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CHAPTER THREE
Project Selection and Portfolio Management
Chapter Outline
Project Profile
Project Selection Procedures: A Cross-Industry Sampler
Introduction
3.1 Project Selection
3.2 Approaches to Project Screening and Selection
Method One: Checklist Model
Method Two: Simplified Scoring Models
Limitations of Scoring Models
Method Three: The Analytical Hierarchy Process
Method Four: Profile Models
3.3 Financial Models
Payback Period
Net Present Value
Discounted Payback
Internal Rate of Return
Choosing a Project Selection Approach
Project Profile
Project Selection and Screening at GE: The Tollgate Process
3.4 Project Portfolio Management
Objectives and Initiatives
Developing a Proactive Portfolio
Keys to Successful Project Portfolio Management
Problems in Implementing Portfolio Management
Summary
Key Terms
Solved Problems
Discussion Questions
Problems
Case Study 3.1: Keflavik Paper Company
Case Study 3.2: Project Selection at Nova Western, Inc.
Internet Exercises
Notes
TRANSPARENCIES
3.1 SIMPLIFIED CHECKLIST MODEL FOR PROJECT SELECTION
Performance on Criteria
High Medium Low
Project Criteria
Project Alpha Cost X
Profit Potential X
Time to Market X
Development Risks X
Project Beta Cost X
Profit Potential X
Time to Market X
Development Risks X
Project Gamma Cost X
Profit Potential X
Time to Market X
Development Risks X
Project Delta Cost X
Profit Potential X
Time to Market X
Development Risks X
3.2 SIMPLE SCORING MODEL
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project Alpha
Cost 1 3 3
Profit Potential 2 1 2
Development Risk 2 1 2
Time to Market 3 2 6
Total Score 13
Project Beta
Cost 1 2 2
Profit Potential 2 2 4
Development Risk 2 2 4
Time to Market 3 3 9
Total Score 19
3.3 PROFILE MODEL
3.4 FINANCIAL MODELS - PAYBACK PERIOD
Comparison of Payback for Projects A and B
Project A Year Cash flow Cum. Cash Flow
0 ($500,000) ($500,000)
1 50,000 (450,000)
2 150,000 (300,000)
3 350,000 50,000
4 600,000 650,000
5 500,000 1,150,000
Payback = 2.857 years
Rate of Return = 35%
Project B Year Cash flow Cum. Cash Flow
0 ($500,000) ($500,000)
1 75,000 (425,000)
2 100,000 (325,000)
3 150,000 (175,000)
4 150,000 (25,000)
5 90,000 875,000
Payback = 4.028 years
Rate of Return = 24.8%
3.5 FINANCIAL MODELS – NET PRESENT VALUE
ASSUME: $100,000 INITIAL INVESTMENT
REQUIRED RATE OF RETURN: 10%
INFLATION: 4%
USEFUL LIFE: 4 YEARS
ANTICIPATED CASH FLOWS:
Year 1: $20,000
Year 2: $50,000
Year 3: $50,000
Year 4: $25,000
EXAMPLE - DISCOUNT FACTOR FOR YEAR ONE
Discount factor = (1/(1 + .10 + .04)1) = .8772
Discounted Cash Flows and NPV
Year Inflows Outflows Net flow Discount Factor NPV
0
100,000 (100,000) 1.000 (100,000)
1 20,000
20,000 0.8772 17,544
2 50,000
50,000 0.7695 38,475
3 50,000
50,000 0.6749 33,745
4 25,000
25,000 0.5921 14,803
Total $4,567
3.6 FINANCIAL MODELS – DISCOUNTED PAYBACK
ASSUME: $100,000 INITIAL INVESTMENT
REQUIRED RATE OF RETURN: 12.5%
EXAMPLE - DISCOUNT FACTOR FOR YEAR ONE
Discount factor = (1/(1 + .125)1) = .89
Project Cash Flow
Year Discounted Undiscounted
1 $8,900 $10,000
2 7,900 10,000
3 7,000 10,000
4 6,200 10,000
5 5,500 10,000
Payback Period 4 Years 3 Years
3.7 PROJECT PORTFOLIO MANAGEMENT
Project Portfolio Matrix
DISCUSSION QUESTIONS
If you were to prioritize the criteria for a successful screening model, which
criteria would you rank at the top of your priority list? Why?
