Project Selection and

Portfolio Management

03-01
 Chapter 3 Learning Objectives
After completing this chapter, students will be able to:
 Explain six criteria for a useful project-
selection/screening model.
 Understand how to employ checklists and simple
scoring models to select projects.
 Use more sophisticated scoring models, such as the
Analytical Hierarchy Process.
 Learn how to use financial concepts, such as the
efficient frontier and risk/return models.

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 Chapter 3 Learning Objectives
After completing this chapter, students will be able to:
 Employ financial analyses and options analysis to
evaluate the potential for new project investments.
 Recognize the challenges that arise in maintaining an
optimal project portfolio for an organization.
 Understand the three keys to successful project
portfolio management.

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 Project Selection
Screening models help managers pick winners from a
pool of projects. Screening models are numeric or
nonnumeric and should have:
Realism
Capability
Flexibility
Ease of use
Cost effectiveness
Comparability

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 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

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 Approaches to Project Screening
Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
Financial models

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7
 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

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 An Example

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 Simplified Scoring Models
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)
Relative scores can be misleading!

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 An Example

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 Date Weighting Date 1 - Date 2 - Date 3 -
1 – Low Dubai England Rihanna
Importance
2 – Medium
Importance
3 – High
Importance
Food 3 3 1 3
Courteous 3 2 3 3
Dress 2 1 2 3
6 6 9

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 Project Weight Rating (1 – 100) Score
UWI 0.6 1
Kaizen 0.2 .18
Hydenpghgh 0.2 .72
100%

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 Analytic Hierarchy Process
The AHP is a four step process:
1. Construct a hierarchy of criteria and subcriteria
2. Allocate weights to criteria
3. Assign numerical values to evaluation dimensions
4. Scores determined by summing the products of
numeric evaluations and weights
Unlike the simple scoring model, these scores can be
compared!

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 Constructing a hierarchy of criteria and sub-
criteria

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 Allocating weights to previously developed
criteria and, where necessary, splitting
overall criterion weight among sub-criteria

FIGURE 3.1 Sample AHP with Rankings for Salient Selection Criteria
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 Project – Weighting Score Cost Score
Build a (1 – 5)
House
Foundation 0.50
1. Buying 0.20 2 0.4
Concrete
blocks
2. Buying 0.30 5 1.5
cement
1.9

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 Use the pairwise comparison process to
assign numerical values to the dimensions
of the evaluation scale.

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 1 – Poor (0.1) Cost Project
2 – Fair (0.2) 0.6 Time to
3 – Good (0.3) Develop
4 – Very Good 0.4
(0.4)
5 – Excellent
(0.5)
Low Cost High Cost Short Term Long Term
0.2 0.4 0.1 0.3
Project A – 5 (0.5) 5 (0.5) (0.2)(0.5) +
Paint a wall (0.1)(0.5) =
0.15
Project B – 1 (0.1) 1 (0.1) (0.4)(0.1)+(
Build a chair 0.3)(0.1) =
0.07

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 Scores determined by summing the
products of numeric evaluations and
weights
 In the final step, multiply the numeric evaluation of
the project by the weights assigned to the evaluation
criteria and then add the results for all criteria.
 To illustrate how the calculations are derived, let us
take the Aligned project as an example.
 Remember that each rating (Excellent, Very Good,
Good, etc.) carries with it a numerical score
 Figure 3.2. These scores, when multiplied by the
evaluation criteria and then added together, yield:
 (.1560)(.3) + (.3640)(1.0) + (.1020)(.3) + (.1564)(1.0) +
(.0816)(.3) + (.1400)(1.0) = .762 20
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 Profile Models
 Profile models allow managers to plot risk/return
options for various alternatives and then select the
project that maximizes return while staying within a
certain range of minimum acceptable risk.
 “Risk,” of course, is a subjective assessment: It may be
difficult to reach overall agreement on the level of risk
associated with a given project.

