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