Of the criteria for successful screening models, realism would top the priority list. Realism requires that the model be in line with the constraints and objectives of the organization. The other criteria are based on how usable and applicable the model is. However, these measures would mean little if the model was unable to provide a recommendation that was usable within the resources available to the company (i.e., a realistic alternative).
What are the benefits and drawbacks of checklists as a method for screening project alternatives?
Project checklists are easy to use, based on a simplistic visual model with a basic scoring system. Using a checklist enhances the input and discussion during the screening process. Unfortunately, the model also has its shortcomings. The two most significant shortcomings are the subjectivity of the rating system and the lack of a weighting system. The weighting system is important in establishing trade-offs between criteria.
How does use of the Analytical Hierarchy Process (AHP) aid in project selection? In particular, what aspects of the screening process does the AHP seem to address and improve directly?
The Analytical Hierarchy Process (AHP) breaks the broad criterion categories of other selection models into smaller, more manageable pieces that each has a more defined focus. This allows the AHP to create a more accurate ordering of priorities than other models. It also enables a better demonstration of how potential alternatives meet organizational goals and strategy. Weighting that is absent or inefficient under the checklist and scoring model is improved. AHP allows weighting by main and subcriterion, which eliminates the double counting of the scoring model. Finally, the AHP creates results that are easily compared between projects as well as within cost/benefit analysis.
What are the benefits and drawbacks of the profile model for project screening? Be specific about the problems that may arise in identifying the efficient frontier.
The profile model is beneficial because it clearly outlines the relationship between risk and return of project alternatives. It also establishes a threshold for eliminating or qualifying projects. On the other hand, it may not be as effective for selecting alternatives because it limits discriminating criteria to risk and return only. Additionally, it can be difficult to accurately quantify risk.
How are financial models superior to other screening models? How are they inferior?
Financial models are superior to screening models in that they link project alternatives to financial performance. The results of financial models are non-subjective, meaning they are not subject to individual interpretation (i.e., a 10% return means a 10% return regardless of who is looking at it). Therefore, it becomes easier to compare the benefits of one project alternative versus another. The models do have some drawbacks. Due to the required information in determining NPV and IRR, it may be difficult to make long-term estimates accurately (i.e., one would have to estimate future inflation and interest rates). Economic conditions may be unknown or unstable; therefore, determinations made about the economic future may turn out to be invalid.
How does the options model address the problem of nonrecoverable investment in a project?
The options model looks at alternatives faced when a company has already made an investment in a project. Confronted with different possibilities of how to handle the non-recoverable investment (or past investment), the options model reveals whether investing in the project in the future will be beneficial, or whether the company should simply allow the project to live out its current potential.
What advantages do you see in the GE Tollgate screening approach? What disadvantages do you see? How would you alter it?
The major advantage and disadvantage of GE’s Tollgate screening approach are derived from the same source – multiple checks and reviews. The advantage of the process is that the project is under constant review, which means that problems are addressed immediately, and time and money are not continually invested in doomed projects. However, this same process may lead to excessive delays in projects due to time spent on checklists and reviews, and waiting for the feedback loop to be completed. Perhaps maintaining the process but reducing the number of players involved may help to speed up the process while still reaping the benefits of the system and reducing the risk of projects. For example, perhaps having one review board (e.g., a cross-functional team headed by a member of senior management) that meets briefly but frequently with the project team for progress updates would eliminate some of the bureaucratic levels in the system.
Why is project portfolio management particularly challenging in the pharmaceutical industry?
Portfolio management is difficult in the pharmaceutical industry due to the high uncertainty, low success rate, long lead time, and high investment costs of pharmaceutical projects. The uncertainty and high risk associated with the costs and success rates make it difficult to create a balanced, reliable portfolio. The portfolio must be constantly updated and reevaluated as projects fail, stall, or become obsolete.
What are the keys to successful project portfolio management?
The keys to successful project portfolio management are flexibility (i.e., freedom from layers of authority) and open communication, which allows projects teams to be innovative, using low cost methods to test new markets or product ideas, and smooth, timely transitions between projects.
What are some of the key difficulties in successfully implementing project portfolio management practices?
There are several common problems that may hinder successful implementation of portfolio management. To begin with, top management may run into conflicts with technical staff. For instance, engineers may not want to alter or abandon a project that management finds too risky. Another difficulty is investment in projects that do not fall in line with portfolio priorities. Strategy and the portfolio must remain aligned for project portfolios to be successful. A highly detrimental occurrence revolves around unpromising projects wherein companies continue to pour money into projects even after there is no hope for the project’s success. Finally, project portfolio management may fail due to a lack of resource. Primarily, this happens when there are not enough personnel to support the implementation, or when there are not enough resources to initiate the desired set of projects.
