Project Selection & Models

Provided By: Professor Altaf Jalil Date: 09.03.2009 BBA-11th Bach (Section: B)

Meaning of Project Selection

Project selection is the process of evaluating individual projects or groups of projects and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. This same systematic process can be applied to any area of the organizations business in which choices must be made between competing alternatives. For example: a manufacturing firm can use selection techniques to choose which machine to adopt in a part-fabrication process. Project selection is only one of many decisions associated with project management. Project selection models may be quite simple to understand or they may be extremely complex.

Criteria of Project Selection Model

The proper selection of investment projects is crucial to the long run survival of every firm. Daily we whiteness the result of both good and bad investment choices. Project selection models can be used to increase profits, select investments for limited capital resources, or improve the competitive position of the organization. So, when a firm chooses a project selection model, the following criteria are most important-

1. Realism: The model should reflect the reality of the managers decision solution, including the multiple objectives of both the firms and its managers. Without a common measurement system, direct comparison of different of different projects is impossible. The model should take into account the realities of the firms limitations or facilities, capital, personnel etc. 2.Capability: The model should be sophisticated enough to deal with multiple time periods, simulate various situations both internal and external to the project and optimize the decision. An optimizing model will make the comparisons that management deems important, consider major risks and constraints. 3.Flexibility: The model should have the ability to be easily modified or to be selfadjusting in response to changes in the firms environment. For example: tax laws changes, new technological advancements alter risk levels. 4.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 unavailable equipment.

5.Cost: Data gathering and modeling costs should be low relative to the cost of the project and must surely be less than the potential benefits of the project. 6.Easy computerization: It must 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.

Preparatory Steps in Using Selection Model

It is important to remember that numbers may represent the qualities of a project and that subjective measures are not necessarily less useful or reliable than so-called objective measures. The preparatory steps include1.Firms objectives: the model must evaluate potential projects by the degree to which they will meet the firms objectives. To construct a selection model it is necessary to develop a list of the firms objectives. The list should go beyond the typical clichs about survival and maximizing profits, which are certainly real goals. Other objectives might include- maintenance of share of specific markets, development of image, decries tin sensitivity to business cycles, maintenance of employment and system.

2.Weight: when the list of objectives has been developed, the elements in the list should be weighted. Each item is added to the list because it represents a contribution to the success of the organization. The weight reflects different degrees of contribution of each element makes in accomplishing a set of goods. 3.Probable Impacts Of The Project: The probable contribution of each project to each project to each of the goals must be estimated. A project is selected on rejected because it is predicted to have certain outcomes if implemented. These outcomes are expected to contribute to goal achievement.

Types of Project Selection Models

There are two types of project selection models- nonnumeric models and numeric models.

1. Nonnumeric models are as follows:

(a) The Sacred Cow: In this case the project is suggested by a senior or powerful official in the organization. The project is sacred in the sense that it will be maintained until successfully concluded, or until the boss, personally, recognizes the idea as a failure and terminates it.

(b) The Operating Necessity: If a flood is threatening the plant, a project to build a protective dike does not require much formal evaluation, in an example of this scenario. If the project is required in order to keeps the system operating and if the system worth saving the estimated cost of the project, project cost will be examined to make sure they are kept as low as is consistent with project success, but the project will be funded. (c) The Competitive Necessity: Although the planning process for the project was quite sophisticated, the decision to undertake the project was based on a desire to maintain the companys competitive position in the market. (d) Product Line Extension: In this case, a project to develop and distribute new products would be judge on the degree to which it fits the firms existing product line, fills a gap, strengthens a weak line, or extends the line in a new, desirable direction. (e) Comparative Benefit Model: For this situation assume that an organization has many projects to consider. Senior manager would like to select a subset of the project that would most benefit the firm, but the projects do not seem to be easily comparable.

2. Numeric Models:
Numeric models are classified into two heads these are namely(a) Profitability (b) Scoring. (a) Profitability: These are as follows> Payback period: The payback period for a project is the final initial fixed investment in the project divided by the estimated annual cash inflows from the project. The method has some merits and demerits: Merits: 1. It is easy to calculate 2. It is simple to understand 3. This method is an improvement over the APR approach Demerits: 1. It is completely ignores all cash flows after the payback period 2. This can be very misleading in the capital budgeting evaluations 3. It ignores time value of money 4. It considers only the recovery period as a whole

>Average Rate of Return: The ARR is the ratio of the average annual profit to the initial or average inve3stment in the project. This method has also some merits and demerits. Merits: 1. It is easy to calculate 2. It is simple to understand & use 3. Total benefits associated with the project are taken into account Demerits: 1. The earnings calculations ignore the reinvestment potential of a project benefits 2. It does not take into account the time value of money 3. This method does not take into consideration any benefits which can accrue to the firm form the sale >Net Present Value Method: It may be described as the summation of the PV of cash inflow in each year minus the summation of PV of new cash out flows in each year.

