV of Cash Outflow OR PI= B/C ratio = NPV PV of Cash Outflow Decision rule: Accept if PI is greater than 1. Reject if PI is lesser than 1. Indifferent if P/I =1.

37. B/C Ratio Example Project A Project B „ Present value cash inflows „ Present value cash inflows $500,000 $100,000 „ Present value cash outflows „ Present value cash outflows $300,000 $ 50,000 „ Benefit/Cost Ratio „ Benefit/Cost Ratio 1.67 2.0

38. Advantages of Profitability Models • Easy to use and understand • Based on accounting data and forecasts • Familiar and well understood • Give a go/no-go indication • Can be modified to include risk

39. Disadvantages of Profitability Models • Ignore non-monetary factors • Some ignore time value of money • Discounting models (NPV, IRR) are biased to the short-term • Payback models ignore cash flow after payback

40. Scoring Models • Unweighted factor model • Weighted factor model

41. Unweighted 0-1 Factor Model • Each factor is weighted the same • Less important factors are weighted the same as important ones • Easy to compute • Just total or average the scores

42. Unweighted 0-1 Factor Model Example

43. Unweighted Factor Scoring Model For “Estimated annual profits in dollars”, we might construct the following scale: X marks in 0-1 scoring model are replaced by numbers, from a 5 point scale. For “No decrease in the quality of final product”, we might construct scale:

44. Weighted Factor Model • When numeric weights reflecting the relative importance of each individual factor are added, we have a weighted factor scoring model. • Each factor is weighted relative to its importance • Weighting allows important factors to stand out • Factors need to sum to one • All weights must be set up so higher values mean more desirable

45. Weighted Factor Model n si = Σsijwj j=1 si = Total score theith project sij = Score of theith project on j thcriterion wj = Weight of the j thcriterion

46. Weighted Factor Model-Example We can evaluate 5 alternative cars : • Leviathan 8, • NuevoEcon, • Maxivan, • Sporticar 100, & • Ritzy 300.

48. Performance measures & equivalent scores for selection of an automobile Cost data in $ 1000s .

49. Weighted Factor Model Example

50. Nonnumeric Models • Models that do not return a numeric value for a project that can be compared with other projects • These are really not “models” but rather justifications for projects • Just because they are not true models does not make them all “bad”