Order 1328631: Project Management

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9/12/18

Project Management Class – 2

Project Selection

Selecting Projects; Meeting Organizational Objectives Ø Although every project begins with a proposal, not every proposal become

a project!

Ø Project selection is process of evaluating projects and choosing them so firm objectives are met

Ø Ensure that several conditions are considered 1. Is the project potentially profitable? 2. Is the project required? 3. Does firm have the skills to complete the project? 4. Does it have capacity to carry out the project? 5. Can project be economically successful?

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Screening of Projects

Ø Projects are selected based on qualitative and/or quantitative models.

Ø Today, we discuss the most common models.

Ø Multiple criteria may be applied until the team is satisfied that all selected projects align with the overall business strategy.

Project Selection

Ø Projects can be categorized as one of the following: vCompliance: Projects that are essential to meet new requirements

imposed by internal and external entities § Internal entities may be executive management § External entities may be government regulations and requirements § “Must do” projects; if not implemented, may face penalties

vEmergency: Projects that are needed to meet emergency conditions; may be “must-do” projects; if not implemented, organizations may not be fully operational to fulfill their core competencies

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Project Selection (Cont.)

vMission Critical: Critical to the mission of a company § If not completed, would cause immediate, unacceptably negative

impact to business vOperational: Projects that are needed to support current operations

§ Increase process efficiency § Reduce product cost § Improve performance and other metrics

vStrategic: Projects that are essential to support long-range mission (increase revenue, increase market-share)

Selection Methods

Ø There are many different methods for selecting projects, and may be grouped into two fundamental types 1. Nonnumeric: does not use numbers for evaluation

a) Sacred cow b) Operating/competitive necessity c) Comparative benefits (Q-sort method)

2. Numeric: uses numbers for evaluation a) Financial assessment methods b) Financial options and opportunity costs c) Scoring methods

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Nonnumeric Selection Methods

Sacred cow § The CEO or other executive senior may suggest a potential product or

service that the organization might offer to customers. § It becomes a “sacred cow” which will be shown to be technically, if not

economically, feasible! § Whatever the selection process, the project will be approved! Operating/competitive necessity § This method selects any project that is necessary for continued operation of

a group, facility, or the firm itself. § The company may invest in a new product/service which is not profitable

but to be competitive and keep its share in market!

Nonnumeric Selection Methods (Cont.)

Comparative benefits (Q-sort method) § You need to select projects from a list. § Based on the desired criteria, separate the projects into three subsets; good,

fair, poor. § If there are more than 7 or 8 members in a subset, divide the group into two

subsets; e.g., “good-plus” and “good-minus”. § Continue subdividing until no set has more than 7 or 8 members. § Rank-order the items in each subset § Arrange the subsets in order of rank, and the entire list will be in order.

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Nonnumeric Selection Methods (Cont.)

Original deck 18 Projects

Good level 13

Poor level 5

High Good 9

Low Good 4

High Good plus 4

High Good minus 5

Rank members in each subset. Arrange the subsets.

Numeric Selection Methods

§ Most firms select projects on the basis of their expected economic value to the firm.

§ We discuss the most widely used methods: 1. Payback period 2. Discounted cash flow 3. Real Option analysis 4. Scoring methods

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Numeric Selection Methods Payback Period § The initial fixed investment in the project divided by the estimated annual

net cash inflows from the project. § A project requires an investment of $100,000. § It is expected that the project returns a net cash inflow of $25,000 each year. § What is the payback period?

§ The payback period is often considered a measure of risk to the firm. § The longer the payback period, the greater the risk!

Payback period = 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐅𝐢𝐱𝐞𝐝 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐀𝐧𝐧𝐮𝐚𝐥 𝐍𝐞𝐭 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬

= 𝟏𝟎𝟎,𝟎𝟎𝟎 𝟐𝟓,𝟎𝟎𝟎

Numeric Selection Methods Discounted Cash Flow

§ What is the drawbacks of the payback period method? 1. It ignores the time value of money 2. It ignores any returns beyond the payback period

§ The discounted cash flow method considers § The time value of money § The inflation rate § The firm’s return-on-investment

§ The annual cash inflows and outflows are collected and discounted to their net present value (NPV) using the organization’s rate of return

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Cash Flow: The difference between cash received from sales and other sources, and cash outflow for labor, material, overhead, and taxes.

Present Value: The sum, in current value, of all future cash flows of an investment proposal.

Ø The current value is calculated based on a given interest rate (discount rate)

Numeric Selection Methods Discounted Cash Flow

𝐭 = 𝟎 𝐭 = 𝟏 𝐭 = 𝟐 𝐭 = 𝟑

REVENUE

COST

What’s the value of project at time 𝒕 = 𝟎?

