Yarmouk University

Hijjawi Faculty For Engineering Tech

Project Management
and Quality Control

Lecture03

Mwaffaq Otoom & Shadi Alboon

Overview

What is project selection?

What techniques are used to select projects?

Project selection models and evaluation
factors

Numeric models

Nonnumeric models

Lecture03

Mwaffaq Otoom

Project selection

Project selection is the process of evaluating
individual projects or groups of projects, and then
choosing to implement some set of them so that the
objectives of the parent organization will be achieved.

Managers often use decision-aiding models to
abstract the relevant issues about a problem from the
plethora of details in which the problem is embedded.

Models represent the problems structure and can be
useful in selecting and evaluating projects.
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Mwaffaq Otoom & Shadi Alboon

What Projects to Bid on

Company selection of the projects they will bid on is generally
based on:

Their own expertise and track record

Resources they have available

Their chance of winning the bid

They do not want to waste that effort on bids where they are
unlikely to be successful

Preparing a bid is expensive!

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Mwaffaq 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 of competing for limited resources.

Why Project Selection Models?

Models abstract the relevant issues about a problem from the plethora of
details in which the problem is embedded (Model is a representative of the
reality, not the exact replica (reality is more complex)

Models help make rational decisions (Models do not make decisions, people
do)

Lecture03

Mwaffaq Otoom & Mohammad Al Bataineh

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 of the 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
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 of Use - 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 of
the project.

Easy Computerization It must be easy and convenient to gather, store and
manipulate data in the model.

Lecture03

Mwaffaq Otoom & Mohammad Al Bataineh

Nature of Project Selection Models

Two basic types of project 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).

If the estimated level of goal 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 of the
reality they are meant to reflect (Reality is far too complex for us to capture more
than a small fraction of it in any model. )

Lecture03

Mwaffaq Otoom & Mohammad Al Bataineh

Project Evaluation Factors

Production Factors

Interruptions, learning, process

Marketing Factors

Customer management issues

Financial Factors

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?

Lecture03

Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

Project Evaluation Factors

Production Factors

Interruptions, learning,
process

Marketing Factors

Customer management
issues

Financial Factors

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?

Lecture03

Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

Numeric models

Models that return a numeric value for a
project that can be easily compared with other
projects

Two major categories of numeric models:
1. Profit/profitability (considered the sole measure of
project acceptability)
2. Scoring (multiple criteria for project evaluation/selection
are used)
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Mwaffaq Otoom & Mohammad Al Bataineh

10

Numeric models: Profit/Profitability

Models that use profitability as the sole measure of project
acceptability there are several models:
Payback Period - Initial fixed investment/estimated annual net cash
inflows from the project. .

Average Rate of Return - 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) of all future

expected cash flows/initial cash investment

Lecture03

Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

11

Cash Inflows & Outflows

Cash Inflow > Cash Outflow

Positive Cash Flow
Cash Inflow < Cash Outflow

Negative Cash Flow

Lecture 03

Shadi Alboon & Mohammad Al Bataineh

12

Payback Period example

The Payback Period = The length of time until the original investment has been
recouped (repaid) by the project net cash inflow

Project Cost
Payback Period =
Annual Cash Flow
Assuming a project costs $100,000 to implement and has annual net
cash inflows of $25,000, then the payback period will be

$100, 000
Payback Period =
=4
$25, 000

the number of
years required
for the project
to repay its
initial fixed
investment

The lower the payback period, the less the risk to which the firm is exposed.

The major advantage of this model is its simplicity.

The major disadvantage is that it does not take into account the time-value of money.
Lecture03

Mwaffaq Otoom & Shadi Alboon & Mohammad Al Bataineh

13

Payback Period Drawbacks

1. Does not consider the time value of money.
2. More difficult to use when cash flows change
over time.
3. Less meaningful over longer periods of time
(due to the time value of money).
4. It ignores any cash flows beyond the payback
period.

However, it is relatively simple to
calculate & to understand.
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Mwaffaq Otoom

14

Average Rate of Return (ARR)

The Average Rate of Return is the ratio of the average annual
profit (either before or after taxes) to the initial or average
investment in the project.

