Yarmouk University Yarmouk UniversityHijjawi Faculty For Engineering Tech Hijjawi Faculty For Engineering TechProject Management and Quality Control1Mwaffaq Otoom & Shadi AlboonLecture03OverviewWhat is project selection?What techniques are used to select projects?Project selection models and evaluation factors factors Numeric models Nonnumeric models2Lecture03Mwaffaq OtoomProject selectionProject selection is the process ofevaluating individual projects or groups ofprojects, and then choosing to implement some set ofthem so that the objectives ofthe parent organization will be achieved.3Mwaffaq Otoom & Shadi AlboonLecture03objectives ofthe parent organization will be achieved.Managers often use decision-aiding models to abstract the relevant issues about a problem from the plethora ofdetails in which the problem is embedded.Models represent the problems structure and can be useful in selecting and evaluating projects.What Projects to Bid on Company selection ofthe projects they will bid on is generally based on:Their own expertise and track recordResources they have availableTheir chance ofwinning the bid Their chance ofwinning the bid They do not want to waste that effort on bids where they are unlikely to be successful Preparing a bid is expensive!4Lecture03Mwaffaq Otoom & Shadi Alboon Criteria for Project Selection Each project has different risks, benefits and costs often much uncertainty. Companies need to be able to evaluate and select those projects that most closely fit the firms strategic objectives always done in the context ofcompeting for limited resources.5Lecture03Mwaffaq Otoom & Mohammad Al Batainehin the context ofcompeting for limited resources. Why Project Selection Models? Models abstract the relevant issues about a problem from the plethora ofdetails in which the problem is embedded (Model is a representative ofthe reality, not the exact replica (reality is more complex) Models help make rational decisions (Models do not make decisions, people do)Criteria for Project Selection Models When a firm chooses a project selection model, the following criteria are most important: Realism The model should take into account the realities ofthe firms limitations on facilities, capital, personnel, and so forth. Capability- The model should be sophisticated enough to deal with multiple time periods, simulate various situations both internal and external to the project (e.g., strikes, interest rate changes), and optimize the decision. Flexibility The model should have the ability to be easily modified, or to be Flexibility The model should have the ability to be easily modified, or to be self-adjusting in response to changes in the firms environment (e.g. tax laws change, new technological advancements alter risk levels, and, above all, the organizations goals change). Ease ofUse - The model should be reasonably convenient, not take a long time to execute, and be easy to use and understand. Cost - Data-gathering and modeling costs should be low relative to the cost ofthe project. Easy Computerization It must be easy and convenient to gather, store and manipulate data in the model.6Lecture03Mwaffaq Otoom & Mohammad Al BatainehNature ofProject Selection Models Two basic types ofproject selection models: Numeric models (Use financial metrics such as cash flow, profit etc.) Nonnumeric models (do not use numbers as inputs into the model, but other data or considerations). Ifthe estimated level ofgoal achievement is sufficiently large, the project is selected. Two Critical Facts: Models do not make decisions - People do!A model helps in making project selection decisions. All models, however sophisticated, are only partial representations ofthe reality they are meant to reflect (Reality is far too complex for us to capture more than a small fraction ofit in any model. )7Lecture03Mwaffaq Otoom & Mohammad Al BatainehProject Evaluation Factors Production Factors Interruptions, learning, process Marketing Factors Customer management issues Financial Factors Return on investment what is Return on investment what is acceptable? Personnel Factors Skills and training, working conditions what impact on employee motivation? Administrative and Miscellaneous Factors Regulatory standards, strategic fit with what?8Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh Lecture03Project Evaluation Factors Production Factors Interruptions, learning, process Marketing Factors Customer management issues Financial Factors Return on investment Return on investment what is acceptable? Personnel Factors Skills and training, working conditions what impact on employee motivation? Administrative and Miscellaneous Factors Regulatory standards, strategic fit with