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Project Selection/Appraisal TechniquesET4S24 Project Management and Techniques Darren Evans

1ObjectivesDiscuss the tools and techniques available to select the most appropriate project or option

BackgroundOrganisations need to be selective in projects they undertake. Otherwise, they would work on all projects proposed in the organisation.The projects need to align with the organisation's strategy, and provide some kind of return on investment, whether it is financial or some other criteria the organisation finds important.Multiple Project Management IssuesDelays in one project impacting othersResource conflictsTechnology dependenciesLack of resource smoothingPeaks and valleys of resource utilisationBottlenecks with scarce resources

Criteria for Project Selection ModelsRealism - reality of managers decisionCapability- able to simulate different scenarios and optimise the decisionFlexibility - provide valid results within the range of conditionsEase of Use - reasonably convenient, easy execution, and easily understoodCost - Data gathering and modeling costs should be low relative to the cost of the projectEasy Computerisation - must be easy and convenient to gather, store and manipulate data in the modelProject selection matrixCriteriaPossible Benefit MeasurementsFinancial returnNet present value (NPV)Cost/benefit analysisInternal rate of return (IRR)Cost avoidanceCost/benefit analysis (calculate savings and all costs)Technical advancement or innovationWill it apply only to the project, the entire organization, or will what is developed during the project be marketable outside the organisation?Will it appear as innovative to others in industry, thus creating prestige for the organisation?Market value/shareIncrease value/share according to set formula, research, or surveysPublic perceptionMeasure perceived increase/decrease in perception based on focus groups, surveys, or interviews. Estimate the awareness/perception that will be created.Calculate the number of people affected/made awareAlignment with organisation expertiseDoes the project team have the expertise to do the project? Can the organisation acquire the expertise and does it want to?Will the project efforts help develop some expertise or skill it wants developed?Needed infrastructure improvementImproved productivity-show cost savings if possibleDescribe old system/processes that might collapse or slow down and include impactCompare with other infrastructure projectsNature of Project Selection Models2 Basic Types of ModelsNumericNonnumericTwo Critical Facts:Models do not make decisions - People do!All models are only partial representations of realityNonnumeric ModelsSacred Cow - project is suggested by a senior and powerful official in the organisationOperating Necessity - the project is required to keep the system runningCompetitive Necessity - project is necessary to sustain a competitive positionProduct Line Extension - projects are judged on how they fit with current product line, fill a gap, strengthen a weak link, or extend the line in a new desirable way.Numeric Models: Profit/ProfitabilityPayback period - initial fixed investment/estimated annual cash inflows from the projectAverage Rate of Return - average annual profit/average investment Discounted Cash Flow - Present Value Method Internal Rate of Return - Finds rate of return that equates present value of inflows and outflowsPayback periodThe time taken for the income of a project to recover the initial capital outlay [represented in years]Suppose you are considering the purchase of an item of equipment for 24,000 that will save 8,000 in labour costs for each of 5 yearsWhat is the payback period?

Payback period - 2ADVANTAGESSimple to calculate.Easy to understand.Technological change is rapid and quick payback on investment is desirableDISADVANTAGESCash flows after payback period ignored.Who decides the optimal pay back time?Does not take into account profitability over the life of the project.Payback period - 3

YearProject 1 OutlayProject 2 Outlay20,00020,000Return12000700022000700032000500045000300058000100061000010007110001000Average rate of return [ARR]Calculates an average return over the life of a project.Compares this with the initial investment. Takes into account all cash-flows.Looks at the whole life of the project.The project with the highest ARR is normally chosen.

