AD 642 Project Selection Strategies and Portfolios Sources

AD 642 Project Selection Strategies and Portfolios Sources: Gray / Larson | Alan Probst, Uwisc | Rodney Noehme

Why Project Managers Need to Understand the Strategic Management Process • Changes in the organization’s mission and strategy – Project managers must respond to changes with appropriate decisions about future projects and adjustments to current projects. – Project managers who understand their organization’s strategy can become effective advocates of projects aligned with the firm’s mission. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Graw. Hill/Irwin 2– 2

The Strategic Management Process: An Overview • Strategic Management – Provides theme and focus of the future direction for the firm. • Responding to changes in the external environment— environmental scanning • Allocating scarce resources of the firm to improve its competitive position—internal responses to new action programs – Requires strong links among mission, goals, objectives, strategy, and implementation. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Graw. Hill/Irwin 2– 3

Strategic Management Process (cont’d) Four of Activities of the Strategic Management Process 1. Review and define the organizational mission. 2. Set long-range goals and objectives. 3. Analyze and formulate strategies to reach objectives. 4. Implement strategies through projects Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Graw. Hill/Irwin 2– 4

Strategic Management Process Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. FIGURE 2. 1 Mc. Graw. Hill/Irwin 2– 5

Characteristics of Objectives S Specific Be specific in targeting an objective M Measurable Establish a measurable indicator(s) of progress A Assignable Make the objective assignable to one person for completion R Realistic State what can realistically be done with available resources T Time related Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi EXHIBIT 2. 1 n 2– 6

Project Portfolio Management Problems • The Implementation Gap – The lack of understanding and consensus on strategy among top management and middle-level (functional) managers who independently implement the strategy. • Organization Politics – Project selection is based on the persuasiveness and power of people advocating the projects. • Resource Conflicts and Multitasking – The multiproject environment creates interdependency relationships of shared resources which results in the Mc. Gra starting, stopping, and restarting projects. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. w. Hill/Irwi n 2– 7

Benefits of Project Portfolio Management • Builds discipline into project selection process. • Links project selection to strategic metrics. • Prioritizes project proposals across a common set of criteria, rather than on politics or emotion. • Allocates resources to projects that align with strategic direction. • Balances risk across all projects. • Justifies killing projects that do not support organization strategy. • Improves communication and supports agreement on project goals. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi EXHIBIT 2. 2 n 2– 8

Portfolio of Projects by Type Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi FIGURE 2. 2 n 2– 9

A Portfolio Management System Selection Criteria Financial: payback, net present value (NPV), internal rate of return (IRR) Non-financial: projects of strategic importance to the firm. Multi-Weighted Scoring Models Use several weighted selection criteria to evaluate project proposals. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 10

Financial Models • The Payback Model – Measures the time it will take to recover the project investment. – Shorter paybacks are more desirable. – Emphasizes cash flows, a key factor in business. – Limitations of payback: • Ignores the time value of money. • Assumes cash inflows for the investment period (and not beyond). • Does not consider profitability. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 11

Financial Models (cont’d) • The Net Present Value (NPV) model – Uses management’s minimum desired rate-of-return (discount rate) to compute the present value of all net cash inflows. • Positive NPV: the project meets the minimum desired rate of return and is eligible for further consideration. • Negative NPV: project is rejected. Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 12

Net Present Value (NPV) and Internal Rate of Return (IRR): Example Comparing Two Projects EXHIBIT 2. 3

Time Value of Money • Money’s value changes over time • A dollar today is worth more than a dollar tomorrow • When time value is considered, the cost-effectiveness of a project can change

Today’s dollar is worth more because: • Interest rates $100 you invest at a 4% interest rate today will be worth $104 in 1 year, thus making today’s money worth more • Inflation You purchase 20 items today at $1. 00 each for $20. 00 After one year, due to inflation, those same items cost $1. 50 each and you can only purchase 13. 33 of that same item with our $20. 00. Thus, today’s money is worth more.