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 Profile Models
 In Figure 3.4, the six project alternatives are plotted on
a graph showing perceived Risk on the y-axis and
potential Return on the x-axis. Because of the cost of
capital to the firm, we will specify some minimum
desired rate of return. All projects will be assigned
some risk factor value and be plotted relative to the
maximum risk that the firm is willing to assume.
 Figure 3.4, therefore, graphically represents each of
our six alternatives on a profile model. (Risk values
have been created here simply for illustrative
purposes.)
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 Profile Models
Show risk/return options for projects.
X7
X6
Maximum
Desired Risk

Criteria
X2 selection as
axes
Risk

X4 X5

Efficient Frontier
X3
Rating each
project on
X1
criteria
Minimum Return
Desired Return
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Figure 3.4 03-23
 Profile Models
 In Figure 3.4, we see that Project X2 and Project X3
have similar expected rates of return.
 Project X3, however, represents a better selection
choice. Why? Because the company can achieve the
same rate of return with Project X3 as it can with
Project X2 but with less risk.
 Likewise, Project X5 is a superior choice to X4:
Although they have similar risk levels, X5 offers greater
return as an investment.
 Finally, while Project X6 offers the most potential
return, it does so at the highest level of risk.
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25
 Financial Models
Based on the time value of money principal

 Payback period
 Net present value
 Internal rate of return
 Options models

All of these models use discounted cash flows

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 Payback Period
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)

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 Payback Period Example
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 Divide the
0 ($200,000) ($200,000) cumulative
amount by the
1 $75,000 ($125,000) cash flow amount
2 $75,000 ($50,000) in the third year
and subtract from
3 $75,000 $25,000
3 to find out the
25, 000 moment the
3− 2.67 years
= project breaks
75, 000
even. 03-28
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 Investment 100,000
Year 0 (100,000) (100,000)
Year 1 25,000 (75,000)
Year 2 25,000 (50,000)
Year 3 25,000 (25,000)
Year 4 50,000 25,000
4–
25000/50000
= 3.5
3 years, 6
months

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 Investment 100,000
Year 0 (100,000) (100,000)
Year 1 25,000 25,000- (75000)
(100000)
Year 2 25,000 25000-(75000) (50000)
Year 3 25,000 25000-(50000) (25000)
Year 4 25,000 25000-(25000) 0
Payback 4

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 Net Present Value
 The most popular financial decision-making approach
in project selection, the net present value (nPv)
method, projects the change in the firm’s value if a
project is undertaken.
 Thus a positive NPV indicates that the firm will make
money—and its value will rise—as a result of the
project.
 Net present value employs discounted cash flow
analysis, discounting future streams of income to
estimate the present value of money. Projects the
change in the firm’s stock value if a project is
undertaken.
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 Net Present Value
Ft
NPV= I o + ∑
(1 + r + pt )t
where
Ft = net cash flow for period t
Higher NPV
R = required rate of return
values are better!
I = initial cash investment
Pt = inflation rate during period t

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 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.
The NPV
Year Net flow Discount NPV
column total
0 -$60,000 1.0000 -$60,000.00 is negative,
1 $15,000 0.9009 $13,513.51 so don’t
2 $15,000 0.8116 $12,174.34 invest!
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
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 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.
What is your NPV?

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 Year Inflow Outflow Net Flow Discount NPV
Rate
0 (60000) (60000) 1.0000 (60000)
1 15,000 15000 1/(1+8%+3% 13513.5
)^1=0.9009
2 15,000 15000 1/(1+8%+3% 12174.3
)^2=0.8116
3 15,000 15000 1/(1+8%+3% 10967.9
)^3=0.7311
4 15,000 15000 1/(1+8%+3% 9880.96
)^4=0.6587
5 15,000 15000 1/(1+8%+3% 8901.77
)^5=0.5934
-$4,561.54
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 Year Inflow Outflow Net Flow Discount Rate NPV
0 (500,000) (500,000) 1.0000 (500,000)
1 50000 50000 1/(1+.20+.03)^1 40650
=0.8130

2 250000 250000 1/(1+.20+.03)^2 165245

=0.6609

3 350000 350000 1/(1+.20+.03)^3 188084

=0.5373

-106019

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 Net Present Value Extended Example
Assume that you are considering whether or not to
invest in a project that will cost $100,000 in initial
investment. Your company requires a rate of return of
10%, and you expect inflation to remain relatively
constant at 4%. You anticipate a useful life of four
years for the project and have projected future cash
flows as follows:
 Year 1: $20,000
 Year 2: $50,000
 Year 3: $50,000
 Year 4: $25,000
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 Net Present Value Example
We know the formula for determining NPV:

 We can now construct a simple table to keep a running

score on discounted cash flows (both inflows and
outflows) to see if the project is worth its initial
investment. We already know that we will need the
following categories: Year, Inflows, Outflows, and NPV.
We will also need two more categories:
 Net flows: the difference between inflows and outflows
 Discount factor: the reciprocal of the discount rate (1/(1
+ r + p)t)
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 Net Present Value Example
 How did we arrive at the Discount Factor for Year 1, 3?
Using the formula we set above, we calculated the
appropriate data:
 Discount factor for Year 1 = (1/(1 + .10 + .04)^1) = .8772
 Discount factor for Year 2 = (1/(1+.10+.04)^2) = 0.7695
 Discount factor for Year 3 = (1/(1 + .10 + .04)^3) = .6749
 Discount factor for Year 4 = (1/(1+.10+.04)^4) = 0.5921

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 NPV Extended Example

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 Internal Rate of Return
 Internal rate of return (IRR) is an alternative
method for evaluating the expected outlays and
income associated with a new project investment
opportunity.
 The IRR method asks the simple question: What rate
of return will this project earn?
 Under this model, the project must meet some
required “hurdle” rate applied to all projects under
consideration.

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 Internal Rate of Return
A project must meet a minimum rate of return
before it is worthy of consideration.
t
ACFt
IO = ∑ Higher IRR values
n =1 (1 + IRR )t are better!
where
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

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 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 17%; does this project meet the threshold?

Year Net flow Discount NPV

This table
0 -$40,000 1.0000 -$40,000.00
has been
1 $14,000 0.9009 $12,173.91
calculated
2 $14,000 0.8116 $10,586.01 using a
3 $14,000 0.7312 $9,205.23 discount
4 $14,000 0.6587 $8,004.55 rate of
-$30.30 15%

The project doesn’t meet our 17% requirement

and should not be considered further.
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 Extended Example
 Let’s take a simple example. Suppose that a project
required an initial cash investment of $5,000 and was
expected to generate inflows of $2,500, $2,000, an
$2,000 for the next three years.
 Further, assume that our company’s required rate of
return for new projects is 10%. The question is: Is this
project worth funding?

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 Extended Example
 Answering this question requires four steps:
 1. Pick an arbitrary discount rate and use it to
determine the net present value of the stream of cash
inflows.
 2. Compare the present value of the inflows with the
initial investment; if they are equal, you have found
the IRR.
 3. If the present value is larger (or less than) than the
initial investment, select a higher (or lower) discount
rate for the computation.
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 Extended Example
 4. Determine the present value of the inflows and
compare it with the initial investment. Continue to
repeat steps 2–4 until you have determined the IRR.
 Using our example, we know:
 Cash investment = $5,000
 Year 1 inflow = $2,500
 Year 2 inflow = $2,000
 Year 3 inflow = $2,000
 Required rate of return = 10%

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 Extended Example

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 Extended Example
 If the IRR is greater than or equal to the company’s
required rate of return, the project is worth funding.
 In Example 3.6, we found that the IRR is 15% for the
project, making it higher than the hurdle rate of 10%
and a good candidate for investment.

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 Options Models
NPV and IRR methods don’t account for failure to
make a positive return on investment. Options
models allow for this possibility.

Options models address:

1. Can the project be postponed?
2. Will future information help decide?

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 Project Portfolio Example - Project
Selection and Screening at Ge: the tollgate
Process

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall FIGURE 3.6 GE’s Tollgate Process 03-50
 GE Tollgate Review Process Flow Map

Figure 3.7 03-51

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 Project Portfolio Management
The systematic process of selecting, supporting, and
managing the firm’s collection of projects.
Portfolio management requires:
 decision making,
 prioritization,
 review,
 realignment, and
 reprioritization of a firm’s projects.

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 Pharmaceuticals Development Process

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 Keys to Successful
Project Portfolio Management
Flexible structure and freedom of
communication

Low-cost environmental scanning

Time-paced transition

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 Problems in Implementing
Portfolio Management
 Conservative technical communities

 Out of sync projects and portfolios

 Unpromising projects

 Scarce resources

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 Summary
1. Explain six criteria for a useful project-selection
screening model.
2. Understand how to employ checklists and simple
scoring models to select projects, including the
recognition of their strengths and weaknesses.
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.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 03-56

 Summary
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.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 03-57

 Group Activity
 Draft a project charter with your group based on the
following proposed project.

 Use the template provided on myelearning

 Project:
 Paint the exterior of your private residential home.

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Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 03-59