Average rate of return [ARR]ARR = average benefit x 100Initial investment(shown as percentage)

Refer to previous example:

Average rate of return - 2

YearProject 1 OutlayProject 2 Outlay20,00020,000Return12000700022000700032000500045000300058000100061000010007110001000Average rate of return - 2

Project 1Benefit = 40,000 over 7 yearsAv benefit = 40k/7 = 5714ARR = (5714/20000) x 10029%Project 2Benefit = 25,000 over 7 yearsAv benefit = 25k/7 = 3571ARR = (3571/20000) x 10018%

Average rate of return [ARR] - 2ADVANTAGESSimplicityA Yields a percentage figure for comparison between projects or options. Does not need cash flow timing to calculate.DISADVANTAGESDoes not normally take into account the project duration or timing of cash flowsThe concept of profit can be very subjectiveNo definitive signal given by ARR to help managers decide whether or not to investDiscounted cash flowWhat is it?Discounted Cash Flow is a technique that enables the analysis of future net cash flows discounted back at 'an appropriate interest rate' into present value terms so as to compare (or assess viability of) alternative projects.It is the most widely used investment appraisal technique.It relies on a discount rate also known as rate of return or interest rate or growth rate.Three techniques use DCFNet Present Value (NPV)Internal Rate of Return (IRR)Discounted PaybackDiscounted cash flow - 2What Discount Rate?Discount rates are decided at corporate level and reviewed annually.Projects are normally given a threshold figure to achieve or improve on.The discount rate is normally based on the opportunity cost rate - i.e. what could the capital sum get as a return if invested in the next best alternative. This could be base growth interest rates.Remember the RISK and UNCERTAINTY elements which go into the determination of the discount rate (acquisition and product life).Discounted cash flow - 3Present value - the current value of future cash flows.Assuming a 10% interest rate, would you prefer 100 today or in a years time?Obviously, you would want the 100 today.If you invest the 100 at 10%, you could expect 110 in a years time.Present value is the exact reverse.The value of 100 in a years time is 90.90Formula: D.F. = 1 / (1+r)n (r = rate, n = year)DF = 1/(1+0.1)1 = 0.9090Refer to Discount Factor (D.F.) or Present Value (P.V.) tablesNet Present Value (NPV)Net Present Value (NPV)NPV is simply the sum of ALL the DISCOUNTED cash-flows including the current outflow.INVEST if NPV is positive.INVEST in the project that gives the largest NPV (bearing in mind risk).Net Present Value (NPV) - 2ADVANTAGESTakes into account the time value of money.It expresses all future cash flows in today's values, which enables direct comparison of options.Allows for inflation and escalation.Looks at whole project.Yields a single figure for profitabilityDISADVANTAGESMore complex to calculate.Relies on (accurate) discount rate.Accuracy limited by accuracy of estimates.Net Present Value (NPV) - 3Two alternative project options are being considered for implementation where each have a potential 8 year useful lifeBoth Projects however have the option to be sold on after 6 years although they have differing salvage ratesIf the discount rate is 8% which alternative should be selected? Should either projects be sold on when they could be?Formula: D.F. = 1 / (1+r)n (r = rate, n = year)

Option A

Option B

Initial cost in yr 1[,000]450300Annual benefit [,000]

64102Salvage value [,000]

250130

Discounted PaybackThis takes account of the changing value of money with time and amends our view of the payback periodAn initial investment of 2,324,000 is expected to generate 600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%.Discounted PaybackYearCash FlowPresent Value FactorDiscounted Cash FlowCumulative Discounted0-23400001-2340000-234000016000000.9009540540-179946026000000.8116486960-131250036000000.7312438720-87378046000000.6587395220-47856056000000.5935356100-12246066000000.5346320760198300Pay back 5.45 years 5monthsInternal Rate of Return [IRR]The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised.The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.

