Transcript Slide 1

Project Initiation,
Selection, and Planning
Importance of Project Selection
“There are two ways for a
business to succeed at new
projects: doing projects right,
and doing the right projects.”
R.G. Cooper, S. Edgett, E. Kleinschmidt. 2000.
Research and Technology Management.
Good project selection makes the later job of
running projects much easier.
Also, poorly selected projects may be doomed
from the start.
On average, companies are less good at project
selection than they are at project operation. 2
Different Approaches to Project
Selection
There are two fundamentally different approaches
to project selection.
In the first approach, projects are evaluated
individually, and that information is used to make
a go / no go decision.
In the second approach, project selection is
viewed as a portfolio planning problem, and the
go /no go decisions for all projects are made
simultaneously.
The second approach, where possible, is much
better, since it controls risk through
diversification, utilizes resources more efficiently,
and optimizes overall performance.
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Some hybrid approaches may also be useful.
Individual Project Selection Overview
1. Strategic factors
Competitive necessity: keep a foothold in the
market, not get left behind
Market expansion opportunities: not yet
profitable, but need to establish a
presence
Consistency: in line with overall
organization’s mission statement
Image: potential impact of project on
corporate image
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Individual Project
Selection - Overview
2. Project portfolio factors
Diversification: reduce market and other
risks by maintaining a mix of projects
Cash flow constraints: balance available cash
over time and across projects
Resource constraints: plan available
resources (facility, personnel) over time
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Analyzing Project Portfolios:
Bubble Diagram
Prob of Commercial Success
High
Shapes
Shading
Zero
High
Expected NPV
Color
Size
Low
Bubble diagrams are useful for representing a set of
projects and visualizing a project portfolio.
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Individual Project Selection
- Overview
3. Project risk factors
Probability of research being successful
Probability of development being successful
Probability of project success w.r.t. scope
Probability of commercial success
Overall risk of project
Competitors in market and their reactions
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Individual Project Selection Overview
4. Quantitative factors
Payback period
Net present value / internal rate of return
Expected commercial value
Real options
Multifactor scoring
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Payback Period Analysis
Number of years needed for the
project to repay its initial fixed
investment.
Example:
A project costs $100,000 and is
expected to save the company
$20,000 per year
Payback Period =
$100,000 / $20,000 = 5 years
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Comments on Payback Period

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Easy to calculate and explain, and
sometimes can be used to achieve a
common purpose throughout an
organization.
Ignores the time value of money,
including interest rates and inflation.
Ignores money earned after the
payback period.
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Net Present Value (NPV)
Let Ft = net cash flow in period t
(t = 0, 1,..., T), where F0 = initial
cash investment at time t = 0 and
r = discount rate of return (hurdle
rate)
T
Ft
NPV  
t
t 0 (1  r )
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Internal Rate of Return (IRR)

Find a value of r such that NPV is
equal to 0 (but this value may not
be unique)
Example (with T = 2):
Find r such that
F1
F2
F0 

