PROJECT EVALUATIONSELECTION Project Management M Tech III Sem

PROJECT EVALUATION/SELECTION Project Management M. Tech – III Sem

Steps in project evaluation �Estimate project cash – flows. �Establish the cost of capital. �Apply a suitable decision or appraisal criterion.

PROJECT CASH FLOW

Project Cash Flow �Basic principles �Components �Example

Basic Principles �Incremental principles �Long-term funds principles �Exclusion of financial cost principles �Post-tax principle.

Incremental principles � Project cash flow for ith year = {cash flow of the firm with the project for ith year } – {cash flow of the firm without the project for ith year } � Guidelines: Ø Consider all incidental effects – profitability/loss due to the project on other activities. Ø Ignore sunk costs – already spent for preliminary works, but not directly connected to the project. (R&D, Market Research, Consultant’s Fees) Ø Include Opportunity cost – resources already available with the firm like land, equipment can be used for project with opp. Cost. Ø Allocation of Overhead: indirect expenses.

Net Working Capital �Change in Net Working Capital--Net working capital is defined as current assets minus current liabilities. �Investment in working capital is a cash outflow during the year in which investment takes place �Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

Long – term funds principle �Focused on the profitability of long term funds like equity stockholders, preference stockholders, debentures etc. , Ø The sacrifice made by suppliers of long term funds is equal to the outlays on fixed assets and net working capital. Ø Benefits: Operational cash inflows after taxes and salvage value of fixed

Exclusion of Financial Costs �The interest on long term debt is ignored, while computing profit. �The expected dividends are deemed irrelevant in cash flow analysis.

Post-tax principle �Tax must be properly deducted in deriving the cash flow. �Cost of capital is also included in posttax terms.

Components of cash flow �Initial Investment �Operating cash inflows �Terminal Cash flow

Initial Investment New Project Cost of capital assets + Installation costs + working capital Margin + preliminary and preoperative expenses – Tax shield on capital assets Replacement Project Cost of replacement capital assets + Installation costs – post tax proceeds from the sale of old capital assets + change in working capital Margin + preliminary and pre-operative expenses* – Tax shield on replacement capital assets * Usually NA for replacement projects

Operating cash inflows New Project Replacement Project Profit after Tax + Depreciation + Other non-cash charges +Interest on long term debt(1 -tax rate) Change in Profit after Tax + Change in Depreciation + Change in Other noncash charges + Change in Interest on long term debt(1 -tax rate)

Terminal Cash flows New Project Replacement Project Post tax proceeds from the sale of capital assets + Net recovery of working capital margin Post tax proceeds from the sale of replacement capital assets + Net recovery of working capital margin- Post-tax proceeds from the sale of present capital assets.

Developing Project Cash Flow Statement Cash flow statement + Net income +Depreciation Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income -Capital investment + Proceeds from sales of depreciable assets - Gains tax - Investments in working capital + Working capital recovery + Borrowed funds -Repayment of principal Operating activities + Investing activities + Financing activities Net cash flow 15

EXAMPLE

COST OF CAPITAL

Cost of Capital �Rate of return on investments for the market value of the firm to remain unaffected. �Components: ØEquity capital ØPreference capital ØLong-term debt capital �Firm’s cost of capital is the weighted arithmetic average of the post tax cost of various sources of long term finance used by it.

Conditions to evaluate new investments �Risk of new investment proposal is the same as the risk of existing investments. �Capital structure of the firm will not be affected by the investment proposal.

Miscoceptions �This concept is too academic or impractical. �Cost of equity is equal to dividend rate or return on equity. �Retained earnings are cost free/lesser than external equity. �Depreciation has no cost. �Cost of capital can be defined in terms of an accounting based measure. �If a project is heavily financed by debt , its weighted average cost of capital is low.