Value of Money Over Time Future Value Measures what today’s money would be worth at a specified time in the future assuming a certain discount rate Present Value Measures what money at a specified period of time in the future would be worth if valued in terms of today’s money

Discount Rate • The rate used in calculating the present value of expected yearly benefits and costs • Used to reflect the time value of money • The higher the discount rate, the lower the present value of future cash flows

Real vs Nominal Discount Rates A nominal discount rate that reflects expected inflation should be used to discount nominal benefits and costs Market interest rates are nominal interest rates

Real vs. Nominal Rate The nominal rate is the real discount rate adjusted to eliminate the effect of expected inflations should be used to discount constant-dollar or real benefits and costs A real discount rate can be approximated by subtracting expected inflation from a nominal interest rate

Real Discount Rate (1+ Nominal Interest Rate) = (1 + Real Interest Rate) * (1 + Inflation rate)

Free Cash Flows Free Cash Flow is a measure of cash flow remaining after all expenditures required to maintain the operation

Future vs Present Value • Future Value = Present Value X (1+discount rate) raised to a power of the number of years • Present Value = Future Value/ (1+discount rate) raised to a power of the number of years

Example Future value of 100 of today’s dollars in five years. 100 X (1. 0 +. 04)5 = 121. 67 where. 04 is the discount rate.

Example Present Value of 100 dollars five years in the future. 100 / (1. 0 +. 04)5 = $82. 19

Would you rather pay $15, 000 now for a year’s worth of your newborn’s education or $30, 000 eighteen years from now?

Present value of $30, 000 eighteen years into the future + 30000 divided by (1+. 04)18 = $14, 809

So why is this important? Understanding the time value of money can help you identify misconceptions about real costs and benefits of projects or courses of action

• Future value, present value, and discount rates are used to determine Net Present Value • Net Present Value is a component of Cost Benefit Analysis • Net Present Value is a criterion for deciding whether a government program can be justified on economic principles.

Net Present Value (NPV) • NPV is the future stream of benefits and costs converted into equivalent values today • Programs with a positive NPV are generally cost effective • Programs with negative NPV are generally not cost effective

Calculating NPV • Assign monetary values to benefits and costs • Discount future benefits and costs using an appropriate discount rate • Subtract the sum total of discounted costs from the sum total of discounted benefits

Project Example Project A produces $5, 000 of revenue in 2006 Project B produces $5, 200 of revenue in 2007 Which is the more fiscally sound project?

Project Example • You cannot directly compare two different years without discounting • 2006 is Present Value • 2007 is Future Value

Project Example § You must find the PRESENT VALUE of Project B in 2006 to compare § Since this is a government project, we’ll use 4. 5% interest on a US Treasury Bond as the Discount Rate

Project Example • The PRESENT VALUE of Project B is determined by: $5, 200 / (1+ 0. 045) = $4, 976 NPV = $4, 976

Project Example After discounting, the present value of : Project A Project B = = $5, 000 $4, 976 Choose Project A

Real World Example New County Historical Society & Museum Construction cost: $10, 000 Visitor ticket: $15 Annual expected visitors Expected growth of visitors horizon) 12% (for 10 year Annual maintenance costs $10, 000 w/7% growth Annual repair expenses Discount rate Depreciation Capital Expenditure $300, 000 Inventory, etc. $5, 000 w/5% growth 56, 700 $5, 000 w/7% growth Bond Rate) 4. 85% (10 yr Treasury $285, 714 w/5% growth

Real World Example For each year of payback of 10 year project: Projected revenues – annual maintenance and repair expenses = Benefits Add benefits + depreciation Subtract capital expenditure for the year and change in working capital to get Free Cash Flows/(1+. 0485) to the power of the year number (1 -10) for Present Value of Cash Flows (PVCF) Total of ten year’s PVCF – Cost of Construction = NPV this project is $249, 758; generally cost effective

Real World Example HOWEVER, if you decrease the expected growth rate in paying visitors from 12% to only 5% the entire picture changes With only a 5% expected increase, using the same formula, our NPV result is a negative ($2, 698, 349), a major loss and commonly viewed as not costeffective

Introduction to Real Options Traditional NPV analysis usually does not address the decisions that managers have after a project has been accepted. In reality, capital budgeting and project management is typically dynamic, rather than static in nature. Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. Real option analysis incorporates typical NPV budgeting analysis and also incorporates opportunities resulting from managers’ decisions. 8 -39

