PROJECT SELECTION AND

PORTFOLIO MANAGEMENT
Chapter 3
CHAPTER 3 (PART 1)
LEARNING OBJECTIVES
After completing this chapter, students will be able to:
1.Explain six criteria for a useful project selection/screening
model.
2.Understand how to employ checklists and simple scoring
models to select projects.
3.Use more sophisticated scoring models, such as the
Analytical Hierarchy Process.
4.Learn how to use financial concepts, such as the efficient
frontier and risk/return models.
CHAPTER 3 (PART 2)
LEARNING OBJECTIVES
After completing this chapter, students will be able to:
5.Employ financial analyses to evaluate the potential for
new project investments.
6.Recognize the challenges that arise in maintaining an
optimal project portfolio for an organization.
7.Understand the three keys to successful project portfolio
management.
8.Understand the proactive portfolio matrix.
PMBOK CORE CONCEPTS

Project Management Body of Knowledge (PMBoK) covered

in this chapter includes:
Portfolio Management (PMBoK 1.4.2)
PROJECT SELECTION

 Firms are inundated with project opportunities

 No organization has unlimited resources to work on these
opportunities
 Screening models help managers pick winners from a pool of
projects
 There two classes of screening model, Numeric (quantitative
and complex) and Nonnumeric (qualitative and simple)
 PROJECT SELECTION

The following issues (Souder 1983) should be considered when

one evaluates a screening model:
Realism: Realistic with respect to key resources and interms of risks invloved.
Reflect constraints and organizational goals
Capability: widely useable, robust enough to accommodate new criteria and
constraints (e.g. long-term vs. short-term projects, projects with different
commercial objectives etc.)

Flexibility: easy to modify, e.g. allow for adjustments due to changes in exchange
rates, tax. laws, building codes etc.

Ease of use: useable by many organizational members and easily understood

Cost effectiveness: cost effective in terms of time and money

Comparability: broad enough to be applied to multiple projects and must support

general comparisons of project alternatives.
ISSUES IN PROJECT SCREENING
AND SELECTION
1. Risk – unpredictability to the firm
a. Technical
b. Financial
c. Safety
d. Quality
e. Legal exposure
2. Commercial – market potential
a. Expected return on investment
b. Payback period
c. Potential market share
d. Long-term market dominance
e. Initial cash outlay
f. Ability to generate future business/new markets
ISSUES IN PROJECT SCREENING
AND SELECTION
3. Internal operating – changes in firm operations
a. Need to develop/train employees
b. Change in workforce size or composition
c. Change in physical environment
d. Change in manufacturing or service operations
4. Additional
a. Patent protection
b. Impact on company’s image
c. Strategic fit

All models only partially reflect reality and have both

objective and subjective factors imbedded.
APPROACHES TO
PROJECT SCREENING

Checklist model
Simplified scoring models
Analytic hierarchy process
Profile models
CHECKLIST MODEL

A checklist is a list of criteria applied to possible

projects.

✓Requires agreement on criteria

✓Assumes all criteria are equally important

Checklists are valuable for recording opinions

and stimulating discussion.
CHECKLIST MODEL (TABLE 3.2)

Project Gamma is
the best alternative
here
LIMITATIONS OF CHECKLIST
MODEL
A checklist model has flaws:

✓It is subjective
✓Fail to resolve trade-off issues

Some criteria might be more important

than the others
SIMPLIFIED SCORING MODELS

Each project receives a score that is the weighted

sum of its grade on a list of criteria. Scoring
models require:
agreement on criteria
agreement on weights for criteria
a score assigned for each criteria
Score =  (Weight  Score)
Relative scores can be misleading!
SIMPLIFIED SCORING MODELS
SIMPLIFIED SCORING MODELS
(TABLE 3.3)

Project Beta (with

a total score of 19)
is the best
alternative
LIMITATION OF SCORING MODEL

Scoring model has the following flaws:

✓It is not very accurate. We do not know by how

much (%) one weight is better than the other
✓Dependant on the relevance of the selected
criteria and accuracy of the weight

There can be issue of double counting and over-

estimation
ANALYTIC HIERARCHY PROCESS

The AHP is a four step process:

1. Construct a hierarchy of criteria and subcriteria.
2. Allocate weights to criteria.
3. Assign numerical values to evaluation dimensions.
4. Determine scores by summing the products of
numeric evaluations and weights.
Unlike the simple scoring model, these scores can
be compared!
 AHP STRUCTURING THE
HIERARCHY OF CRITERIA

Suppose, A firm’s IT steering committee has selected thee criteria for evaluating
project alternatives-

18
 Sample AHP with Rankings
for Salient Selection Criteria
(Figure 3.1)

Finance Strategy IT (14%)

(52%) (34%)
Short-term Market share
(.52x.3)=15.6 0.0816
%
Long-term Retention
(.52x.7)= 0.1564
36.4%
Cost
managemen
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 AHP: ASSIGNING NUMERICAL
VALUES

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 AHP: THE PROJECT RATING
SPREADSHIT

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LIMITATION OF AHP

AHP model has the following flaws:

✓It does not account for ‘negative utility’.