The ARR is NOT the reciprocal of the payback period, because average annual
profits are usually not equivalent to net cash inflows.
Example: Assuming that the average annual profits of a project are $15,000, then the
Average Rate of Return (ARR) is
Average annual profit

Average Rate of Return =

$15,000
= 0.15
$100,000

Project cost

The major advantage of this model is its simplicity.

The major disadvantage is that it does not take into account the time-value of money.
Lecture03

Mwaffaq Otoom & Mohammad Al Bataineh

15

ARR Example
Cost

Machine A

Machine B

$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

Year 5

$11,375

$3,375

Total earnings (profits)

$36,875

$36,875

Estimated life

5 years

5 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.
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Shadi Alboon & Mohammad Al Bataineh

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Discounted Cash Flow (NPV)

(Net Present Value): The current worth of a
stream of future cash inflows and outflows in
todays dollars, given a specified rate of return
(The rate of return is also called: the Discount Rate or Hurdle Rate or Cutoff Rate).

Widely used to evaluate projects.

Includes the time value of money (the value of
money figuring in a given amount of interest for a
given period of time). ($1 today>$1 in 10 years)

Includes all inflows and outflows, not just the ones
through to the payback point.
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Mwaffaq Otoom & Mohammad Al Bataineh

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Discounted Cash Flow (NPV)

Requires a percentage to use to reduce future cash flows
the discount rate.

Discount Rate: the rate of return that could be earned
on an investment in the financial markets with similar risk.

The discount rate may also be known as a hurdle
(difficulty) rate or cutoff rate.

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 of a project.
Lecture03

Mwaffaq Otoom

18

Calculating Project NPV

Ft
NPV (project) = A0 + t =1
t
(1 + k )
n

A0 : Initial cash investment (because this is an outflow,

it will be negative).
Ft : The net cash flow in time period t (negative for
outflows)
k : The required rate of return (The discount rate)
t : The number of years of the period considered






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A higher NPV is better.

The higher the discount rate, the lower the NPV.
If the project is successful, cash flows will become positive.
Mwaffaq Otoom & Mohammad Al Bataineh

19

NPV with Inflation Rate

To include the impact of inflation (or deflation), we
have

where
pt : is the predicted rate of inflation during period t.

The project is acceptable if the sum of the net present values
of all estimated cash flows over the life of the project is positive.
Lecture 03

Mwaffaq Otoom & Mohammad Al Bataineh

20

NPV example 1
Initial investment of $100,000 with a net cash inflow of $25,000
per year for a period of 8 years, a required rate of return of
15%, and an inflation rate of 3% per year, we have:
8

$25,000
NPV (project) = $100,000 +
t
t =1 (1 + 0.15 + 0.03)
= $1,939
The present value of the inflows is greater than the present
value of the outflow the NPV is positive.
Therefore the project is acceptable!
Lecture03

Mwaffaq Otoom & Mohammad Al Bataineh

21

132332
166047
100,
77076
25927
46726
28838
46088
76852
3054
54672
7128
39161
000
10
11
189
37
5
04
6
2
(1 + 0.10)12

NPV Example 2

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 of 100,000 (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 of return is 10%.
Therefore, the NPV(Project) is $65,816.04
Lecture 03

A. Al-Tamimi & Mohammad Al Bataineh

22

132332
166047
100,
77076
25927
46726
28838
46088
76852
3054
54672
7128
39161
000
10
11
189
37
5
04
6
2
(1 + 0.10)12

NPV Example 3

The hurdle rate is 12%  k = 0.12.

The expected rate of inflation to be about 3%  p = 0.03..

The Net Present Value of the project is positive and, thus, the project can be accepted.
Lecture 03

Mohammad Al Bataineh

23

Profitability Index (PI)

PI: is the net present value of all future expected cash
flows divided by the initial cash investment.
PV of future expected cash flows
Profitability Index =
Initail cash investment

Also known as the benefitcost ratio.

As the value of the PI increases, so does the financial
attractiveness of the proposed project.
Rules for selection or rejection of a project:

If PI > 1 then the project may be accepted.

If PI < 1 then the project is rejected.

If PI = 1 then this indicates breakeven ().
Lecture 03

Shadi Alboon & Mohammad Al Bataineh

24

18000
==16363
7520
9924
6147
(1 + 0.1)1342

Profitability Index: Example 1

Given:

Investment = $40,000.