what?9Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh Lecture03Numeric models Models that return a numeric value for a project that can be easily compared with other projects Two major categories ofnumeric models:1. Profit/profitability(considered the sole measure ofproject acceptability)2. Scoring (multiple criteria for project evaluation/selection are used)10Lecture03Mwaffaq Otoom & Mohammad Al BatainehNumeric models: Profit/Profitability Models that use profitability as the sole measure ofproject acceptability there are several models: Payback Period - Initial fixed investment/estimated annual net cash inflows from the project. . Average Rate ofReturn - Average annual profit/initial or average Average Rate ofReturn - Average annual profit/initial or average investment in the project . Discounted Cash Flow - Also referred to as the Present Value Method Profitability Index Net present value (NPV) ofall future expected cash flows/initial cash investment 11Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh Lecture03Cash Inflows & OutflowsCash Inflow > Cash Outflow Positive Cash FlowCash Inflow < Cash Outflow Negative Cash FlowLecture 03 Shadi Alboon & Mohammad Al Bataineh 12Payback Period exampleProject CostPayback PeriodAnnual Cash Flow=The Payback Period = The length oftime until the original investment has been recouped (repaid) by the project net cashinflowthe number of13$100, 000Payback Period 4$25, 000= =The lower the payback period, the less the risk to which the firm is exposed. Lecture03the number ofyears required for the project to repay itsinitial fixed investmentAssuming a project costs $100,000 to implement and has annual net cash inflows of$25,000, then the payback period will beMwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh The major advantage ofthis model is its simplicity. The major disadvantage is that it does not take into account the time-value ofmoney.Payback Period Drawbacks1. Does not consider the time value ofmoney.2. More difficult to use when cash flows change over time.3. Less meaningful over longer periods oftime (due to the time value ofmoney).3. Less meaningful over longer periods oftime (due to the time value ofmoney).4. It ignores any cash flows beyond the payback period.14Lecture03Mwaffaq Otoom However, it is relatively simple to calculate & to understand.Average Rate ofReturn (ARR) The Average Rate ofReturn is the ratio ofthe average annual profit (either before or after taxes) to the initial or average investment in the project. The ARR is NOT the reciprocal ofthe payback period, because average annual profits are usually not equivalent to net cash inflows.15$15,000Average Rate of Return 0.15$100,000= =Average annual profitProject costLecture03Mwaffaq Otoom & Mohammad Al BatainehExample: Assuming that the average annual profits ofa project are $15,000, then the Average Rate ofReturn (ARR) is The major advantage ofthis model is its simplicity. The major disadvantage is that it does not take into account the time-value ofmoney.ARR ExampleMachine A Machine BCost$56,125$58,125 Annual estimated income after reduction (profit)Year 1$3,375$11,375 Year 2$5,375$9,375 Year 3$7,375$7,375 Year 4$9,375$5,375 Lecture 03Shadi Alboon & Mohammad Al Bataineh16Year 4$9,375$5,375 Year 5$11,375$3,375 Total earnings (profits) $36,875$36,875 Estimated life5 years5 years Average Annual Profit = Total earnings / Estimated life in years Machine A: $36,875/5 = $7,375 Machine B: $36,875/5 = $7,375 ARR for Machine A : 7375/56125 = 0.131 or 13.1% ARR for Machine B : 7375/58125 = 0.127 or 12.7% Machine A would be preferred as ARR is higher.Discounted Cash Flow (NPV) (Net Present Value): The current worth ofa stream offuture cash inflows and outflows in todays dollars, given a specified rate ofreturn (The rate ofreturn is also called: the Discount Rate or Hurdle Rate or CutoffRate).Widely used to evaluate projects. Widely used to evaluate projects.Includes the time value ofmoney (the value ofmoney figuring in a given amount ofinterest for a given period oftime). ($1 today>$1 in 10 years)Includes all inflows and outflows, not just the ones through to the payback point.17Lecture03Mwaffaq Otoom & Mohammad Al BatainehDiscounted Cash Flow (NPV)Requires a percentage to use to reduce future cash flows the discount rate. Discount Rate: the rate ofreturn that could be earned on an investment in the financial markets with similar risk.The discount rate may also be known as a hurdle The discount rate may also be known as a hurdle(difficulty) rate or cutoffrate.There will usually be one overall discount rate that is used as the standard for a company (set internally and used to evaluate all projects).Cash flows are likely to vary over the life ofa project.18Lecture03Mwaffaq