Real options and decision trees, an example A new proposed project would cost $500 now (t=0) in order to explore the project’s feasibility. Next year, it will cost an additional $1500 at t=1 upon final acceptance, and is expected to produce cash flows in years 2 through 6 (from t=2 to t=6). Our current (t=0) forecast for cash flows CF 2 through CF 6 is: 70% probability of $1000 per year 30% probability of $400 per year Next year (t=1), we will know cash flows CF 2 through CF 6 with certainty; they will be either $1000 or $400 per year. 8 -40

Traditional or static NPV Calculate the expected cash flows CF 2 through CF 6 E(CF) = (0. 70)(1000) + (0. 30)(400) = $820 per year A time line of expected cash flows is shown below. 8 -41

Traditional or static NPV • Now calculate the NPV of the project’s timeline. • This project’s NPV consists of the following items: – $500 spent today – $1500 spent at t=1 – Five expected cash flows of $820 each from t=2 to t=6 (a n=5 year annuity). The PV annuity formula produces a value for t=1, which must be discounted by n=1 years from t=1 to t=0. 8 -42

Traditional or static NPV This estimated NPV of $585. 884 is incomplete. It assumes the continuation of the project from t=0 to termination at t=6 if the project is accepted today. All we have is the NPV of expected future cash flows, ignoring the option to abandon the project. In reality, if $500 is spent today, then next year at t=1, the firm has the option to either spend $1500 to continue, or abandon the project. The decision at t=1 to continue or abandon depends on whether CF 2 to CF 6 are then known to be $1000 or $400 per year. If the project is believed to be negative NPV at t=1, then it will be cancelled at that time. 8 -43

NPV including the option to abandon When the $1500 expenditure is made at t=1, we know if CF 2 through CF 6 is either $1000 or $400 per year. We first calculate the project’s NPV 1, for CF 1 through CF 6 being $1000 per year. We deem this as the success NPV. From today’s (t=1) perspective, this success NPV has a p=70% chance of occurring. 8 -44

NPV including the option to abandon Next we calculate the project’s NPV 1, for CF 1 through CF 6 being $400 per year. We deem this as the failure NPV. From today’s (t=1) perspective, this failure NPV has a p=30% chance of occurring. 8 -45

NPV including the option to abandon What is today’s (t=0) decision, based on this new scenario analysis of next year’s likelihood of p=70% success and p=30% failure? NPV 0 = -500 + (0. 7)[success NPV 1/(1+r)] + (0. 3)[failure NPV 1/(1+r)] We will not go forward next year with negative NPV 1, therefore the failure NPV 1 is ZERO, as the project will just be cancelled at t=1 if CF 2 through CF 6 are then known to be $400 per year. PV 0 = -500 + (0. 7)[1852/(1+0. 15)] + (0. 3)[0] = $627. 399 8 -46

NPV including the option to abandon Note that this dynamic NPV=$627. 399 is greater than the earlier static NPV=$585. 884. The $41. 52 difference is the value of the option to abandon. A decision tree of the project is shown below. 8 -47

Second example of incorporating the option to abandon A project has a k=10% cost of capital. If accepted, the project costs $1100 today at t=0. Next year, at t=1, we will know whether or not the project is actually a success or failure. Today at t=0, all we know are the probabilities of future success or failure. Success: probability=50%, and the project will generate cash flows of $180 per year forever (perpetuity) if a success. Failure: probability=50%, and the project will generate cash flows of $30 per year forever (perpetuity) if a failure. Project X can be abandoned at t=1 for $500 salvage value. CFs here are perpetuities. The PV of a perpetuity is always PV=CF/r 8 -48

Second example, NPV while ignoring the option to abandon Expected annual CF = (p success)(180) + (p failure)(30) = (0. 5)(180) + (0. 5)(30) = $105 The expected cash flow is $105 per year forever. NPV 0 = -1100 + 105/0. 1 = -1100 + 1050 = -$50 If treated as a project that is allowed to continue forever after t=0 acceptance, the expected NPV is negative. Under this type of analysis (ignoring the abandonment option), the project should be rejected. 8 -49

Second example A tree diagram of the project is shown below. There are really two NPVs for this project; one for success and one for failure, each with a probability of 50%. Success, p=50% CF = $180/year, forever, PV 0 = 180/0. 1 = $1800 Investment costs $1100 today Failure, p=50% CF = $30/year, forever, PV 0 = 30/0. 1 = $300 Or abandon at t=1 for $500 8 -50