Internal Rate of Return [IRR]

Internal Rate of Return [IRR]Need to compare 2 different interest rates one yielding a positive NPV and one a negative NPVRemember we are trying to find the IRR when NPV =0

IRR = Lowest discount rate + (diff in rates x lowest rate NPV)Diff in NPVIRR exampleAn initial investment of 25,000 in a project produces cash inflows of 6595, 7250, 9550, 9000 and 5000 at 12 month intervals. The cost of capital to finance the project is 12 %.You are required to decide whether the project is worthwhile using:The Net Present Value The Internal Rate of Return

Weighted Factor Scoring ModelThe weighted scoring method, also known as 'weighting and scoring', is a form of multi-attribute or multi-criterion analysis. It involves identification of all the non-monetary factors (or "attributes") that are relevant to the project; the allocation of weights to each of them to reflect their relative importance; and the allocation of scores to each option to reflect how it performs in relation to each attribute.http://www.dfpni.gov.uk/eag-the-weighting-and-scoring-method

Weighted Factor Scoring Model - 1Identify the relevant attributes

Example: In a certain health service appraisal, the relevant attributes are identified as:number of cases treated;waiting time;patient access; anddisruption to services.

Weighted Factor Scoring Model - 2Allocation of weighting to each attribute

Example: The group appraising our hypothetical health services project has decided that the following weights are appropriate:number of cases treated - 40%waiting time - 30%patient access - 20%disruption to services - 10%

Weighted Factor Scoring Model - 3Scoring the optionsExample: The health service group scores four options against the attributes as follows:

Weighted Factor Scoring Model - 4Calculate weighted scoresExample: Combining the last two examples results in the following weighted scores:

Risk AnalysisPrincipal contribution of risk analysis is to focus the attention on understanding the nature and extent of the uncertainty associated with some variables used in a decision making process

Sensitivity analysisSensitivity analysis is a commonly employed risk analysis technique which involves making minor changes to key variables in order to observe the effect on the originally predicted outcome.Risk and uncertainty can be minimised by demonstrating that the project is not sensitive to such variationsRefer to examples in workbookSummary - Project AppraisalThe use of specific techniques is normally guided by company procedure.Analysis of risk is often a pre-requisiteQualitative techniques need to be considered as well as quantitative techniques.Refer to example in Handout

Recommended readingRefer to notes/links on BlackboardMeredith R & Samuel J. Mantel, Jr., Project Management: A Managerial Approach Chapter 2, Wiley International

WEIGHTING 1CriteriaWeight FactorKIOSKFINANCIAL ADVISORFRANCHISEKIOSKFINANCIAL ADVISORFRANCHISEIncrease market share as the investment company of choice5577253535Good financial return4637241228Provide possible innovation in investment tools and techniques3954271512Support the corporate culture of employee supporting employee21532106Increase public awareness1856856867787KIOSKCriteriaRatingIncrease market share5Good financial return6Innovation9Support culture1Increase public awareness8FINANCIAL ADVISORCriteriaRatingIncrease market share7Good financial return3Innovation5Support culture5Increase public awareness5FRANCHISECriteriaRatingIncrease market share7Good financial return7Innovation4Support culture3Increase public awareness6

WEIGHTING 2CriteriaWeight FactorKIOSKFINANCIAL ADVISORFRANCHISEKIOSKFINANCIAL ADVISORFRANCHISEIncrease market share as the investment company of choice5577253535Good financial return4637241228Provide possible innovation in investment tools and techniques3954271512Support the corporate culture of employee supporting employee21532106Increase public awareness1856856867787CriteriaWeight FactorKIOSKFINANCIAL ADVISORFRANCHISEKIOSKFINANCIAL ADVISORFRANCHISEIncrease market share as the investment company of choice3577152121Good financial return4637241228Provide possible innovation in investment tools and techniques5954452520Support the corporate culture of employee supporting employee1153153Increase public awareness28561610121017384KIOSKCriteriaRatingIncrease market share5Good financial return6Innovation9Support culture1Increase public awareness8FINANCIAL ADVISORCriteriaRatingIncrease market share7Good financial return3Innovation5Support culture5Increase public awareness5FRANCHISECriteriaRatingIncrease market share7Good financial return7Innovation4Support culture3Increase public awareness6

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