Project Selection and

Portfolio Management

Chapter 3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-1

 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
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-2
 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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-3

 Approaches to Project Screening

• Checklist model
• Simplified scoring models
• Analytic hierarchy process
• Profile models
• Financial models

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 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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-5

 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!
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-6
 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!
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-7
 Profile Models
Show risk/return options for projects.

X6
Maximum Criteria
Desired Risk X2
X4 X5 selection as
R axes
i X3
s X1
k Efficient Frontier
Rating each
Minimum project on
Return
Desired Return criteria

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-8

 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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-9

 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)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-10

 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 cumulative
amount by the cash
0 ($200,000) ($200,000) flow amount in the
third year and subtract
1 $75,000 ($125,000) from 3 to find out the
2 $75,000 ($50,000) moment the project
breaks even.
3 $75,000 $25,000
25, 000
3  2.67 years
75, 000
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 Net Present Value
Projects the change in the firm’s stock value if a
project is undertaken.
Ft
NPV  I o  
(1  r  pt )t
where Higher NPV
Ft = net cash flow for period t values are better!
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-12
 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.

Year Net flow Discount NPV

The NPV
0 -$60,000 1.0000 -$60,000.00 column total is
1 $15,000 0.9009 $13,513.51 negative, so
2 $15,000 0.8116 $12,174.34 don’t 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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 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
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-14
 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 15%
-$30.30
The project doesn’t meet our 17% requirement
and should not be considered further.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-15
 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 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.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-17

 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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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-20