Life of the Machine = 5 Years.

Calculate the NPV and
Profitability Index (PI) at 10%
discount rate

Total Present Value = 16363+9924+7520+6147 = $43679

Net Present Value (NPV) = -40000+43679 = $3679
PI = 43679/40000 = 1.091 > 1

 Accept the project!

Lecture 03

A. Al-Tamimi & Shadi Alboon & Mohammad Al Bataineh

25

Profitability Index: Example 2

A Company is 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.

Profitability Index (PI) = $65M / $50M = 1.3

Net Present Value = PV of Net Future Cash Flows Initial Investment required

Net Present Value = $65M-$50M = $15M.

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 = 1.3
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Shadi Alboon

26

Advantages of Profitability Numeric

Models

1
2
3



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The 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.
Model 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.

Mwaffaq Otoom & Shadi Alboon & Mohammad Al Batainegh

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Disadvantages of Profitability
Numeric Models

1 These models ignore all nonmonetary factors except risk.

that do not include discounting ignore the timing of the
2 Models
cash flows and the timevalue of money.
that reduce cash flows to their present value are strongly
3 Models
biased toward the short run.
Payback-type models ignore cash flows beyond the payback period.


These models rely on accurate estimations of cash flow (which can
 be difficult to make).
These models cannot deal with a lot of the complexity of the
 modern firm reliance on financial data only.
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Mwaffaq Otoom & Shadi Alboon & Mohammad Al Batainegh

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Numerical Models: Scoring Models

Scoring models attempt to overcome some of the
disadvantages of probability models by
incorporating additional decision criteria.

Use multiple criteria to evaluate a project with a
score for each criteria.

Vary widely in their complexity and information
requirements.

Some scoring models examples
Unweighted 0-1 Factor Model
Weighted Factor Scoring Model
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Mwaffaq Otoom & Shadi Alboon

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Unweighted (0-1) Factor Model

Uses a set of relevant factors as determined by
management.

Each factor is weighted the same.

Less 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.
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Unweighted (0-1) Factor Model

Example

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Weighted Factor Scoring Model

When numeric weights reflecting the relative
importance of each 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.
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Weighted Factor Scoring Model

For example we can give a score range (0-5) for some
parameters according to certain criteria, such as the
importance of each parameter :
Weight

Meaning

Very high importance

High importance

Medium importance

Low importance

Very low importance

Not important

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we can make
it easier

Shadi Alboon

Weight

Meaning

Very high
importance

Low
importance

Not important

33

Weighted Factor Scoring Model

In general, the Weighted Factor Scoring Model takes the
form:

The weights, , may be generated by any technique that is

acceptable to the organizations policy makers (e.g. The
Delphi Technique).

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Mwaffaq Otoom

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Weighted Factor Scoring Model

Example
Illustrative Example: The choice of an automobile for purchase
(Common Problem).

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Mwaffaq Otoom

35

Weighted Factor Scoring Model

Example

When numeric weights have
been generated, it is helpful (but
not necessary) to scale the weights
so that

The weights represent the relative importance of the criteria measured on a 10point scale.

The numbers in parentheses show the proportion of the total weight carried by
each criterion (They add to only .99 due to rounding.)

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Mwaffaq Otoom

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Weighted Factor Scoring Model

Example

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 of carrying children,
status, safety features like dual airbags or ABS) prior to making a firm decision.
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Mwaffaq Otoom

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Advantages of the Scoring Model

They 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.

They are a direct reflection of management policy.

Easily altered to accommodate change in management
policy or priorities.

They allow for sensitivity analysis, because trade-off
between factors is easily observable.
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Mwaffaq Otoom

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Disadvantages of the Scoring Model

Ease of use can lead to the inclusion of too
many criteria.

The output of a scoring model is strictly a
relative measure rather than an absolute go/no
go indication.

Unweighted scoring models assume all criteria
are of equal importance this is seldom the
case.
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Mwaffaq Otoom

39

Summary

Primary selection model criteria are: realism, capability,
flexibility, ease of use, and cost.

In preparing to use a model, a firm must identify its
objectives, weighting them relative to each other, and
determining the probable impacts of the project on the
firms competitive abilities.

Models can be numeric or nonnumeric.

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Mwaffaq Otoom

40

Questions

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