INSTRUCTOR’S RESOURCE MANUAL
CHAPTER THREE
Project Selection and Portfolio Management
To Accompany
PROJECT MANAGEMENT:
Achieving Competitive Advantage
By
Jeffrey K. Pinto
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
2
CHAPTER THREE
PROJECT PROFILE – Project Selection Procedures: A Cross-Industry Sampler
INTRODUCTION
3.1 PROJECT SELECTION
3.2 APPROACHES TO PROJECT SCREENING AND SELECTION
Method One: Checklists
Method Two: Simple Scoring Models
Limitations of Scoring Models
Method Three: The Analytical Hierarchy Process
Method Four: Profile Models
3.3 FINANCIAL MODELS
Payback Period
Net Present Value
Discounted Payback
Internal Rate of Return
Options Models
Conclusions: Picking a Selection Approach
PROJECT PROFILE: Project Selection and Screening at GE: The Tollgate Process
3.4 PROJECT PORTFOLIO MANAGEMENT
Objectives and Initiatives: The Tasks of Portfolio Management
Developing a Proactive Portfolio
Some Keys to Successful Project Portfolio Management
Problems with Implementing Portfolio Management
Summary
Key Terms
Solved Problems
Discussion Questions
Problems
Case Study 3.1: Keflavik Paper Company
Case Study 3.2: Project Selection at Nova Western, Inc.
3
Internet Exercises
Bibliography
4
TRANSPARENCIES
3.1 SIMPLIFIED CHECKLIST MODEL FOR PROJECT
SELECTION
Performance on Criteria
High
Project
Criteria
Project Alpha
Cost
Profit Potential
Time to Market
Development Risks
Project Beta
Project Gamma
Project Delta
Cost
Profit Potential
Time to Market
Development Risks
Cost
Profit Potential
Time to Market
Development Risks
Cost
Profit Potential
Time to Market
Development Risks
Medium
Low
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
5
3.2 SIMPLE SCORING MODEL
Project
(A)
Importance
Weight
Score
(A) x (B)
Weighted
Score
Cost
1
3
3
Profit Potential
2
1
2
Development Risk
2
1
2
Time to Market
3
2
6
Criteria
(B)
Project Alpha
Total Score
13
Project Beta
Cost
1
2
2
Profit Potential
2
2
4
Development Risk
2
2
4
Time to Market
3
3
9
Total Score
19
6
3.3 PROFILE MODEL
7
3.4 FINANCIAL MODELS - PAYBACK PERIOD
Comparison of Payback for Projects A and B
Project A
Year
Cash flow
Cum. Cash Flow
0
($500,000)
($500,000)
1
50,000
(450,000)
2
150,000
(300,000)
3
350,000
50,000
4
600,000
650,000
5
500,000
1,150,000
Payback = 2.857 years
Rate of Return = 35%
Project B
Year
Cash flow
Cum. Cash Flow
0
($500,000)
($500,000)
1
75,000
(425,000)
2
100,000
(325,000)
3
150,000
(175,000)
4
150,000
(25,000)
5
90,000
875,000
Payback = 4.028 years
Rate of Return = 24.8%
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3.5 FINANCIAL MODELS – NET PRESENT VALUE
ASSUME: $100,000 INITIAL INVESTMENT
REQUIRED RATE OF RETURN: 10%
INFLATION: 4%
USEFUL LIFE: 4 YEARS
ANTICIPATED CASH FLOWS:
Year 1:
Year 2:
Year 3:
Year 4:
$20,000
$50,000
$50,000
$25,000
EXAMPLE - DISCOUNT FACTOR FOR YEAR ONE
Discount factor = (1/(1 + .10 + .04)1) = .8772
Discounted Cash Flows and NPV
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
100,000
(100,000)
1.000
(100,000)
1
20,000
20,000
0.8772
17,544
2
50,000
50,000
0.7695
38,475
3
50,000
50,000
0.6749
33,745
4
25,000
25,000
0.5921
14,803
Total
$4,567
9
3.6 FINANCIAL MODELS – DISCOUNTED PAYBACK
ASSUME: $100,000 INITIAL INVESTMENT
REQUIRED RATE OF RETURN: 12.5%
EXAMPLE - DISCOUNT FACTOR FOR YEAR ONE
Discount factor = (1/(1 + .125)1) = .89
Project Cash Flow
Year
Discounted
Undiscounted
1
$8,900
$10,000
2
7,900
10,000
3
7,000
10,000
4
6,200
10,000
5
5,500
10,000
Payback Period
4 Years
3 Years
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DISCUSSION QUESTIONS
1. If you were to prioritize the criteria for a successful screening model, which of
those criteria do you rank at the top of your priority list? Why?
Of the criteria for successful screening models, realism would top the priority list.
Realism requires that the model is inline with the constraints and objectives of the
organization. The other criteria are based on how usable and applicable the model is.
However, these measures would mean little if the model was unable to provide a
recommendation that was usable within the resources available to the company (i.e.
realistic alternative).
2. What are the benefits and drawbacks of project checklists for screening
alternatives?
