ET4S24

PROJECT MANAGEMENT AND

TECHNIQUES

Project Selection/Appraisal
Techniques
Darren Evans

Objectives

Discuss the tools and techniques

available to select the most
appropriate project or option

Background

Organisations need to be selective in

projects they undertake.
Otherwise, they would work on all
projects proposed in the organisation.
The projects need to align with the
organisation's strategy, and provide
some kind of return on investment,
whether it is financial or some other
criteria the organisation finds important.

Multiple Project Management Issues

Delays in one project impacting others

Resource conflicts
Technology dependencies

Lack of resource smoothing

Peaks and valleys of resource utilisation

Bottlenecks with scarce resources

Criteria for Project Selection Models

Realism - reality of managers decision

Capability- able to simulate different scenarios and

optimise the decision

Flexibility - provide valid results within the range of

conditions

Ease of Use - reasonably convenient, easy execution,

and easily understood

Cost - Data gathering and modeling costs should be

low relative to the cost of the project

Easy Computerisation - must be easy and

convenient to gather, store and manipulate data in the
model

Project selection matrix

Criteria

Possible Benefit Measurements

Financial return

Net present value (NPV)

Cost/benefit analysis
Internal rate of return (IRR)

Cost/benefit analysis (calculate savings and all costs)

Will it apply only to the project, the entire organization,

or will what is developed during the project be
marketable outside the organisation?
Will it appear as innovative to others in industry, thus
creating prestige for the organisation?

Increase value/share according to set formula, research,

or surveys

Measure perceived increase/decrease in perception

based on focus groups, surveys, or interviews. Estimate
the awareness/perception that will be created.
Calculate the number of people affected/made aware

Does the project team have the expertise to do the

project? Can the organisation acquire the expertise and
does it want to?
Will the project efforts help develop some expertise or
skill it wants developed?

Improved productivity-show cost savings if possible

Describe old system/processes that might collapse or
slow down and include impact
Compare with other infrastructure projects

Cost avoidance

Technical advancement
or innovation

Market value/share

Public perception

Alignment with
organisation expertise

Needed infrastructure
improvement

Nature of Project Selection Models

2 Basic Types of Models

Numeric
Nonnumeric

Two Critical Facts:

Models

do not make decisions - People do!

All models are only partial representations of
reality

Nonnumeric Models

Sacred Cow - project is suggested by a senior and

powerful official in the organisation

Operating Necessity - the project is required to

keep the system running

Competitive Necessity - project is necessary to

sustain a competitive position

Product Line Extension - projects are judged on

how they fit with current product line, fill a gap,
strengthen a weak link, or extend the line in a new
desirable way.

Numeric Models: Profit/Profitability

Payback period - initial fixed

investment/estimated annual cash inflows
from the project

Average Rate of Return - average

annual

profit/average investment

Discounted Cash Flow - Present Value

Method

Internal Rate of Return - Finds rate

of return that equates present value of inflows
and outflows

Payback period

The time taken for the income of a

project to recover the initial capital
outlay [represented in years]
Suppose you are considering the
purchase of an item of equipment for
24,000 that will save 8,000 in labour
costs for each of 5 years
What is the payback period?

Payback period - 2

ADVANTAGES

Simple to calculate.
Easy to understand.
Technological change is rapid and quick
payback on investment is desirable

DISADVANTAGES

Cash flows after payback period ignored.

Who decides the optimal pay back time?
Does not take into account profitability over
the life of the project.

Payback period - 3
Project 1 Outlay

Project 2 Outlay

20,000

20,000

Year

Return

2000

7000

2000

7000

2000

5000

5000

3000

8000

1000

10000

1000

11000

1000

Average rate of return

[ARR]

Calculates an average return over the

life of a project.
Compares this with the initial
investment.
Takes into account all cash-flows.
Looks at the whole life of the project.
The project with the highest ARR is
normally chosen.

Average rate of return

[ARR]
ARR = average benefit x 100
Initial investment
(shown as percentage)

Refer to previous example:

Average rate of return - 2

Project 1 Outlay

Project 2 Outlay

20,000

20,000

Year

Return

2000

7000

2000

7000

2000

5000

5000

3000

8000

1000

10000

1000

11000

1000

Average rate of return - 2

Project 1
Benefit = 40,000 over 7 years
Av benefit = 40k/7 = 5714
ARR = (5714/20000) x 100
29%
Project 2
Benefit = 25,000 over 7 years
Av benefit = 25k/7 = 3571
ARR = (3571/20000) x 100
18%

Average rate of return

[ARR] - 2

ADVANTAGES

Simplicity
A Yields a percentage figure for comparison
between projects or options.
Does not need cash flow timing to calculate.

DISADVANTAGES

Does not normally take into account the

project duration or timing of cash flows
The concept of profit can be very subjective
No definitive signal given by ARR to help
managers decide whether or not to invest

Discounted cash flow

What is it?

Discounted Cash Flow is a technique that enables the

analysis of future net cash flows discounted back at
'an appropriate interest rate' into present value terms
so as to compare (or assess viability of) alternative
projects.
It is the most widely used investment appraisal
technique.
It relies on a discount rate also known as rate of
return or interest rate or growth rate.
Three techniques use DCF

Net Present Value (NPV)

Internal Rate of Return (IRR)
Discounted Payback

Discounted cash flow - 2

What Discount Rate?

Discount rates are decided at corporate level and

reviewed annually.
Projects are normally given a threshold figure to
achieve or improve on.
The discount rate is normally based on the
opportunity cost rate - i.e. what could the capital sum
get as a return if invested in the next best alternative.
This could be base growth interest rates.
Remember the RISK and UNCERTAINTY elements
which go into the determination of the discount rate
(acquisition and product life).