CASE STUDIES
Case Study 3.1: Keflavik Paper Company
Keflavik Paper is an organization that has been facing serious problems with the results of its projects. Specifically, the company’s project development record has been spotty: while some projects have been delivered on time, others have been late. Budgets are routinely overrun and product performance has been inconsistent, with the result of some projects yielding good returns and others losing money. They have hired a consultant to investigate some of the principle causes underlying these problems, and he believes that the primary problem is not how projects are run but how they are selected in the first place. Specifically, there is little attention paid to the need to consider strategic fit and portfolio management in selecting new projects. This case is intended to get students thinking of alternative screening measures that could potentially be used when deciding whether to invest in a new project.
Questions:
Keflavik Paper presents a good example of the dangers of excessive reliance on one screening technique (in this case, discounted cash flows). How might excessive or exclusive reliance on other screening methods discussed in this chapter lead to similar problems?
Some measures that allow us to screen projects may lead to the wrong conclusions; for example, suppose that we selected projects in construction settings for their aesthetic appeal and ability to promote our name across the industry. If insufficient attention was then paid to issues such as cost of the project or safety concerns, we may be selecting projects that will ultimately damage our reputation or drive us out of business. Instructors should probe various screening techniques for their strengths and weaknesses to ultimately demonstrate that effective screening methods usually rely on multiple complementary measures for selecting projects.
Assume that you are responsible for maintaining Keflavik’s project portfolio. Name some key criteria that should be used in evaluating all new projects before they are added to the current portfolio.
Students can use this as a brainstorming exercise. Among the criteria they could list are: 1) the relationship to current projects or products the company carries; 2) the new market penetration potential; 3) technological feasibility; and 4) the cost of development. This is a short list and students could potentially add several other criteria to it.
What does this case demonstrate about the effect of poor project screening methods on a firm’s ability to manage its projects effectively?
The firm’s ad hoc approach to project selection demonstrates that even taking on projects that could yield strong cash flows may injure the organization due to its inability to manage them well. Further, it highlights the dangers of using either a single or one heavily-weighted criterion for project selection. Successful project portfolios are consciously constructed and managed as a coherent whole, not simply a collection of diverse opportunities.
Case Study 3.2: Project Selection at Nova Western, Inc.
This case presents an example that is common, one in which different screening methods may yield different findings. In this case, two projects are competing for funding; Project Janus, championed by the organization’s software development group, and Project Gemini, which has the backing of their business applications organization. Using a weighted scoring model, it appears that Project Gemini offers the best alternative in terms of the criteria employed. On the other hand, when a discounted cash flow approach is used, the results suggest that Project Janus will earn greater returns on initial investment. Instructors can use this case to illustrate the fact that many times, selection models will point to conflicting results, particularly when financial models are paired with non-financial approaches.
Instructors can fashion a debate from this case in which they assign one team to serve as champions for Project Janus and the other for Project Gemini. It is a valuable exercise for requiring students to commit to one approach or another, defend their positions, and also examine these competing models for their strengths and weaknesses.
Questions:
Phyllis has called you into her office to help her make sense of the contradictions in the two project evaluations. How would you explain the reasons for the divergence of opinion from one technique to the next? What are the strengths and weaknesses of each screening method?
The chapter notes several strengths and weaknesses of each project screening method that should be considered in this case. It is not uncommon for financial and non-financial screening methods to yield competing information; thus, an argument could be made that using only these two methods is insufficient and in fact, an enhanced screening model should be developed for Nova that considers these factors as part of an overall, larger model of choice. Those instructors familiar with Expert Choice™ software could set up this case as an exercise using the Analytical Hierarchy Process (AHP) discussed in the chapter.
Choose the project that you think, based on the two analyses, Nova Western should select. Defend your choice.
A reasonable case could be made for selecting either Project Janus or Project Gemini. For example, though Project Janus offers a higher net present value for the initial investment, the payoff period is two years longer than Project Gemini, suggesting that if the firm does not wish to tie its money up for too long, Gemini might be a reasonable alternative choice. Likewise, the weighted criteria model seems to favor Project Gemini. Students should be encouraged to consider the criteria Nova employed in project selection. Are they reasonable or should other factors be considered as well?