OtoomCalculating Project NPVA : Initial cash investment (because this is an outflow,A0: Initial cash investment (because this is an outflow, it will be negative).F : The net cash flow in time period t (negative for ( )=++ =ntttkFA101(project) NPV19Ft: The net cash flow in time period t (negative for outflows)k : The required rate ofreturn (The discount rate)t : The number ofyears ofthe period considered A higher NPV is better. The higher the discount rate, the lower the NPV. Ifthe project is successful, cash flows will become positive.Lecture03Mwaffaq Otoom & Mohammad Al BatainehNPV with Inflation Rate To include the impact ofinflation (or deflation), we haveLecture 03 Mwaffaq Otoom & Mohammad Al Bataineh 20where pt : is the predicted rate ofinflation during period t. The project is acceptable ifthe sum ofthe net present values ofall estimated cash flows over the life ofthe project is positive. NPV example 1 Initial investment of$100,000 with a net cash inflow of$25,000 per year for a period of8 years, a required rate ofreturn of15%, and an inflation rate of3%per year, we have:( ) 03 . 0 15 . 0 1000 , 25 $000 , 100 $ (project) NPV8+ ++ =tMwaffaq Otoom & Mohammad Al Bataineh 21The present value ofthe inflows is greater than the present value ofthe outflow the NPV is positive. Therefore the project is acceptable!( )939 , 1 $03 . 0 15 . 0 1000 , 100 $ (project) NPV1=+ ++ == ttLecture03 A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over 12 months. This project will have an immediate (t=0) cash outflow of100,000 (which might include machinery, NPV Example 20100, 000(1 0.10)+154672(1 0.10)+239161(1 0.10)+33054(1 0.10) +47128(1 0.10) +525927(1 0.10) +628838(1 0.10) +746088(1 0.10) +877076(1 0.10) +946726(1 0.10) +1076852(1 0.10) +11132332(1 0.10) +12166047(1 0.10) +outflow of100,000 (which might include machinery, and employee training costs). The monthly net income is depicted in the income statement sheet each for months 112. All values are after-tax. The required rate ofreturn is 10%. Lecture 03A. Al-Tamimi & Mohammad Al Bataineh 22Therefore, the NPV(Project) is $65,816.04 NPV Example 30100, 000(1 0.10)+154672(1 0.10)+239161(1 0.10)+33054(1 0.10) +47128(1 0.10) +525927(1 0.10) +628838(1 0.10) +746088(1 0.10) +877076(1 0.10) +946726(1 0.10) +1076852(1 0.10) +11132332(1 0.10) +12166047(1 0.10) + The hurdle rate is 12% k = 0.12. The expected rate ofinflation to be about 3% p = 0.03..Lecture 03Mohammad Al Bataineh 23The Net Present Value ofthe project is positive and, thus, the project can be accepted.Profitability Index (PI)PI: is the net present value ofall future expected cash flows divided by the initial cash investment.PV of future expected cash flowsProfitability IndexInitail cash investment=Also known as the benefitcost ratio.As the value ofthe PI increases, so does the financial attractiveness ofthe proposed project. Rules for selection or rejection ofa project: IfPI > 1 then the project may be accepted. IfPI < 1 then the project is rejected. IfPI = 1 then this indicates breakeven ().Shadi Alboon & Mohammad Al Bataineh24Lecture 03Profitability Index: Example 1Given: Investment = $40,000. Life ofthe Machine = 5 Years. Calculate the NPV and Profitability Index (PI) at 10% 11800016363(1 0.1)=+2180009924(1 0.1)=+3180007520(1 0.1)=+4180006147(1 0.1)=+Profitability Index (PI) at 10% discount rate Lecture 03 A. Al-Tamimi & Shadi Alboon & Mohammad Al Bataineh 25Total Present Value = 16363+9924+7520+6147 = $43679Net Present Value (NPV) = -40000+43679 = $3679PI = 43679/40000 = 1.091 > 1Accept the project!Profitability Index: Example 2 Profitability Index (PI) = $65M / $50M = 1.3 Net Present Value = PV ofNet Future Cash Flows Initial Investment required A Companyis undertaking a project at a cost of$50 million which is expected to generate future cash flows with a present value of$65 million. Calculate the Profitability Index. Net Present Value = PV ofNet Future Cash Flows Initial Investment required Net Present Value = $65M-$50M = $15M.Lecture 03 Shadi Alboon 26 The information about NPV and initial investment can be used to calculate Profitability Index as follows: Profitability Index = 1 + ( Net Present Value / Initial Investment Required ) Profitability Index = 1 + $15M/$50 = 1.3Advantages ofProfitability Numeric ModelsThe undiscounted models (such as Payback Period) are simple to use and understand.Based on readily available accounting data and forecasts to determine the cash flows.12327Lecture03Mwaffaq Otoom & Shadi Alboon & Mohammad Al BataineghModel output is Familiar and well understood by business decision makers.Model outputs allow absolute go/no-go decisions, because they are based on an absolute profit/profitability scale.Some profit models account for project risk.3