0
2
1  r (1  r )
Note that, in a typical project, early cash flows are
negative.
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NPV Example
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Phase I Research and Product
Development: $18 million annual
research cost for 2 years.
Phase II Market Development: $10
million annual expenditure for 2 years
to develop marketing and distribution
channels.
Phase III Sales: All cash flows are
after-tax and occur at year's end.
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NPV Example
The results of Phase II (available at the end of
year 4) identify the product's market potential
as indicated below:
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NPV Example
Year
1
2
3
4
5
…
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Expected Cash Flow ($m)
-18
-18
-10
-10
10
10
10
If the discount rate is 5 percent, the discounted
expected cash flow at the end of the 4th year
(from years 5 to 24) is $124.62m.
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NPV Example
Expected cash flows (with sale of product at end of year 4)
Cash Outflow Cash Inflow
NPV
Year 1
18.00
-18.00/(1+r)
Year 2
18.00
-18.00/(1+r)2
Year 3
10.00
-10.00/(1+r)3
Year 4
10.00
124.62
+114.62/(1+r)4
This is the discounted value of future sales at the end of year 4
The internal rate of return is 49.12%.
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Criticisms of NPV Analysis
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Assumes that cash flow forecasts are
accurate; ignores the “human bias”
effect
Does not take into account the possibility
that decisions (and therefore cash flows)
may adapt to changing circumstances
over time
Ignores project portfolio issues
Use of a single discount rate for the
entire project is problematic, since risk is
typically reduced as the project evolves
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A Reasonable Practical Approach
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Since several quantitative measures for evaluating
projects, a reasonable procedure is needed for using this
information.
Many companies use a two step approach that starts with
“filtering”.
In the first step, project selection is simplified by
eliminating projects that fail any of several tests, e.g. a
payback period of 5 years or less, or an IRR of 15% or
less.
In the second step, a smaller set of remaining projects is
then studied in greater detail, possibly including the
consideration of both quantitative and qualitative factors.
This two step approach is simple, efficient and justifiable.
How successful this approach is depends greatly on the
details, such as how accurately the filters are set.
This approach also largely ignores project portfolio issues.
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Expected Commercial Value (ECV)
Probability = pc
Probability = pt
Develop
New
Product
Technical
Success
Probability = 1 - pt
Launch
New
Product
Commercial
Success (with net
benefit = NPV)
Commercial
Failure (with net
benefit = 0)
Probability = 1 - pc
Technical
Failure
Risk class 1
Risk class 2
ECV is the expected NPV of the project, calculated by using
the probabilities of the various alternatives.
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ECV Example
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The design of a new product is expected to
take 3 years, at a cost of $6m/year
There is a .8 probability that the product
will be technically feasible
If feasible, the product can be launched in
year 4 with an estimated cost of $5.5M
If launched, the product will be a
commercial success with probability 0.6,
earning gross revenues of $15M per year
for 5 years
If it is a commercial failure, then the
revenue is only $2M per year for 5 years
The discount rate is 10 percent
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ECV Example
5 Years
Probability = 0.6
3 Years
Research &
Product
Development
Annual
Cost: $6M
Probability = 0.8
Development
Succeeds
One-time
cost of $5.5M
Launch
New
Product
Probability = 0.2
Development
Fails
Drop
Product
Commercial Success
Revenue $15M/yr
Commercial
Failure
Revenue $2M/yr
Probability = 0.4
No Cost
Discount rate
r1=10%
Discount rate
r2=10%
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ECV Example
$M
Year
What’s
Happening
1
Commercial
Success
Commercial
Failure
10%
Expected
Annual
Cash
Flow
Discounted
Cash Flow
Technical
development
(6.00)
(5.45)
2
Technical dev.
(6.00)
(4.96)
3
Technical dev.
(6.00)
(4.51)
4
Product sales
$15
$2
3.44
2.35
5
Product sales
$15
$2
7.84
4.87
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Product sales
$15
$2
7.84
4.43
7
Product sales
$15
$2
7.84
4.02
8
Product sales
$15
$2
7.84
3.66
Total = 4.40
Example calculation: .8[(.6)(15)+(.4)(2)-5.50]+.2(0)=3.44
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Criticisms of ECV Analysis
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Using expectation does not capture
worst case risk
The possibility of changing decisions
in the future changes the risk
characteristics of the project.
Consequently, the use of the same
discount rate may be inappropriate.
However, it’s not clear what other
discount rate should be used.
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Project Selection
The Rating Checklist Approach
 Checklist construction
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Identify the criteria or the set of
requirements
Score each project according to how well
it does with respect to each criterion.
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Words such as “excellent”, “good”, “poor”,
etc., are usually assigned with numerical
values.
Garrison Keillor, “A Prairie Home Companion”:
“Lake Wobegon, where all the women are
strong, all the men good-looking and all the
children are above average”.
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An Example of rating checklist
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The Scoring Approach

The built-in assumption in the rating checklist
approach is that each criterion is equally weighted.