What does this case suggest to you about the use of project selection methods in organizations? How would you resolve the contradictions found in this example?
A successful screening model is often a comprehensive one. Simplistic models typically yield simplistic answers and their consistency from method to method is questionable. As the chapter demonstrates, the most effective screening techniques used in organizations today are complex, multifaceted, and comprehensive in nature. One simple solution to this case might be to use the results of the discounted cash flow analysis as an additional factor in the weighted scoring model, whereby the net present value becomes an additional selection criterion to consider along with the other factors already listed. Likewise, students should be asked to consider if any of the criteria in the scoring model represent “must” items that cannot be compromised, such as safety. Finally, students may point out that the potential profit factor ranks both projects identical. However, the DCF model shows that Project Janus might reasonably be ranked higher. Ask students how this reevaluation might change final results.
PROBLEMS
Checklist. Suppose that you are trying to choose which of two IT projects to accept. Your company employs three primary selection criteria for evaluating all IT projects: 1) proven technology, 2) ease of transition, and 3) projected cost savings.
One option, Project Demeter, is evaluated as:
Technology high
Ease of transition low
Projected cost savings high
The second option, Project Cairo, is evaluated as:
Technology medium
Ease of transition high
Projected cost savings high
Construct a table identifying the projects, their evaluative criteria, and ratings. Based on your analysis, which project would you argue in favor of adopting? Why?
Solution:
Performance on Criteria
High Medium Low
Project Criteria
Project Demeter Technology X
Ease of Transition X
Projected Cost Savings X
Project Cairo Technology X
Ease of Transition X
Time to Market X
On the basis of this checklist, and assuming that all criteria are equally weighted, Project Cairo is marginally superior to Project Demeter. Cairo scores two highs and one medium, while Demeter scores two highs and one low.
Checklist. Consider the following information in choosing among the four project alternatives below (labeled A, B, C, and D). Each has been assessed according to four criteria:
Payoff potential
Lack of risk
Safety
Competitive advantage
Project A is rated:
Payoff potential high
Lack of risk low
Safety high
Competitive advantage medium
Project B is rated:
Payoff potential low
Lack of risk medium
Safety medium
Competitive advantage medium
Project C is rated:
Payoff potential medium
Lack of risk medium
Safety low
Competitive advantage low
Project D is rated:
Payoff potential high
Lack of risk high
Safety medium
Competitive advantage medium
Construct a project checklist model for screening these four alternatives. Based on your model, which project is the best choice for selection? Why? Which is the worst? Why?
Solution:
Performance on Criteria
High Medium Low
Project Criteria
Project A Payoff Potential X
Lack of Risk X
Safety X
Competitive Advantage X
Project B Payoff Potential X
Lack of Risk X
Safety X
Competitive Advantage X
Project C Payoff Potential X
Lack of Risk X
Safety X
Competitive Advantage X
Project D Payoff Potential X
Lack of Risk X
Safety X
Competitive Advantage X
According to this checklist, it appears that Project D is the best option, as all ratings are either High or Medium. Project C is the worst option, with only two Medium and two Low ratings.
3.3 Scoring Model. Suppose the information in Problem 2 was supplemented by importance weights for each of the four assessment criteria, where 1 = low importance and 4 = high importance:
Assessment Criteria: Importance Weights
Payoff potential 4
Lack of risk 3
Safety 1
Competitive advantage 3
Assume, too, that evaluations of high receive a score of 3, medium 2, and low 1. Recreate your project scoring model and reassess the four project choices (A, B, C, and D). Now which project alternative the best? Why?
Solution:
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project A
Payoff Potential 4 3 12
Lack of risk 3 1 3
Safety 1 3 3
Competitive Advantage 3 2 6
Total Score 24
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project B
Payoff Potential 4 1 4
Lack of risk 3 2 6
Safety 1 2 2
Competitive Advantage 3 2 6
Total Score 18
Project C
Payoff Potential 4 2 8
Lack of risk 3 2 6
Safety 1 1 1
Competitive Advantage 3 1 3
Total Score 18
Project D
Payoff Potential 4 3 12
Lack of risk 3 3 9
Safety 1 2 2
Competitive Advantage 3 2 6
Total Score 29
Therefore, students should choose Project D, which has the highest total score of 29.