Second example • The first timeline shows the project, if successful and, of course, never abandoned. • The second timeline shows the project, if an eventual failure and not abandoned. • The third timeline shows the project, if known to be a failure at t=1 and abandoned at t=1 for $500 (the project’s t=1 cash flow will be earned). t=0 CF 0 = -1100 t=1 t=2 CF 1 = 180 CF 2 = 180 t=1 t=2 CF 1 = 30 CF 2 = 30 t=1 CF 1 = 30 + 500 salvage 8 -51

Second example NPV 0 (if success) = -1100 + 180/0. 1 = -1100 + 1800 = $700 NPV 0 (if failure): this issue must be further addressed in detail. Either the project can be continued at t=1 or it can be abandoned and the assets sold for $500 salvage value. First, calculate the NPV 0 if as though the project is continued in operation as a failure with the $30 annual cash flows: Failure NPV 0 = -1100 + 30/0. 1 = -1100 + 300 = -$800 8 -52

Second example Now investigate abandoning the project at t=1 if we realize it is a failure. At t=1 one cash flow (the only project cash flow since the project is then cancelled) of $30 is received and then the assets are sold for $500. This abandon upon failure NPV 0 is thus: NPV 0 = -1100 + 30/(1+0. 1) + 500/(1+0. 1) = -1100 + 481. 18 = $618. 18 if abandoned at t=1. If a failure at t=1, the abandonment NPV is higher than the NPV if allowed to continue. 8 -53

Second example If accepted today, at t=0, there is a 50% chance that the project will be allowed to operate forever, and a 50% chance that it will be abandoned for a $500 salvage value. Dynamic NPV 0 = (0. 5)[success NPV 0] + (0. 5)[failure NPV 0] Dynamic NPV 0 = (0. 5)[700] + (0. 5)[-618. 18] = $40. 91. The project should now be accepted since the NPV becomes positive when we allow for project abandonment. 8 -54

Second example The NPV 0 = –$50 if the project is treated as continuing forever after acceptance. The NPV 0 = $40. 91 when we include the decision to abandon at t=1 when the project becomes a failure. The difference between these two NPVs is called the value of the option to abandon. Value of option = 40. 91 – (– 50) = $90. 91 8 -55

Types of Real Options Investment timing options Often, the option to delay investment is valuable if market or technology conditions are expected to improve. Abandonment/shutdown options Two example were previously shown Growth/expansion options May be valuable if the demand turns out to be greater than expected Flexibility options Projects may be more valuable if an allowance is made for greater future modifications. 8 -56

Project Screening Matrix Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi FIGURE 2. 3 n 2– 57

Applying a Selection Model • Project Classification – Deciding how well a strategic or operations project fits the organization’s strategy. • Selecting a Model – Applying a weighted scoring model to bring projects to closer with the organization’s strategic goals. • Reduces the number of wasteful projects • Helps identify proper goals for projects • Helps everyone involved understand how and why a project is selected Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 58

Project Proposals • Sources and Solicitation of Project Proposals – Within the organization – Request for proposal (RFP) from external sources (contractors and vendors) • Ranking Proposals and Selection of Projects – Prioritizing requires discipline, accountability, responsibility, constraints, reduced flexibility, and loss of power. • Managing the Portfolio – Senior management input – The priority team (project office) responsibilities Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 59

Managing the Portfolio • Senior Management Input – Provide guidance in selecting criteria that are aligned with the organization’s goals – Decide how to balance available resources among current projects • The Priority Team Responsibilities – Publish the priority of every project – Ensure that the project selection process is open and free of power politics. – Reassess the organization’s goals and priorities – Evaluate the progress of current projects Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi n 2– 60

Project Screening Process Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi FIGURE 2. 5 n 2– 61

Project Portfolio Matrix Copyright © 2006 The Mc. Graw-Hill Companies. All rights reserved. Mc. Gra w. Hill/Irwi FIGURE 2. 7 n 2– 62

Project Portfolio Matrix Dimensions Bread-and-butter projects Involve evolutionary improvements to current products and services. Pearls Represent revolutionary commercial advances using proven technical advances. Oysters Involve technological breakthroughs with high commercial payoffs. White elephants Projects that at one time showed promise but are no longer viable.