Scoring models extend this approach by assigning a
weight to each criterion to indicate its relative
importance.
1. Assign a weight wi to criterion i in accordance with
its relative importance.
2. A total score is computed for each project j:
Tj=i wisij,
where sij is the rating of project j under criterion i.
3. Projects with low total scores will be eliminated.
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An example of a scoring model for
screening projects
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Multifactor Project Scoring Example
Attribute
Scale
Weight
Will the project
unlikely 1 2 3 4 5 likely
increase market share?
30%
Is new facility needed?
15%
Are there safety
concerns?
yes
(2)
likely
(1)
unsure
(3)
no
(4)
no
(5)
10%
Likelihood of
successful technical
development?
unlikely 1 2 3 4 5 likely
20%
Likelihood of
successful commercial
development?
unlikely 1 2 3 4 5 likely
25%
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Multifactor Project Scoring Example

vi ( xi ) 
xi  L
vi ( xi ) 
U L
To convert various
measurement
scales to a [0,1]
range.
LINEAR SCALE:
EXPONENTIAL
SCALE:
1  e( L  xi )
vi ( xi ) 
1  e( L U )
1.00
0.90

0.80
Attribute Value
0.70
0.60
Linear Scale
Exponential Scale
0.50
0.40
0.30
0.20
Note that the
exponential scale
places a premium
on being
“acceptable”, but not
on “excellence”.
0.10
0.00
1
2
3
4
Response
5
6
7
xi
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Multifactor Project Scoring Example
Weight
0.30
0.15
0.10
0.20
0.25
Attribute
#1
#2
#3
#4
#5
Project A
5
Yes (2)
Likely (1)
4
2
Project B
2
No (4)
Unsure (3)
3
4
Project
score (Vj)
Linear Scale
Project A
1.00
0.25
0
0.75
0.25
0.550
Project B
0.25
0.75
0.50
0.50
0.75
0.525
Exponential Scale
Project A
1.00
0.64
0.00
0.97
0.64
0.751
Project B
0.64
0.97
0.88
0.88
0.97
0.845
Note that the linear scale recommends Project A, whereas the
exponential scale recommends Project B.
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The Scoring Approach

Various formulas have been proposed for
deriving the relative weights. For example,
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Uniform or equal weights: Given N criteria, the
weight for each of them is assigned as wi=1/N.
Rank sum weights: If Ri is the rank position of
criterion i (with 1 as the highest rank) and there
are N criteria, then: wi=(N- Ri+1)/ k(N- Rk+1)
Rank reciprocal weights:
wi=(1/Ri)/ k(1/Rk)
Analytic Hierarchy Process (AHP) is a good
methodology that computes weights and
scores together.
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Project Screening and Selection
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Project screening by checklist and
scoring models

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Project selection by NPV
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Ratings subjective?
Only concerned with monetary value?
Risk? Uncertainty?
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Project selection using decision trees
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Decision trees are a powerful approach for
decision making problems involving
sequential decisions and variable outcomes
over time.
Project selection problem often involves
uncertainties about the future. The
outcomes of a project may change
depending on which future scenario occurs.
A decision tree is a graphical method of
expressing the alternative actions that are
available to the decision maker and the
outcomes that may occur by chance.
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Project Selection by Decision Analysis
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
Example - To determine whether a
project to automate a manufacturing
process should be launched or not.
Depending on the extent of success of
the project, the performance of the
process after the automation project
may turn out to be