3.4 Scoring Model. Now assume that for Problem 3, the importance weights are altered as follows:
Assessment Criteria: Importance Weights
Payoff potential 1
Lack of risk 1
Safety 4
Competitive advantage 2
How does this new information alter your decision? Which project now looks most attractive? Why?
Solution:
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project A
Payoff Potential 1 3 3
Lack of risk 1 1 1
Safety 4 3 12
Competitive Advantage 2 2 4
Total Score 20
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project B
Payoff Potential 1 1 1
Lack of risk 1 2 2
Safety 4 2 8
Competitive Advantage 2 2 4
Total Score 15
Project C
Payoff Potential 1 2 2
Lack of risk 1 2 2
Safety 4 1 4
Competitive Advantage 2 1 2
Total Score 10
Project D
Payoff Potential 1 3 3
Lack of risk 1 3 3
Safety 4 2 8
Competitive Advantage 2 2 4
Total Score 18
Project A would be the best choice, with the highest weighted score.
3.5 Screening Model. Assume that the following criteria relevant to the process of screening various project opportunities are weighted in importance as follows:
Quality (7)
Cost (3)
Speed to market (5)
Visibility (1)
Reliability (7)
Our company has four project alternatives that satisfy these key features as follows:
Alpha Beta Gamma Delta
Quality 1 3 3 5
Cost 7 7 5 3
Speed 5 5 3 5
Visibility 3 1 5 1
Reliability 5 5 7 7
Construct a project screening matrix to identify among these four projects the most likely candidate to be implemented.
Solution:
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project Alpha
Quality 7 1 5
Cost 3 7 21
Speed 5 5 25
Visibility 1 3 3
Reliability 7 5 35
Total Score 91
Project Beta
Quality 7 3 21
Cost 3 7 21
Speed 5 5 25
Visibility 1 1 1
Reliability 7 5 35
Total Score 103
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Project Gamma
Quality 7 3 21
Cost 3 5 15
Speed 5 3 15
Visibility 1 5 5
Reliability 7 7 49
Total Score 105
Project Delta
Quality 7 5 35
Cost 3 3 9
Speed 5 5 25
Visibility 1 1 1
Reliability 7 7 49
Total Score 119
Project Delta represents the best choice, using the weighted scoring model.
3.6 Screening Model. Assume that the following criteria relevant to the process of screening various construction project opportunities are weighted in importance as follows:
Safety (10)
Speed to completion (5)
Sustainable development (4)
Infrastructure modifications (3)
Traffic congestion (5)
Cost (8)
Our company has four project alternatives that satisfy these key features as follows:
Midtown Uptown Downtown Suburb
Safety 6 5 3 8
Speed 3 4 2 5
Sustainable 7 7 5 4
Infrastructure 4 5 4 1
Traffic Cost 2
5 4
5 1
3 8
6
Construct a project screening matrix to identify among these four projects the most likely candidate to be implemented.
Solution:
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Midtown
Safety 10 6 60
Speed 5 3 15
Sustainable 4 7 28
Infrastructure 3 4 12
Traffic 5 2 10
Cost 8 5 40
Total Score 165
Uptown
Safety 10 5 50
Speed 5 4 20
Sustainable 4 7 28
Infrastructure 3 5 15
Traffic 5 4 20
Cost 8 5 40
Total Score 173
(A) (B) (A) x (B)
Importance Weighted
Project Criteria Weight Score Score
Downtown
Safety 10 3 30
Speed 5 2 10
Sustainable 4 5 20
Infrastructure 3 4 12
Traffic 5 1 5
Cost 8 3 24
Total Score 101
Suburb
Safety 10 8 80
Speed 5 5 25
Sustainable 4 4 16
Infrastructure 3 1 3
Traffic 5 8 40
Cost 8 6 48
Total Score 212
The Suburb option represents the best choice, using the weighted scoring model.
3.7 Profile Model. Assume the project profile model shown in Figure 3.10. Define the efficient frontier. The dotted lines represent the minimum return and the maximum risk that the company will accept. Which projects would be suitable for retaining and which should be dropped from the company’s portfolio? Why?
Fig. 3.10 – Project Profile Model
Solution:
The efficient frontier would be a line running between Project B and Project E. Other project options in the portfolio either offer lower potential returns for similar levels of risk (Projects F and C) or are outside the acceptable boundaries for risk and/or return (Projects A and D).
3.8 Profile Model. Using the information from the profile model in Problem 7, construct an argument as to why project B is preferable to project C.