Project Checklists are easy to use, based on a simplistic visual model with a basic scoring
system. Using a checklist enhances the input and discussion during the screening
process. Unfortunately, the model also has its shortcomings. The two most significant
are the subjectivity of the rating system and the lack of a weighting system. The
weighting system is important in establishing trade-offs between criterion.
3. How does use of the Analytical Hierarchy Process (AHP) aid in project selection?
In particular, what aspects of the screening process does the AHP seem to address
and improve directly?
The Analytical Hierarchy Process breaks the broad criterion categories of other selection
models into smaller, more manageable pieces that have more defined focuses. This
allows the AHP to create a more accurate ordering of priorities than other models. It also
enables a better demonstration of how potential alternatives meet organizational goals
and strategy. Weighting that is absent or inefficient under the checklist and scoring
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model is improved. AHP allows weighting by main and sub-criterion which eliminates
the double counting of the scoring model. Finally, the AHP creates results that are easily
compared between projects as well as within in cost/benefit analysis.
4. What are the benefits and drawbacks of the profile model for project screening?
Be specific about the problems that may arise in identifying the efficient frontier.
The Profile Model is beneficial because it clearly outlines the relationship between risk
and return of project alternatives. It also establishes a threshold for eliminating or
qualifying projects. On the other hand, it may not be as effective for selecting
alternatives because it limits discriminating criteria to risk and return only. Additionally,
it can be difficult to accurately quantify risk.
5. How are financial models superior to other screening models? How are they
inferior?
Financial models are superior to screening models in that they link project alternatives to
financial performance. The results of financial models are non-subjective meaning they
are not subject to individual interpretation (10% return means 10% return regardless of
who is looking at it). Therefore, it becomes easier to compare the benefits of one project
alternative versus another. The models do have some drawbacks. Due to the required
information in determining NPV and IRR, it may be difficult to make long-term estimates
accurately (i.e. would have to estimate future inflation and interest rates). Economic
conditions may be unknown or unstable. Determinations are made about the economic
future and may turn out to be invalid.
6. How does the options model address the problem of non-recoverable investment
in a project?
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The options model looks at alternatives faced when a company has already made
investment into a project. Confronted with different possibilities in how to handle the
non-recoverable investment (past investment), the options model reveals whether
investing into the project in the future will be beneficial or whether the company should
simply allow the project to live out its current potential.
7. What advantages do you see in the GE Tollgate screening approach? What
disadvantages do you see? How would you alter it?
The major advantage and disadvantage of GE’s Tollgate screening approach are derived
from the same source – multiple checks and reviews. The advantage of the process is the
project is under constant review. This means problems are addressed immediately and
that time and money is not continually invested in doomed projects. However, this same
process may lead to excessive delays in projects due to time spent on checklists, reviews
and waiting for the feedback loop to be completed. Perhaps maintaining the process, but
reducing the number of players involved may help to speed up the process while still
reaping the benefits of the system and reducing the risk of projects. For example,
perhaps having one review board (a cross-functional team headed by a member of senior
management) that meets briefly, but frequently with the project team for progress updates
would eliminate some of the bureaucratic levels of the system.
8. Why is project portfolio management particularly challenging in the
pharmaceutical industry?
Portfolio management is difficult in the pharmaceutical industry due to the high
uncertainty, low success rate, long lead time and high investment costs of pharmaceutical
projects. The uncertainty and high risk associated with the costs and success rates make
it difficult to create a balanced, reliable portfolio. The portfolio must be constantly
updated and reevaluated as projects fail, stall or become obsolete.
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9. What are the keys to successful project portfolio management?
The keys to successful project portfolio management are flexibility (freedom from layers
of authority) and open communication which allows projects teams to be innovative,
using low cost methods to test new markets or product ideas, and smooth, timely
transitions between projects.
10. What are some of the key difficulties is successfully implementing portfolio
management practices?
There are several common problems that may hinder successful implementation of
portfolio management. To begin with, top management may run into conflicts with
technical staff. For instance, engineers may not want to alter or abandon a project that
management finds too risky. Another difficulty is investment in projects that do not fall
inline with portfolio priorities. Strategy and the portfolio must remain aligned for project
portfolios to be successful. A highly detrimental occurrence revolves around
unpromising projects. Here, companies continue to poor money into projects even after
there is no hope for the project’s success. Finally, project portfolio management may fail
due to a lack of resource. Primarily, this comes when there are not enough personnel to
support the implementation or when there are not enough resources to initiate the desired
set of projects.
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CASE STUDIES
Case Study 3.1: Keflavik Paper Company
Keflavik Paper is an organization that has lately been facing serious problems with the
results of its projects. Specifically, the company’s project development record has been
spotty: While some projects have been delivered on time, others have been late. Budgets
are routinely overrun, and product performance has been inconsistent, with the results of
some projects yielding good returns and others losing money. They have hired a
consultant to investigate some of the principle causes that are underlying these problems
and he believes that the primary problem is not how project are run but how they are
selected in the first place. Specifically, there is little attention paid to the need to consider
strategic fit and portfolio management in selecting new projects. This case is intended to
get students thinking of alternative screening measures that could potentially be used
when deciding whether or not to invest in a new project.
