Chapter 2

Selecting Projects Strategically

Project Selection Models

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Problems With Multiple Projects
1. Delays in one project delays others
2. Inefficient use of resources
3. Bottlenecks in resource availability

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 Project Results
 30 Percent are cancelled midstream
 Over half - upto190 percent over budget
 Over half - 220 percent late

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

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 Project Management Maturity
 Project management maturity refers to
mastery of skills required to manage project
competently
 Number of ways to measure
 Most organizations do not do well

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Project Selection and Criteria of Choice
 Project selection…
 Evaluating
 Choosing
 Implementing

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 Types of Companies
 Companies considering projects fall into two broad
categories:
1. Companies whose core business is completing projects
2. Companies whose core business is something else
 They can also be broken down as:
1. Companies looking at projects to do for others
2. Companies looking at projects to do for themselves

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 Project Companies
 Must select which projects they will bid on
 Generally based on…
 Their expertise
 Resource they have availability
 Their chance of winning bid
 Preparing a bid is expensive
 They do not want to waste that effort on bids where
they are unlikely to be successful

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 Non-Project Companies
 Must decide which potential projects they will
pursue
 Available capital is the major constraint
 Profitability is often the major criteria
 Must evaluate approaches when there is more
than one project that can accomplish a goal

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 Project Selection 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

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Criteria For 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
 It is not possible to know ahead of time if a project will
succeed or fail

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 Criteria (Continued)

 Companies need a way of weeding out the bad

projects while keeping the good ones
 No model can predict with absolute certainty
 No model could predict
 The explosion of the Challenger
 What we want is a model with a “good batting
average”

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 Model Criteria
 Realism
 Capability
 Flexibility
 Easy to use
 Inexpensive
 Easy to implement

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 Realism
 Needs to include all objectives of the firm
 Needs to include the firms expertise as well as its
limitations
 Needs to report results in a fashion that allows
different projects to be compared, e.g. how do we
compare a project to lower production cost and one
to raise market share

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 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

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

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 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

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 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

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 Easy to Implement
 This is less of an issue with modern
spreadsheets
 However, a model to be used to evaluate all
the firm’s projects should be centrally
maintained

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Types of Project Selection Models
 Nonnumeric models
 Numeric models

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 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

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 Types of Nonnumeric Models
 Sacred Cow
 A project, often suggested by top management, that has
taken on a life of its own. It continues, not due to any
justification, but “just because.”
 Operating Necessity
 A project that is required in order to protect lives or
property or to keep the company in operation.
 Competitive Necessity
 A project that is required in order to maintain the
company’s position in the marketplace.

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Types of Nonnumeric Models Continued

 Product Line Extension

 Often, projects to expand a product line are evaluated on
how well the new product meshes with the existing
product line rather than on overall benefits.
 Comparative Benefit
 Projects are subjectively rank ordered based on their
perceived benefit to the company.

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

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

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 Payback Period
 The length of time until the original
investment has been recouped by the project
 A shorter payback period is better

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 Payback Period Example

Project Cost
Payback Period 
Annual Cash Flow

$100,000
Payback Period  4
$25,000
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 Payback Period Drawbacks
1. Does not consider time value of money
2. More difficult to use when cash flows change
over time
3. Less meaningful over longer periods of time
(due to time value of money)

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 Discounted Cash Flow(NPV)
 The value of a stream of cash inflows and outflows
in today’s dollars
 Also know as discounted cash flow or just
discounting
 Widely used to evaluate projects
 Includes the time value of money
 Includes all inflows and outflows, not just the ones
through payback point

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Discounted Cash Flow(NPV) Continued

 Requires a percentage to use to reduce future

cash flows
 This is known as the discount rate
 The discount rate may also be know as a
hurdle rate or cutoff rate
 There will usually be one overall discount rate
for the company

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 NPV Formula

Ft
NPV (project)  A0  t 1
n

1  k t

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 NPV Formula Terms
A0 Initial cash investment
Ft The cash flow in time period t (negative for
outflows)
k The discount rate
T The number of years of life

 A higher NPV is better

 The higher the discount rate, the lower the NPV

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 NPV Example

8
$25,000
NPV (project)  $100,000  
t 1 1  0.15  0.03
t

 $1,939

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 Internal Rate of Return [IRR]
 The discount rate (k) that causes the NPV to be equal
to zero
 The higher the IRR, the better
 Finding the IRR requires a financial calculator or
computer or it can be calculated by hit and trial
 In Excel “=IRR(Series,Guess)”

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 Profitability Index
 NPV divided by initial cash investment
 Ratios greater than 1.0 are good

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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

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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

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 Scoring Models
 Unweighted factor model
 Weighted factor model

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 Unweighted 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

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Unweighted Factor Model Example

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 Weighted Factor Model
 Each factor is weighted relative to its importance
 Weighting allows important factors to stand out
 A good way to include non-numeric data in the
analysis
 Factors need to sum to one
 All weights must be set up so higher values mean
more desirable
 Small differences in totals are not meaningful

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Weighted Factor Model Example

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