PROJECT SELECTION

Strategic Management and Project Selection �Maturity of Project Management �Criteria for PS Models �Nature of PS Models �Types of PS Models �Uncertainty Analysis and Risk Management �Information Base for PS Models �Project Portfolio Process (PPP) �Project Proposal

Overview of PS Process �Project Management Office (PMO): Aligning corporate needs and project goals �Project Selection: Choose candidate project using Evaluation Criteria �Dealing with Uncertainty: Risk Analysis �Strategically selecting best Projects: Project Portfolio Process (PPP) �Locking up the deal: Writing a Project Proposal

PS Models �Idealized view of reality �Representing the STRUCTURE of the problem, not the detail �Deterministic or stochastic

Criteria for Project Selection models �Realism (technical-, resource-, market-risk) �Capability (adequately sophisticated) �Flexibility (valid results over large domain) �Ease of Use (no expert needed to run model) �Cost (much less than project benefit) �Easy Computerization (use standard software)

Nature of PS models: Caveats �Project decisions are made by PM --NOT by PS model! �A PS model APPROXIMATES, but does NOT DUPLICATE reality!

Nature of PS Models: Methodology �Start with detailed list of firm’s goals �Create list of project evaluation factors (PEF’s) �Weigh every element in PEF list �Compute an overall score for project based on weighted PEF’s �Select project that has the closest alignment with firm’s goals

Project Evaluation Factors (PEFs) �Production Factors �Marketing Factors �Financial Factors �Personnel Factors �Administrative and Misc. Factors

Types of PS Models: Nonnumeric �Sacred Cow �Operating Necessity �Competitive Necessity �Product Line Extension �Comparative Benefit Model

Numeric PS Models: Profit / Profitability �Payback Period (PB) �Average Rate of Return �Discounted Cash Flow (NPV-net present value) �Internal Rate of Return �Profitability Index �Other Profitability Models

Numeric PS Models: Scoring �Unweighted 0 -1 Factor Model �Unweighted Factor Scoring Model �Weighted Factor Scoring Model �Constrained Weighted Factor Scoring Model �S = ∑(x) �S = ∑(s·w) ∏(c)

Choosing the PS Model �Dependent on wishes and philosophy of management � 80% of Fortune 500 firms choose “nonnumeric” PS models �Firms with outside funding often chose scoring PS models �Firms without outside funding often chose profit / profitability PS models

Management of Risk: Terminology �Risk: Decision based on complete information about the probability of each possible outcome. �Uncertainty: Decision based on incomplete or insufficient data. �Game: Decision based under conditions of conflict.

Areas of Uncertainty �Project timing & expected cash flow. �Direct outcome of project, i. e. what exactly will the project accomplish �Side effects and unforeseen consequences of project

Window-of-Opportunity Analysis �Estimate IN ADVANCE economic impact of innovation before R&D is undertaken �Set up a baseline of current process as the sum of all current sub processes �Compute cost / performance of new innovation as a multiple of each sub process in the baseline system

Problems Affecting Data Used in PS Models �Accounting: arbitrary assignment of overhead costs, linear cost and revenue forecasts �Measurements: (subjective vs. objective), (quantitative vs. qualitative), (reliable vs. unreliable), (valid vs. invalid) �Technology shock: New technology has to overcome initial resistance threshold.

PROJECT PORTFOLIO

Project Portfolio Process (PPP) �Step 1: Establish a Project Council �Step 2: Identify Project Categories & Criteria �Step 3: Collect Project Data �Step 4: Assess Resource Availability �Step 5: Reduce Project and Criteria Set �Step 6: Prioritize Projects within Categories �Step 7: Prioritize the projects within categories �Step 8: Implement the Process

Project Proposal: Content �Cover letter �Executive summary �Description and past experience of project team �Nature of technical problem to be solved �How to approach solution of technical problem �Plan for implementation of project �Plan for logistic support and administration

Project Proposal: Cover letter & Executive summary �Compose a cover letter as key marketing instrument �Explain fundamental nature and general benefits of project �Minimally technical language

Project Proposal: Past Experience of Project Team �List all key project personnel with titles and qualifications �Include full resume of each principal �Provide all pertinent references

Project Proposal: Technical Approach �General description of problem to be addressed or project to be undertaken �Major subsystems of problem or project �Methodology of solving the problem �Special client requirements �Test and inspection procedures

Project Proposal: Implementation Plan �Estimates of time, cost and materials for each subsystem and the whole project �Establish major milestones to break project into phases �List equipment, overhead and administrative cost �Develop contingency plans (incl. slack time)

Project Proposal: Plan for Administration and Logistic Support �Control over subcontractors �Nature and Timing of all reports (progress, budget, audits) �Change management �Termination Procedures �“touch of class” capabilities (artist’s renderings, meeting facilities, video conferencing, computer graphics)