Disadvantages ofProfitability Numeric ModelsThese models ignore all nonmonetary factors except risk.Models that do not include discounting ignore the timing ofthe cash flows and the timevalue ofmoney.Models that reduce cash flows to their present value are strongly 12328Lecture03Models 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.These models rely on accurate estimations ofcash flow (which can be difficult to make).These models cannot deal with a lot ofthe complexity ofthe modern firm reliance on financial data only.3

Mwaffaq Otoom & Shadi Alboon & Mohammad Al BataineghNumerical Models: Scoring ModelsScoring models attempt to overcome some ofthe disadvantages ofprobability models by incorporating additional decision criteria.Use multiple criteria to evaluate a project with a score for each criteria. score for each criteria.Vary widely in their complexity and information requirements.Some scoring models examples Unweighted 0-1 Factor Model Weighted Factor Scoring Model29Lecture03Mwaffaq Otoom & Shadi AlboonUnweighted (0-1) Factor ModelUses a set ofrelevant factors as determined by management.Each factor is weighted the same.Less important factors are weighted the same asLess important factors are weighted the same as important ones.Easy to compute - just total or average the scores.The major disadvantage is that the model assumes that all factors are equally important.30Lecture03Mwaffaq OtoomUnweighted (0-1) Factor Model Example31Lecture03Mwaffaq OtoomWeighted Factor Scoring ModelWhen numeric weights reflecting the relative importance ofeach individual factor are added ,we have a weighted factor scoring model. Weighting allows important factors to stand out.A good way to include non-numeric data in the analysis.Factors need to sum to one.All weights must be set up so higher values mean more desirable.Small differences in totals are not meaningful.32Lecture03Mwaffaq OtoomWeighted Factor Scoring ModelFor example we can give a score range (0-5) for some parameters according to certain criteria, such as the importance ofeach parameter :MeaningWeightMeaning Weight33Lecture03Shadi AlboonMeaningWeightVery high importance 5High importance 4Medium importance 3Low importance 2Very low importance 1Not important 0we can make it easier Meaning WeightVery high importance5Low importance2Not important 0Weighted Factor Scoring Model In general, the Weighted Factor Scoring Model takes the form:34Mwaffaq OtoomLecture03 The weights,, may be generated by any technique that is acceptable to the organizations policy makers (e.g. The Delphi Technique).Weighted Factor Scoring Model ExampleIllustrative Example:The choice ofan automobile for purchase (Common Problem).35Mwaffaq OtoomLecture03Weighted Factor Scoring Model Example When numeric weights have been generated, it is helpful (but not necessary) to scale the weights so that36Mwaffaq OtoomLecture03 The weights represent the relative importance ofthe criteria measured on a 10-point scale. The numbers in parentheses show the proportion ofthe total weight carried by each criterion (They add to only .99 due to rounding.)Weighted Factor Scoring Model Example37Lecture03Mwaffaq Otoom As Ritzy 300 and NeuvoEcon scores are close to each other, we might want to evaluate these two cars by additional criteria (e.g., ease ofcarrying children, status, safety features like dual airbags or ABS) prior to making a firm decision.Advantages ofthe Scoring ModelThey allow multiple criteria to be used for evaluation.Weighted models recognize that some criteria are more important than others.Structurally simple and relatively easy to understand. Structurally simple and relatively easy to understand.They are a direct reflection ofmanagement policy.Easily altered to accommodate change in management policy or priorities.They allow for sensitivity analysis, because trade-offbetween factors is easily observable.38Lecture03Mwaffaq OtoomDisadvantages ofthe Scoring ModelEase ofuse can lead to the inclusion oftoo many criteria.The output ofa scoring model is strictly a relative measure rather than an absolute go/norelative measure rather than an absolute go/no go indication.Unweighted scoring models assume all criteria are ofequal importance this is seldom the case.39Lecture03Mwaffaq OtoomSummaryPrimary selection model criteria are: realism, capability, flexibility, ease ofuse, and cost.In preparing to use a model, a firm must identify its objectives, weighting them relative to each other, andobjectives, weighting them relative to each other, and determining the probable impacts ofthe project on the firms competitive abilities.Models can be numeric or nonnumeric.40Mwaffaq OtoomLecture03Questions41 41Mwaffaq OtoomLecture03