✓All criteria needs to be fully exposed and
accounted for at the beginning of the selction
process. Which powerful stakeholders of the
organization due to their own agendas may resist
PROFILE MODEL

 Allows one to plot risk vs. return options for

various projects.
 Select the project with the maximum return and
minimum acceptable risk.
 Makes use of financial management concept
called the efficient frontier.
o a set of options that offers the maximum return for a
given level of risk or the minimum risk for a level of
return.
 Profile Models
(figure 3.4)

X7
X6
Maximum
Desired Risk

X2 Criteria
selection as
Risk

X4 X5 axes

Efficient Frontier
X3 Rating each
X1 project on
criteria
Minimum Return
Desired Return
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LIMITATION OF PROFILE MODEL

Profile model has the following flaws:

✓It limits decision criteria to just two – risk and

return.
✓Risk may not be readily quantified.
FINANCIAL MODELS

 Payback period

 Net present value

 Discounted payback period

 Internal rate of return

FINANCIAL MODELS

 Based on time value of money

Time value of money means money earned today is worth
more than the money earned in the future
 For example- $10 in your hand today is worth more than the promise
of $10 in your hand in 3 years (even if it is guaranteed)
 Reasons are-
o Present consumption
o Risk-Inflation makes future dollars ($) worth less in terms of buying power
than today’s money
o Investment opportunity-Money you have today you can invest and
hopefully can make positive investment
So Money Today Is Worth More Than Money In The Future
 NET PRESENT VALUE

Projects the change in the firm’s stock value if a project is

undertaken. Positive NPV is good for company means its
adding wealth to the organization.
Positive NPV means
Ft
NPV = I o + 
(1 + r + pt ) t
firm will make
money. Higher NPV is
where better.
Ft = net cash flow for period t  Net flows: the difference
between inflows and
R = required rate of return outflows
I = initial cash investment  Discount factor (PVF): the
reciprocal of the discount
Pt = inflation rate during period t rate (1/(1+r+p)t) or (1+r+p)-t
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NET PRESENT VALUE EXAMPLE

 Assume that you are considering whether to invest or not in a

project that will cost $100,000 in initial investment. Your
company requires a rate of return of 10% and you expect
inflation to remain relatively constant at 4%. You anticipated a
useful life of four years for the project and have projected future
cash flows as follows:
Year 1: $20,000
Year 2: $50,000
Year 3: $50,000
Year 4: $25,000
 Net Present Value Example
(Table 3.8)

The NPV
column total
(table 3.6)
is positive,
so invest!

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 INTERNAL RATE OF RETURN

A project must meet a minimum rate of return before it is

worthy of consideration. We’re saying what’s the rate that will
give me the desired financial return. [or can imply it is the
discount rate which makes NPV=0]
t
ACFt Higher IRR
IO = 
n =1 (1 + IRR )t
values are
better!
where
ACFt = annual after tax cash flow for time period t ✓ Accept the project
when IRR>r
✓ Reject the project
IO = initial cash outlay when IRR<r
✓ May accept the
n = project's expected life project when IRR=r

IRR = the project's internal rate of return

INTERNAL RATE OF RETURN
EXAMPLE
 INTERNAL RATE OF RETURN
EXAMPLE

This table
has been
calculated
using a
discount
rate of 15%.

The project does meet our requirement at 15% and

should be considered further.
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PAYBACK PERIOD

Determines how long it takes for a project to

reach a breakeven point. It is the estimated time
that will be necessary to recoup the investment.
Investment
Payback Period =
Annual Cash Savings
Cash flows should be discounted.
Lower numbers are better (faster payback).
PAYBACK PERIOD EXAMPLE

 Machine A costs $15,000 & will reduce operating cost by $5,000

per year.
 Machine B costs $12,000 & will reduce operating cost by $ 3,500
Results:
 Machine A payback period= $15,000/$5,000= 3.0 years
 Machine B payback period= $12,000/$3,500= 3.42 years
 Payback period example
(table 3.5)

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 Payback Period Example
(table 3.6)

Divide the
cumulative amount
by the cash flow
amount in the third
year and subtract
from 3 to find out
3 - 50,000 = 2.857
the moment the
350,000 project breaks even.
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 PAYBACK PERIOD EXAMPLE
(TABLE 3.6)

Divide the
cumulative amount
by the cash flow
amount in the third
year and subtract
from 3 to find out
5 – 875,000 = 4.028 the moment the
900,000 project breaks even.
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 DISCOUNTED PAYBACK PERIOD

 Discounted payback period is a modified version of payback

period which accounts for the time value of money.
 Both metrics are used to calculate the amount of time that it will
take for a project to “break even,” or to get the point where the
net cash flows generated cover the initial cost of the project.
 Both the payback period and the discounted payback period can
be used to evaluate the profitability and feasibility of a specific
project.

