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Project Selection
C. Flexibility
1. Must provide valid results within range of conditions the firm might experience. 2. Should be easily modified or self-adjusting to changes in the firm's environment.
Project Selection
D. Ease of Use
1. Reasonably convenient, low execution time, easy to use and understand 2. Should need no special interpretation, no hard-to-acquire data, no excessive personnel or unavailable equipment. 3. Model's variables should rate one to one with real world variables that the manager finds significant to the project. 4. Expected outcomes should be easily simulated
Project Selection
E. Cost
1. Data gathering and modeling costs should be low relative to the project cost. 2. All costs should be considered, and their total should definitely not be greater than the potential benefits of the project.
Project Selection
F. Easy Computerization
1. Convenient to gather and store information in a computerized data base. 2. Easy to manipulate the data in the model such as through a spreadsheet.
Project Selection
II. The Nature of the Project Selection Models A. Two basic model types
1. Numeric - use numbers as inputs. 2. Nonnumeric - don't use numbers as inputs.
Project Selection
C. Necessary for evaluation of a model to develop a fist of the firm's objectives. 1. List generated by top management. 2. Items on the list should be weighted to represent the degree of contribution the item has on the set of goals. 3. Projects are accepted or rejected based on how much their predicted outcomes contribute to goal achievement. 4.Some suggested list categories. a) Production, marketing finance, personnel, administrative
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5.Some list factors are recurring, others have one-time impact. 6. Ranges of uncertainty are helpful for hardto-estimate factors. 7.Thresholds or critical values of acceptance or rejection can be assigned. 8. Items will contain differing levels of specificity.
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III. Type of Project Selection Models A. Nonnumeric Models
1.The Sacred Cow
a) Suggested by a senior and powerful official b) Stopped at successful conclusion or when suggesting official realizes it was a mistake
Project Selection
4. The Product Extension Line
a) Judged on degree to which it fits the firm's existing product line, fills a gap, strengthens a weak link or extends a line into a new desirable direction
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B. Numeric Models - Profit - Profitability
1.Payback Period a) Initial fixed investment in the project divided by the estimated annual cash inflows from the project. 2. Average Rate of Return (ARR) a.) Ratio of average annual profit to the initial or average investment in the project. b.) Both payback and ARR methods ignore the time value of money 3. Discounted Cash Flow - Present Value Method a) Determine net present value (NPV) of all cash flows by discounting them by the required rate of return (hurdle rate). b) Project is acceptable if sum of the NPV is positive.
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5. Profitability Index (benefit-cost ratio)
a) NPV of all future expected cash flows divided by the initial cash investment. b) Acceptable if ratio is greater than 1.0.
Project Selection
7. Advantages of profit-profitability numeric models
a) Undiscounted models simple to use and easy to understand. b) Cash flows come from readily available accounting information. c) Output in familiar terms for decision makers. d) Models usually provide "absolute" go/no-go decisions. e) Some models account for risk. f) Dean's model incorporates impact of project on the rest of the organization
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8.Disadvantages of profit-profitability numeric models
a) Ignore all nonmonetary factors except risk. b) Undiscounted models ignore time value of money and timing of cash flows. c) Present value models are short-run biased. d) Payback model ignores cash flows beyond the payback period. e) Sensitive to data errors from early years of project. f) All discounting nonlinear, so effects of parameter changes are not obvious to most managers. g) Models with research risk can mislead the decision maker. h) Some only apply to projects resulting in new products. i) Not clear how cash flows are properly defined for project evaluation purposes.
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3. Weighted Factor Scoring Model
a) Add weights reflecting the relative importance of the factors and multiply the weight of each factor by its score. Sum these values and compare to a threshold value. b) This method can provide a sensitivity analysis to point out area for project improvement. c) Don't include marginally relevant factors
Project Selection
5. Dean and Nishry's Model
a) Integer programming model that selects the highest scoring project from the scoring model, and then selects them one after another until the resources and depleted
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7. Advantages of Numeric Scoring Models
a) Allow multiple criteria to be used for evaluation and decision. b) Structurally simple and easy to use. c) A direct reflection of management policy. d) Easily altered to meet changes in the environment and in management policy. e) Weighted scoring models allow for the fact that some factorsare more important than others. f) Easy sensitivity analysis to see trade-offs between several criteria.
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8. Disadvantages of Numeric Scoring Models
a) Output is a relative measure, no utility is reflected, thus no direct indication of project support. b) Generally linear, elements are assumed to be 'independent. c) Tendency to include too many criteria. d) Unweighted models assume equal importance of all criteria. e) To the extent to which profit-profitability is included in the scoring model, its advantages and disadvantages appear.
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V. Comments on the Information Base for EvaluationSelection A. Comments on Accounting Data 1. Costs and revenue are assumed to vary linearly with associated changes in inputs and outputs. 2. The standards used to provide cost-revenue information may or may not be accurate representations of the physical systems they are supposed to represent. 3.Incremental analysis should be used to guard against the full-cost approach.
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B. Comment on Measurements 1.Subjective vs. Objective
a. Objective - Measurement taken by reference to an external system. b. Subjective - Reference to a standard that is internal to the system.
Project Selection
4. Valid vs. Invalid
a. Validity - extent to which a piece of information means what we think it means.
Project Selection
VI. Project Proposals A. Proposal Overview
1.Project Proposal - set of documents submitted for evaluation. 2.Can be extensive, usually to prospective outside clients, or brief, usually internal projects.
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C. The Implementation Plan 1.Contains estimates of the time required, the cost, and the materials used. 2. PERT-CPM, time charts, etc. here, also milestones for the project and period by period resource usage. D. The Plan for Logistic Support and Administration 1. Description of the ability of the proposer to supply the routine facilities equipment and skills needed during the project. 2.Section describing how the project will be administered. E. Past Experience 1.Describes past experience of the proposing group. 2. List of key personnel with their titles and qualifications.
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Project Selection
VII. The Past and Future of Project Evaluation/Selection Models A. Post WW II - mostly payback period was used. B. 50's and 60's - profit-profitability was majority.
1.Led to short time-horizon projects
C. 70s - High interest rates raised cut-off rate. Projects with long term payoff horizons were cut back.
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D. Late seventies early eighties - Mostly profit, but a growth in multiple criterion models. E. Recently - Computers are making sensitivity analysis easy, but math programming models are still not being used. Scoring models are now being used. F. Future - More usage of the math programming and scoring models.
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