Merits: 1. It recognizes the time value of money 2. It considers total benefits arising out of the proposal over its lifetime 3. This method is useful for selection of mutually exclusive projects Demerits: 1. It is difficult to calculate 2. It is difficult to understand & use 3. This method does not give suitable results in care of two projects having different effective lives >Internal Rate of Return: It is the rate of results that a project earns. It is defined as the discount rate (r) which makes NPV zero. Merits: 1. It considers time value of money 2. It is easier to understand 3. It takes into account the total cash inflows & outflows 4. It is consistent with the overall objective of maximizing shareholders wealth

Demerits: 1. It involves tedious calculations & complicated computational problems 2. It produces multiple rates which can be confusing 3. The reinvestment rate assumption under IRR method is very unrealistic >Profitability Index: It is known as benefit- cost ratio, the PI is the net present value of all future expected cash flows divided by the initial cash investment. If this ratio is greater than 1.0, the project may be accepted. Merits: 1. It satisfies almost all the requirements of a sound investment criterion 2. It considers all the elements of capital budgeting such as- the time value of money, totally of benefits and so on 3. It is a sound method of capital budgeting Demerits: 1. It is more difficult to understand 2. It involves more computation than the traditional method

(b) Scoring: The scoring models are as follows>Unweighted 0-1 Factor Model: A set of relevant factors is selected by management and usually listed in a preprinted form. One or more rates score the project on each factor, depending on whether or not it qualifies for an individual criterion. The raters are chosen by senior managers. >Unweighted Factor Scoring Model: The disadvantage of unweighted 0-1 factor model helps to evaluate another model that is unweighted factor scoring model. Here the use of a discrete numeric scale to represent the degree to which a criterion is satisfied is widely accepted. >Weighted Factor Scoring Model: When numeric weights the relative importance of each individual factor are added, we have a weighted factor scoring model. Merits of Scoring Model: 1.These models allow multiple criteria to be used for evaluation & decision making, including profit/profitability models and both tangible and intangible criteria. 2.They are structurally simple and therefore easy to understand and use. 3.They are a direct reflection of managerial policy.

4.They are easily altered to accommodate changes in the environment or managerial policies. 5.Weighted scoring models allow for the fact that some criteria are more important than others. 6.These models allow easy sensitivity analysis. The trade-offs between the several criteria are readily observable. Demerits of Scoring Model: 1.The output of a scoring model is strictly a relative measure. Project scores do not represent the value or utility associated with a project and thus do not directly indicate whether or not the project should be supported. 2.In general, scoring models are linear in form and the elements of such models are assumed to be independent. 3.The case of use of these models is conducive to the inclusion of a large number of criteria which may have a very little impact on the total project impact. 4.Unweighted scoring models assume all criteria are of equal importance, which is almost certainly contrary to fact. 5.To the extent that profit/profitability is included as an element in the scoring model.

Choosing A Project Selection Model

Selecting the type of model to aid the evaluation/selection process depends on the philosophy & wishes of management. There are some issues that should be considering for selecting a model. These are as follows: *First the model should be allow the multiple objectives of all organizations to be reflected in the important decision about which projects will be supported & which will be rejected. *Secondly the model should be easily adapted to changes in managerial philosophy or changes in the environment. *Third the model should not be suffered from the bias toward the short run that is inherent in probability models that discount future cash flows.

Special Care Should be Taken in Project Selection Models

For selecting a suitable model the company must be alert about the data which are collected from an accounting data base and other sources. So, here three special problems affecting the data used in project selection models:

1. Comments on accounting data: Whether managers are familiar with

accounting systems or not, they can find it useful to reflect on the methods and assumptions used in the preparation of accounting data. Among the most crucial are the following: > Accountants are live in a linear world. With few exceptions, cost and revenue data are assumed to vary linearly with associated changes in inputs and outputs. > The accounting system often provides cost-revenue information that is derived from standard cost analysis and assumption regarding revenues. These standards may or may not be accurate representations of the cost revenue structure.

2. Comments on measurement: If a performance characteristics cannot be

measured directly as a number, it may be useful to characterize cannot be measured directly as a number, it may be useful to characterized performance verbally and then through a word or equivalency scale use the numeric equivalents of verbal characterizations as model inputs.

3.Comments on technological shock: If the parent organization is not

experienced in the type of the project being considered for selection, performance measures such as time to installation, time to achieve 80% efficiency, cost to install and the like are often underestimated. It is interesting to observe that an almost certain immediate result of installing a new, cost-saving technology is that cost rise.

