UNIVERSITY OF ZAMBIA

CTU Department

MODULE 2: PROJECT SELECTION

 INTRODUCTION
• Since projects in general require a substantial
investment in terms of money and resources, both of
which are limited, it is of vital importance that the
projects that an organization selects provide good
returns on the resources and capital invested.
• This requirement must be balanced with the need for
an organization to move forward and develop.
• The high level of uncertainty in the modern business
environment has made this area of project
management crucial to the continued success of an
organization with the difference between choosing
good projects and poor projects literally representing
the difference between operational life and death.
 Introduction…..
• Project selection is the process of choosing a
project or set of projects to be implemented
by the organization.
• Because a successful model must capture
every critical aspect of the decision, more
complex decisions typically require more
sophisticated models.
• “There is a simple solution to every complex
problem; unfortunately, it is wrong”.
• Project selection decisions are high-stakes because of
their strategic implications.
• The projects a company chooses can define the
products it supplies, the work it does, and the
direction it takes in the marketplace.
• Thus, project decisions can impact every business
stakeholder, including customers, employees,
partners, regulators, and shareholders.
• A sophisticated model may be needed to capture
strategic implications.
• Project decisions are dynamic because a project
may be conducted over several budgeting cycles,
with repeated opportunities to slow, accelerate,
re-scale, or terminate the project.
• Also, a successful project may produce new
assets or products that create time-varying
financial returns and other impacts over many
years.
• A more sophisticated model is needed to address
dynamic impacts
• Project decisions typically produce many different types
of impacts on the organization. For example, a project
might increase revenue or reduce future costs. It might
impact how customers or investors perceive the
organization.
• It might provide new capability or learning, important to
future success.
• Making good choices requires not just estimating the
financial return on investment; it requires understanding
all of the ways that projects add value.
• A more sophisticated model is needed to account for all
of the different types of potential impacts that project
selection decisions can create.
 Project Decisions:

• Project decisions often entail risk and uncertainty.

• The significance of a project risk depends on the
nature of that risk and on the other risks that the
organization is taking.
• A more sophisticated model is needed to
correctly deal with risk and uncertainty.
• Project selection is the process of evaluating
individual projects or groups of projects, and
then choosing to implement them so that the
objectives of the organization will be achieved.
 CRITERIA FOR CHOOSING PROJECT
MODEL

• When a firm chooses a project selection

model, the following criteria, based on
Souder (1973), are most important:
 REALISM

• The model should reflect the reality of the

manager’s decision situation, including the
multiple objectives of both the firm and its
managers.
• Without a common measurement system,
direct comparison of different projects is
impossible.
 CAPABILITY

• The model should be sophisticated enough to

deal with multiple time periods, simulate various
situations both internal and external to the
project (for example, strikes, interest rate
changes), and optimize the decision.
• An optimizing model will make the comparisons
that management deems important, consider
major risks and constraints on the projects, and
then select the best overall project or set of
projects.
 FLEXIBILITY

• The model should give valid results within the

range of conditions that the firm might
experience.
• It should have the ability to be easily modified, or
to be self-adjusting in response to changes in
the firm’s environment; for example, tax laws
change, new technological advancements alter
risk levels, and, above all, the organization’s
goals change.
 EASE OF USE
• The model should be reasonably convenient, not
take a long time to execute, and be easy to use and
understand. It should not require special
interpretation, data that are difficult to acquire,
excessive personnel, or unavailable equipment.
• The model’s variables should also relate one-to-one
with those real-world parameters, the managers
believe significant to the project.
• Finally, it should be easy to simulate the expected
outcomes associated with investments in different
project portfolios.
 COST

• Data gathering and modelling costs should be

low relative to the cost of the project and must
surely be less than the potential benefits of the
project.
• All costs should be considered, including the
costs of data management and of running the
model.
 EASY COMPUTERIZATION

• It should be easy and convenient to gather

and store the information in a computer
database, and to manipulate data in the
model through use of a widely available,
standard computer package such as Excel,
Lotus 1-2-3, Quattro Pro, and like programs.
• The same ease and convenience should apply
to transferring the information to any
standard decision support system.
 Types of Project Selection Models

• There are certain types of project selection

models which are used to select the projects.
• Selection of project is an important part of
business.
• If you choose the wrong project, this may goes to
loss instead of giving business benefits.
• So understanding of project selection models has
utmost importance.
• Below are the utmost important types of project
selection models.
 NON-NUMERIC PROJECT SELECTION MODELS