Time Value of Money

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The basic formula:

Ft = Cash Flow received t periods later in the future k = rate of return pt = inflation rate for period t Vt = Net Present Value (Worth) of the cash flow

Numeric Selection Methods Discounted Cash Flow

𝑉@ = 𝐹@

1 + 𝑘 + 𝑝@ @

Numeric Selection Methods Discounted Cash Flow (DCF)

where 𝐼G = The initial investment 𝐹@ = The net cash flow in period 𝑡 𝑘 = The required rate of return 𝑝@ = Rate of inflation for period 𝑡

𝐍𝐏𝐕 𝐏𝐫𝐨𝐣𝐞𝐜𝐭 = −𝑰𝟎 + P 𝑭𝒕

𝟏 + 𝒌 + 𝒑𝒕 𝒕

𝒏

𝒕U𝟏

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Ø Orang, Inc. is considering two different projects with different initial investments and future inflows.

Ø Based on discounted cash flow analysis, which project is preferred.

DCF Analysis for Multiple Investments

The rate of return k = 8%, and inflation rate p = 2% Cash Flows

YEAR Project A Project B 0 - $20,000 - $30,000 1 $10,000 $15,000 2 $10,000 $15,000 3 $10,000 $15,000

𝐭 = 𝟎 𝐭 = 𝟐 𝐭 = 𝟑𝐭 = 𝟏

𝐏𝐫𝐨𝐣𝐞𝐜𝐭 𝐀

𝐏𝐫𝐨𝐣𝐞𝐜𝐭 𝐁

20K

10K 10K 10K

30K

15K 15K 15K

DCF Analysis for Multiple Investments

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Decision ➨ CHOOSE B

DCF Analysis for Multiple Investments

8.7302 )1.01(

15000 )1.01(

15000

)1.01( 15000

30000

5.4868 )1.01(

10000 )1.01(

10000

)1.01( 10000

20000

= +

+ +

+-=

= +

+ +

+-=

PVB

PVA

PVB

PsychoCeramic Sciences, Inc.

§ PsychoCeramic, Inc. is a large producer of pots and other fragile items. § The firm is considering the installation of a new manufacturing line

that will allow more precise quality control on the size and shape. § The plant engineering department has submitted the project proposal

that estimates the following investment requirements: § Initial investment of $125,000 at the beginning of 2016 § Additional investment of $100,000 to install the machines at the end of 2016 § Another $90,000 to add new material handling system at the end of 2017 § Maintenance expenditures about $15,000 every second year starting from

2019

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PsychoCeramic Sciences, Inc.

§ Projected manufacturing savings and added profits resulting from higher quality are estimated to be $50,000 in the first year of operation (which is 2018), and to peak at $120,000 in the second year of operation.

§ The machinery will have a salvage value of $35,000 after 10 years; the project life.

§ It then follows a gradually declining pattern presented below.

2018 2019 2020 2021 2022 2023 2024 2025 50,000 120,000 115,000 105,000 97,000 90,000 82,000 65,000 35,000

PsychoCeramic Sciences, Inc.

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Ø Future cash flows associated with the investments can be estimated with high degree of certainty

Ø The rate of return does not change over time

Ø When there is high uncertainty (e.g. with the future demand) other methods should be used - such as real options.

Assumption of the Discounted Cash Flow Method

Opportunities arise in the future because…

Ø DCF does not take into account opportunities or uncertainties in the future.

Ø Market uncertainties unfold in the future: ü Demand forecasts improve ü Economic risks realize (e.g. inflation, currency changes, etc.) ü Competitors’ decisions are observed ü Customers’ needs are assessed, etc.

Ø Operational / Technical uncertainties unfold ü Product or Service designs improve ü Costs decrease as firm move on learning curve ü Bugs or technical problems are solved, etc.

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Real Options Analysis – Motivation

Ø Firm can react to opportunities in the future: ü The opportunity to invest in the expansion of

a firm's factory after having more accurate demand forecast.

ü The new market development in future after some market uncertainties resolved.

Ø Real Option Analysis enables us to consider the impact of future opportunities in our current decisions.

Ø Bell is planning to introduce VIDEO-ON-DEMAND in major metropolitan areas in Canada.

Ø This is a highly uncertain market. Ø Launching in Toronto: Launching in Toronto requires an

investment of $1 Million/year for 2 years. Ø Revenue from Toronto market is $2 Million (which will

come in the second year)

Real Options Analysis – Bell (Cont.)