Requirements for Project Proposal

It is appropriate to consider what documentation is needed to evaluate a project that is being considered. The set documents submitted for evaluation is called the project proposal. For preparing project proposals the important factors areTechnical Approach Implementation Plan Logistic Support & Administration Past Experience

Project Proposal

Technical Approach: The proposal begins with a general description of the problem to be addressed. If the problem is complex, the major sub-systems of the problem or project are noted together with organizations approach to each. The presentation is in sufficient detail that a knowledge reader can understand what the propose intends to do. If there is any special client requirements that also include in the proposal. The implementation Plan: The implementation plan for the project contains estimates of the time required, the cost and the material used. Each major sub-system of the project is listed along with estimates of its cost. The plan for Logistic Support & Administration: The proposal includes a description of the ability of the proposer to supply the routine facilities, equipment & skills needed during any project. Another thing also important that is the proposal contains a section explanation how the project will be administrated. Past Experience: All proposals are strengthened by including a section that describes the past experience of the proposing group. It contains a list of key project personnel together with their titles & qualifications. For outsider clients, a full resume of each principal should be attached to the proposal.

Conclusion
Project management refers to the means, techniques and concepts used to run a projects and achieve its objectives. Before getting Involve in managing a certain project organization has to select the best project. For selecting the best project a project manager can use different project selection models. Project selection models c an be used to increase profits, select investments for limited capital resources, or to improve the competitive position of the organization. They can be used for ongoing evaluation as well as initial selection and thus are a key to allocation and reallocation of the organizations scarce resources. This term paper initiated our discussion of the project management process by describing procedures for evaluating and selecting project. We first outlined some criteria for project selection model and then discussed the general nature of these models. We also point out the different types of models in use and their advantages and disadvantages. Selection models concerned with risk and uncertainty. So, project manager should be concerned before choosing a selection model among the alternatives for ensuring that the best project will be selecting for the organization.

CASE
A firm whose cost of capital is 10% in considering two mutually exclusive projects X & Y. The details of which are : Project X 75,000 10,000 20,000 30,000 45,000 60,000 Project Y 75,000 50,000 40,000 20,000 10,000 10,000

Investment Cash inflow

Year-1 Year-2 Year-3 Year-4 Year-5

Requirements to Calculate: 1.(a) Payback Period (b) NPV (c) PI (d) IRR 2. Which Project will You Accept & Why?

Solution 1. (A) Calculation of PBP: The pay back period would be fraction more than 3 year in the case of project X & 1 year in the case of project Y Project X Project Y
3 years

75000-60000 45000

3 years

75000-60000 45000

= 3.33 Years

1.625 Years

(B)

Calculation of NPV: Project X CFAT 10000 20000 30000 45000 60000 PV 10% 0.909 0.826 0.751 0.683 0.621 PV 9090 16520 22530 30735 37260
116135

Project Y Year 1 2 3 4 5 CFAT 50000 40000 20000 10000 10000 PV 10% 0.909 0.826 0.751 0.683 0.621 PV 35450 33040 15020 6830 6210
106550

Year 1 2 3 4 5

Total
So, NPV =116135-75000 = 41135

Total
NPV =106550-75000 =31550

(C) Calculation of PI:

Project X
=
PV of Cash inflow PV of Cash Outflow 116135 75000

Project Y
=
PV of Cash inflow PV of Cash Outflow 106550 75000

1.54

1.42

(D) Calculation of IRR: a. Calculation of fake pay back period

Project X
=
NCO ACAFT

Project Y
=
NCO ACAFT

75000 33000

75000 26000

= 2.27 years

= 2.88 years

Project X

Project Y

b. Trial by Year 1 2 3 4 5 CFAT 10000 20000 30000 45000 60000

34% PV 34% 0.746 0.557 0.416 0.310 0.231 PV 7460 11140 12480 13950 13860
58890

22% Year 1 2 3 4 5 CFAT 50000 40000 20000 10000 10000 PV 22% 0.820 0.672 0.551 0.451 0.370 PV 41000 26880 11020 4510 3700
87110

Total
Project X

Total
Project Y

NPV = 58890-75000 = (16110)

NPV = 87110-75000 = 12110

Project X

Project Y

c. Trial by (2nd time) Year 1 2 3 4 5 CFAT 10000 20000 30000 45000 60000

24% PV 24% 0.806 0.650 0.524 0.423 0.341 PV 8060 13000 15720 19035 20460
76275

40% Year 1 2 3 4 5 CFAT 50000 40000 20000 10000 10000 PV 40% 0.714 0.510 0.364 0.260 0.186 PV 35700 20400 7280 2600 1860
67840

Total
Project X

Total
Project Y

NPV = 76275-75000 = 1275

NPV = 67840-75000 = (7160)

d. By using interpolation formula:

Project X
IRR = A +
C C-D

Project Y
(B-A) IRR = A +
C C-D

(B-A)

= 24% +
= 24.73%

1275 (34%-24%) 1275+16110

= 22% +
= 33.31%

12110 (40%-22%) 12110-7160

Decision
Here we accept the project X because it cover its initial investment (payback period) is very quickly. Project X NPV also greater than project Y and finally its IRR percentage rate is closer the given percentage. Thats why we choose the project x rather than project Y.