Solution:
Project B gives a similar level of potential return while offering significantly lower risk; thus, because profit (return) is similar across the two project options, it would make more sense to adopt the project with a lower overall risk level.
3.9 Discounted Payback. Your company is seriously considering investing in a new project opportunity, but cash flow is tight. Top management is concerned about how long it will take for this new project to pay back the initial investment of $50,000. You have determined that the project should generate inflows of $30,000, $30,000, $40,000, $25,000, and $15,000 for the next five years. Your firm’s required rate of return is 15%. How long will it take to pay back the initial investment?
Solution:
We can set up a discounted cash flow table to calculate the time needed to pay back the initial $50,000 investment. Remember that:
Total outflow = $50,000
Required rate of return = 10%
Discount factor = 1/(1+.15)t
Year Cash Flow Discount Factor New Inflows
0 ($50,000) 1.0 ($50,000)
1 30,000 .87 26,100
2 30,000 .76 22,800
3 40,000 .66 26,400
4 25,000 .57 14,250
5 15,000 .50 7,500
Payback = 2.1 years
Conclusion: You will be able to pay off the initial investment in just over two years.
3.10 Net Present Value. Assume that your firm wants to choose between two project options:
Project A: $500,000 invested today will yield an expected income stream of $150,000 per year for 5 years, starting in Year 1.
Project B: an initial investment of $400,000 is expected to produce this revenue stream: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000, and Year 5 = $200,000.
Assume that a required rate of return for your company is 10% and that inflation is expected to remain steady at 3% for the life of the project. Which is the better investment? Why?
Solution:
First, our required rate of return is 3% + 10% = 13%. Next, using the formula from the chapter, we can calculate the discount factors for the time periods:
(1/(1 + k + p)t)
Then, the formula for Net Present Value allows us to test each option:
NPV = I0 + ? Ft/(1 + r + p)t
We can construct a table that demonstrates projected inflows and outflows for the two projects (below).
Project A
Year Inflows Outflows Net flow Discount Factor NPV
0
500,000 (500,000) 1.000 (500,000)
1 150,000
150,000 0.88 132,000
2 150,000
150,000 0.78 117,000
3 150,000
150,000 0.69 103,500
4 150,000
150,000 0.61 91,500
5 150,000
150,000 0.54 81,000
Total $25,000
Project B
Year Inflows Outflows Net flow Discount Factor NPV
0
400,000 (400,000) 1.000 (400,000)
1 0
0 0.88 0
2 50,000
50,000 0.78 39,000
3 200,000
200,000 0.69 138,000
4 300,000
300,000 0.61 183,000
5 200,000
200,000 0.54 108,000
Total $68,000
Conclusion: In this case, even though both projects offer a positive NPV, the highest NPV is Project B. Therefore, if we can only select one project to fund, Project B offers higher returns.
3.11 Net Present Value. Your vice president of Management Information Systems informs you that she has researched the possibility of automating your organization’s order-entry system. She has projected that the new system will reduce labor costs by $35,000 each year over the next five years. The purchase price (including installation and testing) of the new system is $125,000. What is the net present value of this investment if the discount rate is 10% per year?
Solution:
Using the formulae shown in Problem 10 above, we can construct a discounted cash flow table:
Discounted Cash Flows and NPV
Year Inflows Outflows Net flow Discount Factor NPV
0
125,000 (125,000) 1.000 (125,000)
1 35,000
35,000 0.91 31,818
2 35,000
35,000 0.83 29,050
3 35,000
35,000 0.75 26,250
4 35,000
35,000 0.68 23,800
5 35,000
35,000 0.62 21,700
Total $7,493
Conclusion: Based on this analysis, the NPV for the project is positive, suggesting that the project would be a good investment.
3.12 Net Present Value. A company has four project investment alternatives. The required rate of return on projects is 20%, and inflation is projected to remain at 3% into the foreseeable future. The pertinent information about each alternative is listed in the following chart:
Project Carol Year Investment Revenue Streams
0 $500,000 0
1 50,000
2 250,000
3 350,000
Project George Year Investment Revenue Streams
0 $250,000 0
1 75,000
2 75,000
3 75,000
4 50,000
Project Thomas Year Investment Revenue Streams
0 $1,000,000 0
1 200,000
2 200,000
3 200,000
4 200,000
5 200,000
6 200,000
Project Anna Year Investment Revenue Streams
0 $75,000 0
1 15,000
2 25,000
3 50,000
4 50,000
5 150,000
Which project should be the firm’s first priority? Why? If the company could invest in more than one project, indicate the order in which it should prioritize these project alternatives.