THE SACRED COW

• The senior and The powerful official in the company
suggest the project in this case.
• Mostly the project is simply initiated from an apparent
opportunity or chance which follows an un-established
idea for a new product, for the designing & adoption of
the latest information system with universal database, for
establishment of new market or for some other category
of project that demands the investment of the resources
of the organization.
• The project is created as an immediate result of this
bland approach for investigating about whatever the
boss has proposed.
• The sacredness of the project reflects the fact that it will
be continued until ended or until the boss himself
announces the failure of the idea & ends it.
 THE OPERATING NECESSITY
• If a plant is threatened by the flood then it is not much
complex and effortful to start a project for developing a
protective desk.
• This is best example for the operating necessity. Potential
projects are evaluated by using this criterion of project
selection by the XYZ steel corporation.
• Certain questions come in front if the project is needed in
order to keep the system functioning like is the estimated cost
of the project is effective for the system?
• If the answer of such important question is yes, then the
project costs should be analyzed to ensure that these are
maintained as minimum and compatible with the success of
the project.
• However the project should be financed.
 THE COMPETITIVE NECESSITY

• In the late 1960’s, XYZ Steel considered an

important plant rebuilding project by using this
criterion in its steel bar producing facilities near
Chicago.
• It was clear to the management of the company
that certain modernization is required in its bar mill
in order to keep the current competitive position in
the market area of Chicago.
• Perhaps the project has modern planning process,
the desire to keep the competitive position of the
company in the market provide basis for making
such decision to carry on the project.
 The Competitive Necessity…
• Similarly certain undergraduate and Master
in Business Administration (MBA)
programs are restructured in the offerings of
many universities to keep their competitive
position in the academic market.
• Precedence is taken by the operating
necessity projects over competitive necessity
projects regarding investment. But both of
these types of project selection models are
considered much useful & effective as
compared to other selection models.
 THE PRODUCT LINE EXTENSION

• In case of the product line extension, a project

considered for development & distribution of new
products will be evaluated on the basis of the
extent to which it suits the company’s current
product lines, fortify a weak line, fills a gap, or
enhanced the line in a new & desirable direction.
• In certain cases careful evaluations of profitability
is not needed. The decision makers can perform
actions on the basis of their belief about the
probable influence of the addition of the new
product to the line over the entire performance of
system.
 COMPARATIVE BENEFIT MODEL
• According to this selection model, there are
several projects that are being considered by the
organization.
• Those subset of the projects are selected by the
senior management of the organization can
provide most benefits to the company. But
comparing various projects is not an easy task.
• For example some projects are related to the new
products, some are related to the computerization
of particular records, others are related to make
alteration in the method of production and some of
them may contain such area that cannot be easily
categorized
 Comparative Benefit Model….
• There is no formal method of selection of
projects in the organization but it is the
perception of the selection committee
members that certain projects will benefit
the company more than the others even
they lack the suitable way to specify or
measure the proposed benefit.
 Comparative Benefit Model
• For all sort of projects, if not a formal model, the
concept of comparative benefits is enormously
used for selection decisions.
• United States Companies considering various
social programs for providing funds to them use
this concept to make the decisions.
• All the considered projects with positive
recommendations are examined by the senior
management of the funding organization in order
to make effort to develop a portfolio that can
effectively suits the objectives & budgets of the
organization
 Q-SORT MODEL
• The Q-Sort model is the one of the most straightforward
techniques for ordering projects. According to their
relative merits, the projects are first divided into three
groups which are Good, Fair and Poor.
• The main group is further subdivided into the two types
of fair-minus and fair-plus if any group has the has more
than eight members.
• The projects within each type are ranked from best to
worst when all types have eight or fewer members.
• Again relative merit provides the basis for determining
the order. Specific criterion is used by the rater to rank
each project or he may merely use general entire
judgment.
 Q-Sort Model Example
• One person has the responsibility to carry out the process for
evaluation & selection of the project. In certain cases there is
a selection committee for performing such process.
• If the task is handled by the committee, individual ranking can
be build anonymously and the committee examines the set of
anonymous ranking for consensus.
• These ranking differ from to some degree from rater to rater
but that difference is not much enhanced because the
selected individuals for such committees seldom differ
increasingly on their consideration for the suitability for the
parent organization.
• Finally the projects are selected on sequence of preference,
though they are generally assessed on financial basis before
final selection. There are certain other non-numeric models
for rejecting or accepting projects.
 NUMERIC PROJECT SELECTION MODELS
(PROFIT/PROFITABILITY)

• The profitability is used as the only measure of

acceptability by majority of organizations using
different types of project selection models.
• Following are some of numeric models for project
selection.
1. Payback Period
2. Average Rate of Return
3. Discounted Cash Flow
4. Internal Rate of Return (IRR)
5. Profitability Index
6. Other Profitability Models
 PAYBACK PERIOD