Discounted cash flow - 3

Present value - the current value of future cash

flows.

Assuming a 10% interest rate, would you prefer 100

today or in a years time?
Obviously, you would want the 100 today.
If you invest the 100 at 10%, you could expect 110
in a years time.
Present value is the exact reverse.
The value of 100 in a years time is 90.90
Formula: D.F. = 1 / (1+r)n (r = rate, n = year)
DF = 1/(1+0.1)1 = 0.9090
Refer to Discount Factor (D.F.) or Present Value (P.V.)
tables

Net Present Value (NPV)

Net Present Value (NPV)

NPV is simply the sum of ALL the

DISCOUNTED cash-flows including the
current outflow.
INVEST if NPV is positive.
INVEST in the project that gives the largest
NPV (bearing in mind risk).

Net Present Value (NPV) - 2

ADVANTAGES

Takes into account the time value of money.

It expresses all future cash flows in today's values,
which enables direct comparison of options.
Allows for inflation and escalation.
Looks at whole project.
Yields a single figure for profitability

DISADVANTAGES

More complex to calculate.

Relies on (accurate) discount rate.
Accuracy limited by accuracy of estimates.

Net Present Value (NPV) - 3

Two alternative project options

are being considered for
implementation where each
have a potential 8 year useful
life
Both Projects however have
the option to be sold on after 6
years although they have
differing salvage rates
If the discount rate is 8%
which alternative should be
selected? Should either
projects be sold on when they
could be?

Formula:

D.F. = 1 / (1+r)n
(r = rate, n = year)

Option A Option B

Initial
cost in yr
1[,000]

450

300

Annual
benefit
[,000]

64

102

Salvage
value
[,000]

250

130

Discounted Payback

This takes account of the

changing value of money with
time and amends our view of the
payback period
An initial investment of
2,324,000 is expected to
generate 600,000 per year for 6
years. Calculate the discounted
payback period of the investment
if the discount rate is 11%.

Discounted Payback

Year

Presen
t
Value
Factor

Discoun
ted
Cash
Flow

Cumulat
ive
Discount
ed

234000
0
0

2340000

-2340000

1 600000

0.9009

540540

-1799460

2 600000

0.8116

486960

-1312500

3 600000

0.7312

438720

-873780

4 600000

0.6587

395220

-478560

5 600000

0.5935

356100

-122460

6 600000

0.5346

320760

198300

Cash Flow

Pay

Internal Rate of Return [IRR]

The aim with IRR is to answer the question: 'What

level of interest will this project be able to
withstand?' Once we know this, the risk of
changing interest rate conditions can effectively
be minimised.
The IRR is the annual percentage return achieved
by a project, at which the sum of the discounted
cash inflows over the life of the project is equal to
the sum of the capital invested.
Another way of looking at this is that the IRR is
the rate of interest that reduces the NPV to zero.

Internal Rate of Return [IRR]

Internal Rate of Return [IRR]

Need to compare 2 different interest

rates one yielding a positive NPV and
one a negative NPV
Remember we are trying to find the IRR
when NPV =0

IRR = Lowest discount rate + (diff in rates x lowest rate NPV)

Diff in NPV

IRR example

An initial investment of 25,000 in a

project produces cash inflows of 6595,
7250, 9550, 9000 and 5000 at 12
month intervals. The cost of capital to
finance the project is 12 %.
You are required to decide whether the
project is worthwhile using:

The Net Present Value

The Internal Rate of Return

Weighted Factor Scoring Model

The weighted scoring method, also known

as 'weighting and scoring', is a form of
multi-attribute or multi-criterion analysis.
It involves

identification of all the non-monetary factors

(or "attributes") that are relevant to the project;
the allocation of weights to each of them to
reflect their relative importance; and
the allocation of scores to each option to reflect
how it performs in relation to each attribute.

http://www.dfpni.gov.uk/eag-the-weighting-and-scoring-method

Weighted Factor Scoring

Model - 1

Identify the relevant attributes

Example: In a certain health service

appraisal, the relevant attributes are
identified as:
number

of cases treated;
waiting time;
patient access; and
disruption to services.

Weighted Factor Scoring

Model - 2

Allocation of weighting to each attribute

Example: The group appraising our

hypothetical health services project has
decided that the following weights are
appropriate:
number

of cases treated - 40%

waiting time - 30%
patient access - 20%
disruption to services - 10%

Weighted Factor Scoring

Model - 3

Scoring the options

Example: The health service group scores

four options against the attributes as
follows:

Weighted Factor Scoring

Model - 4

Calculate weighted scores

Example: Combining the last two examples

results in the following weighted scores:

Risk Analysis

Principal contribution of risk

analysis is to focus the attention on
understanding the nature and
extent of the uncertainty associated
with some variables used in a
decision making process

Sensitivity analysis

Sensitivity analysis is a commonly

employed risk analysis technique which
involves making minor changes to key
variables in order to observe the effect
on the originally predicted outcome.
Risk and uncertainty can be minimised
by demonstrating that the project is not
sensitive to such variations
Refer to examples in workbook

Summary - Project Appraisal

The use of specific techniques is

normally guided by company procedure.
Analysis of risk is often a pre-requisite
Qualitative techniques need to be
considered as well as quantitative
techniques.

Refer to example in
Handout

Recommended reading

Refer to notes/links on Blackboard

Meredith R & Samuel J. Mantel, Jr.,
Project Management: A Managerial
Approach Chapter 2, Wiley International