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DISCOUNTED PAYBACK PERIOD-
EXAMPLE
 Suppose we require a 12.5% return on new investments, and we
have a project opportunity that will cost an initial investment of
$30,000 with a promised return per year of $10,000.
 Under the simple simple payback period model, the initial
investment should be paid off in only three years
($30000/$10000=3). However, as table 3.9 demonstrates, when
we discount our cash flows at 12.5% and start adding them, it
actually takes four years to pay back the initial project
investment.
 Discounted payback period
(table 3.9)

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 PROJECT PORTFOLIO
MANAGEMENT
The systematic process of selecting, supporting, and managing the
firm’s collection of projects.
Portfolio management objectives and initiatives require:
• Decision making
• Prioritization
• Review
• Realignment
• Reprioritization of a
firm’s projects
OBJECTIVE OF PORTFOLIO
MANAGEMENT
 Decision: Sometimes its good to say ”NO”……every time you say “yes” to a
project you are saying “no” to every other possible projects that will be using
those similar resources.
 Prioritization: ”What is our mission statement”- we know we cant do
everything. If we can focus on our mission statement and everybody is pulling
in the same direction to achieve those goals we can be very good at that
activity.
 Review: To make sure our projects are and will remain lined up with our
prioritization/ mission statement.
 Realignment: When portfolios are altered by the addition of new projects. We
may need to rebalance, or change strategic fit, or reallocate resources in a
different direction etc.
 Reprioritization: If the company moves toward a new strategic direction then
it will cause you to revisit all the projects in your the portfolio to make
decisions on what needs to be changed and what are still aligned with your
new strategy.
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PROACTIVE PORTFOLIO

 One of the most effective methods for aligning profit objectives

and strategic plans is the development of a proactive project
portfolio, or an integrated family of projects.
 This portfolio classifies projects among four distinct types,
depending on where they fall in the matrix and links the issues
of commercial potential and technical feasibility.
 The classifications are-
i. Bread & butter
ii. Pearls
iii. Oysters
iv. White elephant

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 Proactive portfolio matrix
(figure 3.8)

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 PROACTIVE PORTFOLIO MATRIX

 Bread & Butter: High technical feasibility &

Modest commercial profitability. For
example: improvement of existing product
lines.
 Pearls: High technical feasibility & High
Commercial profitability. These projects
are used to gain strategic market
advantage. This involves projects that
revolutionize a field using well-known or
understood technology that is a find a new
application of existing technology. For
example: sonar imaging to detect deep-
water oil reserve.
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 PROACTIVE PORTFOLIO MATRIX
 Oysters: early stage projects that can gain
significant commercial advantage for the
company that can solve technical
challenges. It involves unknown or
revolutionary technology. For example:
developing extended life batteries for
electric cars.
 White elephant: Low technical feasibility
combines with low commercial impact.
Companied do not invest in such projects
intentionally. Most white elephants starts
life as ‘bread & butter’ projects or ‘oysters’
that never live up to their potential. Though
they consume unnecessary resources & time
to maintain but most companies still carries
it on the rationale that – “We’ve spent too
much on it to just kill it now” or “ Influential
members of the organization support it”
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 KEYS TO SUCCESSFUL
PROJECT PORTFOLIO MANAGEMENT

❖Flexible structure and freedom of communication

(avoiding restrictive layers of bureaucracy and ensure
free flow of knowledge)
❖Low-cost environmental scanning (don’t put
everything in one basket)
❖Time-paced transition (long lead times and planning
ahead- not too much rushing to get the quality and
costing that we want and not compromise in those
aspects)
PROBLEMS IN IMPLEMENTING
PORTFOLIO MANAGEMENT
➢Conservative technical communities (want to maintain
status quo, specially the technical people)
➢Out-of-sync projects and portfolios (losing focus-every
one working toward the same direction i.e. our mission
statement)
➢Unpromising projects (changing winds-something may
have had a bright future before but due to changes in the
market/ environment its not an good idea anymore)
➢Scarce resources (“Yes” means saying “No” to other
projects, so project selection should be done critically due
to scarcity of resources)