Solution:
Project Carol
Year Inflows Outflows Net flow Discount Factor NPV
0
500,000 (500,000) 1.000 (500,000)
1 50,000
50,000 0.81 40,500
2 250,000
250,000 0.66 165,000
4 350,000
350,000 0.54 189,000
Total $(105,500)
Project George
Year Inflows Outflows Net flow Discount Factor NPV
0
250,000 (250,000) 1.000 (250,000)
1 75,000
75,000 0.81 60,750
2 75,000
75,000 0.66 49,500
3 75,000
75,000 0.54 40,500
4 50,000
50,000 0.44 22,000
Total $(77,250)
Project Thomas
Year Inflows Outflows Net flow Discount Factor NPV
0
1,000,000 (1,000,000) 1.000 (1,000,000)
1 200,000
200,000 0.81 162,000
2 200,000
200,000 0.66 132,000
3 200,000
200,000 0.54 108,000
4 200,000
200,000 0.44 88,000
5 200,000
200,000 0.36 72,000
6 200,000
200,000 0.29 58,000
Total $(380,000)
Project Anna
Year Inflows Outflows Net flow Discount Factor NPV
0
75,000 (75,000) 1.000 (75,000)
1 15,000
15,000 0.81 12,150
2 25,000
25,000 0.66 16,500
3 50,000
50,000 0.54 27,000
4 50,000
50,000 0.44 22,000
5 150,000
150,000 0.36 54,000
Total $56,650
Conclusions: The only project worth investing in is Project Anna, because it is the only project with a positive projected NPV. Each of the other three will not pay back the initial investment due to the high cost of capital (discount rate) the firm uses.
3.13 Portfolio Management. Crown Corporation is interested in expanding its project portfolio. This firm, which specializes in water conservation and land reclamation projects, anticipates a huge increase in the demand for home fuel cells as an alternative to current methods of energy generation and usage. Although fuel-cell projects involve different technologies than those in which Crown currently specializes, the profit potential is very large. Develop a list of benefits and drawbacks associated with this potential expansion of Crown’s project portfolio. In your opinion, do the risks outweigh the advantages from such a move? Justify your answer.
Solution:
This question is intended to get students to think creatively about implications of new project ventures, particularly given the organization’s current project portfolio. Sometimes ideas seem to make sense, but instructors should question how these alternative ideas will fit within the current portfolio? What will be the benefits and drawbacks from expanding a portfolio into new areas of technology or outside of the organization’s current range of expertise? Lastly, the TOWS matrix from the chapter can be a useful way of asking students to develop a simple classification matrix for current projects and potential new ones. There are no right or wrong answers to this question; the key is getting students to recognize both benefits and drawbacks from their suggested solution.
You could also offer a simple portfolio consisting of some examples, such as bread and butter, pearls, oysters, and white elephant projects. How would they conceive of the new fuel cell opportunity fitting into such a portfolio? What type of project category do they think the fuel cell project would be? Why? These are questions that can encourage students to apply creativity to their answers.
3.14 Project Screening. Assume you are the IT manager for a large urban health care system. Lately you have been bombarded with requests for new projects, including system upgrades, support services, automated record keeping, billing, and so forth. With an average of 50 software and hardware support projects ongoing at any point in time, you have decided that you must create a system for screening new project requests from the various departments within the health care system. Develop a project selection and screening system similar to GE’s Tollgate process. What elements would you include in such a system? How many steps would you recommend? At what points in the process should “gates” be installed? How might a tollgate system for a software development company differ from one used by an architectural firm specializing in the development of commercial office buildings?
Solution:
This question is intended to get the students to consider how an organization can create decision gates to better screen project opportunities, develop prioritization schemes, and so forth. It is particularly useful to get students to identify a number of reasonable decision gates at which point the projects should be reviewed. A key element in this discussion is for students to realize that just because a project was originally accepted, it does not necessarily follow that it should be pursued to completion, depending upon various environmental factors that may render the project no longer necessary. Again, in developing these decision gates, the instructor should try to get students to think of reviews for ongoing projects, as well on new opportunities. What types of questions should be asked at each stage? What about sunk costs? Should that factor into the decision to maintain the project?
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