poor,
fair, or
excellent.
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Decision Tree Representation
Include
operational
cost savings,
increased
revenue from
better quality.
$27K
$27K
1
1a
Poor(0.5)
$-90K
Fair(0.3)
$40K
Excel.(0.2)
$300K
Don’t automate
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Decision Analysis
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More about this topic later ….
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Project Selection as a Portfolio
Planning Problem
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A project is a multi-period investment problem.
In each time period, the resources that are
available, such as a budget to cover the costs of all
projects in the portfolio, are limited.
If the company is considering many (say 50 or 100)
projects, the number of possible combinations of
selected projects is huge.
In order to select an “optimal” or even good
combination, we need a methodology that can
quickly and accurately compare all these possible
combinations.
The only methodology that can achieve this is 0-1
programming, which can be implemented in Excel.
Microsoft Project and other project management
packages do not provide this capability.
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Project Selection Example
Project A
Revenue by Year
1
2
3
4
($40) $10
$20
$20
Project B
($65)
($25)
$90
$20
Budget Limit
($50)
($50)
$40
$55
Overall score of Project A: .751
Overall score of Project B: .845
We want to maximize the total overall
score, or value delivered, of the portfolio
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0-1 Program for Project Selection
Maximize 0.751a + 0.845b
Subject to
40a + 65b ≤ 90 (Year 1)
-10a + 25b ≤ 20 (Year 2)
-20a + 50b ≤ 40 (Year 3)
-20a + 50b ≤ 55 (Year 4)
a, b = 0 or 1
where a = 1 if project A is selected
0 if not
and b similarly.
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A Dynamic Cash Management Model
Winston-Salem Development Corporation (WSDC) is
trying to complete its investment plans for the next
two years.
Currently, WSDC has $2,000,000 on hand and
available for investment. The following table gives
the cash income from previous investments:
Income
6 MONTHS 12 MONTHS 18 MONTHS
$500,000
$400,000
$380,000
There are 2 development projects in which WSDC is
considering participation along with other non40
WSDC investors.
1. Foster City Development:
If WSDC participated at a 100% level, the
projected cash flow would be:
Income
INITIAL
6 MONTHS
12 MONTHS
18 MONTHS
24 MONTHS
$- 1,000,000
$- 700,000
$ 1,800,000
$ 400,000
$ 600,000
In order to participate at the 100% level, WSDC
would have to lay out $1,000,000 immediately
and $700,000 again in 6 months.
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2. Take over the operation of an old MiddleIncome Housing on the condition that certain
initial repairs be made. At 100%
participation, the cash flow would be:
Income
INITIAL
6 MONTHS
12 MONTHS
18 MONTHS
24 MONTHS
$- 800,000
$ 500,000
$- 200,000
$- 700,000
$ 2,000,000
WSDC can participate in either project at a level less
than 100%. The cash flows would be adjusted
proportionally and outside investors would make up
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the difference.
Now WSDC must decide how much of the $2,000,000
on hand should be invested in each of the projects
and how much should simply be invested in a 6month CD for the 7% semiannual return.
The goal (objective function) is to maximize the cash
on hand at the end of 24 months. The decision
variables are:
F = fractional participation in Foster City project
M = fractional participation in Middle-Income
Housing project
S1 = initial surplus funds to be invested in a 7% CD
S2 = 6 mts. surplus funds to be invested in a 7% CD
S3 = 12 mts. surplus funds to be invested in a 7%CD
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S4 = 18 mts. surplus funds to be invested in a 7%CD
The constraints in this model must say that at the
beginning of each of the four 6-month periods:
cash invested < cash on hand
The first constraint must say:
Initial investment < initial funds on hand
1,000,000F + 800,000M + S1 < 2,000,000
Because of the interest paid, S1 becomes 1.07S1
after 6 months, and similarly for S2, S3, and S4:
700,000F + S2 < 500,000M + 1.07S1 + 500,000
200,000M + S3 < 1,800,000F + 1.07S2 + 400,000
700,000M + S4 < 400,000F + 1.07S3 + 380,000
These constraints provide material balance of the
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cash flows from one time period to another.
Here is the symbolic model for this LP dynamic cash
management model:
Max 600,000F + 2,000,000M + 1.07S4
s.t.
1,000,000F + 800,000M + S1 < 2,000,000
700,000F - 500,000M – 1.07S1 + S2 < 500,000
-1,800,000F + 200,000M – 1.07S2 + S3 < 400,000
- 400,000F + 700,000M – 1.07S3 + S4 < 380,000
F < 1 and M < 1
F > 0, M > 0, Si > 0, i = 1,2,3,4
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Here is the
optimal
solution:
Here are the
formulas
and Solver
Parameters:
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Here is the partial Sensitivity Analysis:
As can be seen from these results, both investment
projects are attractive with WSDC participating fully,
and from the Sensitivity Report, the marginal return
to WSDCs initial funds is 31% over 24 months.
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Decision Support for
Project Selection
Tutorial on Linear Programming with
Excel for Project Selection