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Ø Two years later, the market uncertainty will be resolved. Ø There are two outcomes:

ü Excellent scenario ü Poor scenario

Ø Expansion to other metropolitan Areas: ü Expansion requires an investment of $3 Million/year for 2 years ü After 2 years, in third year, expected revenue will be $5 Million. It can

go up or down by 50% depending the scenario as follows: ü If excellent => Revenue increases by 50% (i.e., revenue = $7.5 m) ü If poor => Revenue decreases by 50% (i.e., revenue = $2.5 m)

Real Options Analysis – Bell (Cont.)

Toronto Phase Expansion Phase Year 2015 2016 2017 2018 2019

Investment

Revenue

Bell is planning to introduce VIDEO-ON-DEMAND in major metropolitan areas in Canada. This is a highly uncertain market.

Launching in Toronto

Market Uncertainty resolves

Expansion to other metropolitan

Areas

$1 M $1 M

$2 M

$3 M $3 M

$7.5 M if Excellent

$2.5 M if Poor

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Two Steps in Project Planning Analysis

STEP-1: Identification of Phases Ø How many stages are there in the project planning horizon? Ø What type of uncertainties unfold? Ø What type of decisions firm make?

STEP-2: Valuation Ø How do we value decisions in the future? Ø How do we carry their effects to the current period? Ø Why can’t we just use DCF?

Example: Oz Toys’ Capacity Planning Program

Ø Oz Toys’ management is considering building a new plant to exploit innovations in process technology.

Ø About three years out, the plant’s capacity may be expanded to allow Oz Toys’ entry into a new market (2019-2022 => Expansion Phase).

Ø Hence, initial investment buys the right to expand (or not) in 3 years (2016-2018 => New plant).

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Example: Oz Toys’ Capacity Planning Program DCF Analysis Phase 1 2016 2017 2018 2019 2020 2021 2022 Revenue 21.2 25 Investment 145 12.2 15 Cash Flow -145 9 10 Discounted Cash Flow (@12%) Revenue 11 57.8 61.8 678 Investment 382 23.1 24.3 26.7 Cash Flow -371 34.7 37.5 651.3 Discounted Cash Flow (@12%) Revenue 21.2 25 11 57.8 61.8 678 Investment 145 12.2 15 382 23.1 24.3 26.7 Cash Flow -145 9 10 -371 34.7 37.5 651 Discounted Cash Flow (@12%)

à NPV (Total)

-145.00 8.04 7.97

-264.07 22.05 21.28 329.97

-145.00 8.04 7.97 -264.07 22.05 21.28 329.97

-19.81 => Based on DCF, not to invest in whole project

A Fact: Expansion Phase Comes with Less Uncertainty

Consider the following Phase-1 and Phase-2 Cash Flows.

Phase-1

Phase-2

Terminate

Technical & Market Uncertainties resolve

Phase 1-Cash Flows 2016 2017 2018 2019 2020 2021 2022

Revenue 21.2 25

Investment 145 12.2 15

Cash Flow -145 9 10

Phase 2-Cash Flows 2016 2017 2018 2019 2020 2021 2022

Revenue 11 57.8 61.8 678

Investment 382 23.1 24.3 26.7

Cash Flow -371 34.7 37.5 651.3

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Need to Take into Account the Future Flexibility

Ø We need to recognize the flexibility in the second phase: ü DCF of Phase 2 will be calculated at the time the decision will be

made. ü Phase 2 will only be undertaken if it is positive

Ø Valuing flexibility in the second phase requires a different technique ü A discretionary investment is similar to a call option ü Call option: Right (not obligation) to acquire

Ø Black-Scholes is often used to value these options.

Future Business Opportunity and Call Option

Ø Characteristics of a business opportunity can be mapped onto a template of a call option.

Project Total revenue / contribution margin for discretionary phase S

Total investment for discretionary phase X Length of time the discretionary phase may be deferred T

Riskiness of Revenue of the discretionary phase (usually measured per year) σ

Time value of money (interest rate) k

Black-Scholes Formula Two numbers suffice

𝑨 = 𝑺 𝑿

𝑩 = 𝑻� ×𝝈

A table that gives the Black- Scholes’ call option value as a fraction of S

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Future Business Opportunity and Call Option

Ø The number “A” indicates discretionary phase’s Profitability Index. Ø The value of discretionary phase can go up or down over time Ø The magnitude of the total change (also known as cumulative

volatility) is captured by “B” Ø σ measures volatility or riskiness of project Ø How to measure σ?

§ Use Monte Carlo simulation to simulate a probability distribution for the project’s returns

§ Gather historical data on returns in the same or related industries § 20-30% per year is not remarkably high for a single project.