• The initial fixed investment in the project divided

by the forecasted annual net cash inflows from the
project is referred to as payback period for the
project. The number of years needed by the
project to refund its initial fixed investment is
reflected in the ratio of these quantities.
• For example suppose a project costs $200,000 to
operate and has annual net cash inflows of
$40,000.
• Then
• Payback Period = $200,000 / $40,000v = 5 Years
 Payback Period……
• This method suppose that the cash inflows
will die hard to the minimum extent to pay
back the investment, and any cash inflows
outside the payback period are ignored.
• This method also functions as inadequate
representative for the risk. The company
faces less risk when it recovers the initial
investment fast.
 AVERAGE RATE OF RETURN

• The ratio of the average annual profit (either after or

before taxes) to the average or initial investment in the
project is referred to as the average rate of return. It is
mostly misunderstood as the reciprocal of payback
period.
• The average rate of return does not generally equal
the reciprocal of the payback period because average
annual profits are generally not equivalent to the net
cash inflows.
• In the above mentioned example, suppose the
average annual profits are $30,000
• Average Rate of Return = $30,000 / $200,000 = 0.15
 Average Rate of Return…
• None of the two above mentioned evaluation
methods are effective for project selection,
though payback period is frequently used and
exhibits reasonable value for decisions
related to cash budgeting.
• These two models have major advantage in
the shape of simplicity, but none of them
cover the important concept of time value of
money.
 DISCOUNTED CASH FLOW

• Discounted cash flow method is also called

Net Present Value (NPV) method.
• The net present value of all cash flows is
determined by discounting them by the
required rate of return in this method.
• Where k = the required rate of return,
• Ft = the net cash flow in period t and
• Ao = the initial cash investment
• In order to cover the affect of inflation in the
equation
• Where, pt is the forecasted rate of inflation
during the period t.
• Net cash flow is likely to be negative in the early life of
the project because of the potential outflow in the form
of initial investment. However cash flow will become
positive when the project acquires the success. If the
sum of the net present value of net present value of all
forecasted cash flows throughout the life of the project
is positive, the project is acceptable.
• A simple example will be adequate. Suppose a project
has initial investment of $100,000. It has net cash
inflow of $25,000 per year for a period of eight years.
The required rate of return for the project is 15% with
an inflation rate of 3% p.a. Now the NPV of this project
is calculated as below
 INTERNAL RATE OF RETURN (IRR)

• If there are two sets expected cash flows,

one for expected cash inflows and other for
expected cash outflows then Internal Rate of
Return is the discount rate that equalizes the
present value of the two sets of flows.
• If Rt is the forecasted cash inflow for period t
and At is a forecasted cash outflow in the
period t, the internal rate of return is the value
of k that satisfies the following equation
• The value of k is ascertained by trial & error.
 6. Profitability Index

• The net present value of all future

expected cash flows divided by the initial
investment is referred to as profitability
index.
• Profitability index is also called the benefit-
cost ratio. The project may be accepted, if
this ratio is higher than 1.0.
 Other Profitability Models

• The models just explained have different

variations that fall into the following three
groups;
1. Those that further split the net cash flow into
components that make up the net flow
2. Those that contain particular terms to
acquaint risk (uncertainty) into the
assessment.
3. Those that widen the analysis to view
impacts that the project can have on
activities or projects in the company
 Advantages of Profit-Profitability Numeric
Models:
• Several comments are in order about all the profit-
profitability numeric models. First, let us consider
their advantages:
• The undiscounted models are simple to use and
understand.
• All use readily available accounting data to
determine the cash flows.
• Model output is in terms familiar to business
decision makers.
• With a few exceptions, model output is on an
“absolute” profit/profitability scale and allows
“absolute” go/no-go decisions.
• Some profit models account for project risk.
 Disadvantages of Profit-Profitability Numeric Models:
• The disadvantages of these models are the following:
– These models ignore all non-monetary factors except risk.
– Models that do not include discounting ignore the timing of the cash
flows and the time–value of money.
– Models that reduce cash flows to their present value are strongly biased
toward the short run.
– Payback-type models ignore cash flows beyond the payback period.
– The internal rate of return model can result in multiple solutions.
– All are sensitive to errors in the input data for the early years of the
project.
• All discounting models are nonlinear, and the effects of changes (or errors)
in the variables or parameters are generally not obvious to most decision
makers
• All these models depend for input on a determination of cash flows, but it is
not clear exactly how the concept of cash flow is properly defined for the
purpose of evaluating projects