Valuing Second Phase

Phase 2 Year

2000 2001 2002 2003 2004 2005 2006 Revenue 11 57.8 61.8 678 Discounted Revenue (@12%) 7.83 36.73 35.07 343.50 S à PV (Revenue) 423.13 Investment 382 23.1 24.3 26.7 Discounted Investment (@12%) 272 14.7 13.788 13.5 X à PV (Investment) 313.9

𝑨 = 𝑺 𝑿 = 𝟒𝟐𝟑 𝟑𝟏𝟑

= 𝟏.𝟑𝟓 𝑩 = 𝑻� ×𝝈 = 𝟑� ×𝟎.𝟒 = 𝟎.𝟔𝟗

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Valuing Project based on Real Option Analysis

Black-Scholes Formula Ø Rows: B Ø Columns: A

Ø The option value of phase 2 is (roughly)

Option Value (Phase 2) = 38% of S = .38 x $423 M = $157 M

Ø The value of the expansion program is

PV (Phase 1) + Option Value (Phase 2) = -129 + 157 = $28 M

1.20 1.25 1.30 à 1.35 1.40 0.55 29.2 31.0 32.8 34.5 36.1 0.60 30.9 32.6 34.3 35.9 37.5 0.65 32.6 34.2 35.8 37.4 38.9

à 0.70 34.2 35.8 37.3 38.8 40.3 0.75 35.9 37.4 38.9 40.3 41.7

Bell – Example

Ø Suppose Discounted Cash Flow is 15%. Ø The payout can go up or down by 50%. Ø What is the Video-On-Demand project valuation for Bell?

Toronto Phase Expansion Phase Year 2015 2016 2017 2018 2019

Investment

Revenue

$1 M $1 M

$2 M

$3 M $3 M

$5 M with

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Bell – Example

Toronto phase Expansion phase

Scoring Method

Ø The project may be selected for funding based on different criteria; not necessarily financial profitability.

Ø You may need to list the multiple criteria of significant interest to management.

Ø A selection committee consisting of senior managers weight each criterion and check off which of the criteria is satisfied.

Ø Those projects that exceed a certain number ma be selected for funding.

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The Weighted Scoring Method

Ø The general mathematical form of the weighted scoring method is

𝑺𝒊 = P𝑺𝒊𝒋𝑾𝒋

𝒏

𝒋U𝟏 where

Si = The total score of the ith project

sij = The score of the ith project on the jth criterion

wj = The weight or importance of the jth criterion

Using a Weighted Scoring to Select Wheels

§ Suppose you you are about purchasing a car. § You have two primary criteria of equal importance; cost and reliability. § You have limited budget and would like to spend no more than $4,200. § Beyond these two criteria, you consider everything else a “nicety” such

as comfort, appearance, etc., with half importance. § You can consider a set of scales for your three criteria as follows

Criterion Scores

1 2 3 4 5 Cost >$5,000 $4,000-$5,000 $3,000-$4,000 $2,000-$3,000 <$2,000 Reliability poor Mediocre Ok Good Great Niceties None Few Some Many Lots

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Using a Weighted Scoring to Select Wheels

§ How to find the weights for different criteria? § Cost and reliability have the same importance § Nicety has half importance § Let Y indicates the weight for cost

𝒀 + 𝒀 + 𝟏 𝟐 𝒀 = 𝟏 ⇒ 𝒀 = 𝟎.𝟒

§ You have identified three possible cars to purchase: 1. Besty for $3,400 with mediocre reliability and fair appearance and

design 2. Minicar for $4,100, good reliability, but needs some body work 3. Old Japanese Import for $2,900.

Using a Weighted Scoring to Select Wheels

Ø You need to score each of the cars on each of the criteria, calculate their weighted scores, and sum them to get a total.

Ø Therefore, it appears that the “Import” with a total weighted score of 3.0 may best satisfy your need for basic transportation.

Criteria and Weights Alternative Car Cost (0.4) Reliability (0.4) Niceties (0.2) Total

Besty 𝟑×𝟎.𝟒 = 𝟏.𝟐 𝟐×𝟎.𝟒 = 𝟎.𝟖 𝟒×𝟎.𝟐 = 𝟎.𝟖 2.8 Minicar 𝟐×𝟎.𝟒 = 𝟎.𝟖 𝟒×𝟎.𝟒 = 𝟏.𝟔 𝟏×𝟎.𝟐 = 𝟎.𝟐 2.6 Import 𝟒×𝟎.𝟒 = 𝟏.𝟔 𝟑×𝟎.𝟒 = 𝟏.𝟐 𝟏×𝟎.𝟐 = 𝟎.𝟐 3.0