Questions:
1. Keflavik Paper presents a good example of the dangers of excessive reliance on
one screening technique (discounted cash flows). How might excessive or
exclusive reliance on other screening methods discussed in this chapter lead to
similar problems?
Some measures that allow us to screen projects may lead to the wrong conclusions; for
example, suppose that we selected projects in construction settings for their aesthetic
appeal and ability to promote our name across the industry. If insufficient attention was
then paid to issues such as cost of the project or safety concerns, we may be selecting
projects that will ultimately damage our reputation or drive us out of business.
Instructors should probe various screening techniques for their strengths and weaknesses
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to ultimately demonstrate that effective screening methods usually rely on multiple,
complementary measures for selecting projects.
2. Assume that you are responsible for maintaining Keflavik’s project portfolio.
Name some key criteria that you believe should be used in evaluating all new
projects before they are added to the current portfolio.
Students can use this as a brain-storming exercise. Among the criteria they could list are:
1) relationship to current projects or products the company carries, 2) new market
penetration potential, 3) technological feasibility, and 4) cost of development. This is a
short list and students could potentially add several other criteria to it.
3. What does this case demonstrate about the affect of poor project screening
methods on a firm’s ability to manage its projects effectively?
The firm’s ad hoc approach to project selection demonstrates that even taking on projects
that could yield strong cash flows may injure the organization due to its inability to
manage them well. Further, it highlights the dangers of using either a single or one
heavily-weighted criterion for project selection. Successful project portfolios are
consciously constructed and managed as a coherent whole, not simply a collection of
diverse opportunities.
Case Study 3.2: Project Selection at Nova Western, Inc.
This case presents an example that is common, in which different screening methods may
yield different findings. In this case, two projects are competing for funding; Project
Janus, championed by the organization’s Software Development group and Project
Gemini, which as the backing of their Business Applications organization. Using a
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weighted scoring model, it appears that Project Gemini offers the best alternative in terms
of the criteria employed. On the other hand, when a Discounted Cash Flow approach is
used, the results suggest that Project Janus will earn greater returns on initial investment.
Instructors can use this case to illustrate the fact that many times, selection models will
point to conflicting results, particularly when financial models are paired with nonfinancial approaches.
Instructors can fashion a debate from this case, in which they assign one team to serve as
champions for Project Janus and the other for Project Gemini. It serves as a valuable
exercise for requiring students to commit to one approach or another, defend their
positions, and also examine these competing models for their strengths and weaknesses.
Questions:
1. Phyllis has called you into her office to help her make sense of the contradictions
in project evaluation. How would you explain the reasons for this divergence of
opinion from one technique to the next? What are the strengths and weaknesses
of each screening method?
The chapter notes several strengths and weaknesses of each project screening method and
these should be considered in this case. It is not uncommon for financial and nonfinancial screening methods to yield competing information; thus, an argument could be
made that using only these two methods is insufficient and in fact, an enhanced screening
model should be developed for Nova that considers these factors are part of an overall,
larger model of choice. Those instructors familiar with Expert Choice™ software could
set up this case as an exercise using the Analytical Hierarchy Process (AHP) discussed in
the chapter.
2. Choose the project that you feel, based on the above analysis, Nova Western
should select. Defend your choice.
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A reasonable case could be made for selecting either Project Janus or Project Gemini.
For example though Project Janus offers a higher net present value for your initial
investment, the payoff period is two years longer than Project Gemini, suggesting that if
the firm does not wish to tie its money up too long, Gemini might be a reasonable
alternative choice. Likewise, the weighted criteria model seems to favor Project Gemini.
Students should be encouraged to consider the criteria Nova employed in project
selection. Are they reasonable, or should other factors be considered as well?
3. What does the above case suggest to you about the use of project selection
methods in organizations? How would you resolve the contradictions found in
this example?
A successful screening model is often a comprehensive one. Simplistic models typically
yield simplistic answers and their consistency from method to method is questionable.
As the chapter demonstrates, most effective screening techniques used in organizations
today are complex, multi-faceted and comprehensive in nature. One simple solution to
this case might be to use the results of the discounted cash flow analysis as an additional
factor in the weighted scoring model, whereby net present value becomes an additional
selection criterion to consider along with the other factors already listed. Likewise,
students should be asked to consider if any of the criteria in the scoring model represent
“must” items that cannot be compromised, such as safety. Finally, student may point out
that the factor, “Potential Profit” ranks both projects identical. However, the DCF model
shows that Project Janus might reasonably be ranked higher. Ask students how this
reevaluation might change final results.
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PROBLEMS
1. Checklist. Suppose that you are trying to choose which of two IT projects to accept.
Your company employs three primary selection criteria for evaluating all IT projects: 1)
proven technology, 2) ease of transition, and 3) projected cost savings.
One option, Project Demeter, is evaluated as:
Technology
high
Ease of transition
low
Projected cost savings
high
The second option, Project Cairo, is evaluated as:
Technology
medium
Ease of transition
high
Projected cost savings
high
Construct a table identifying the projects, their evaluative criteria, and ratings. Based on
your analysis, which project would you argue in favor of adopting? Why?
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Solution:
Performance on Criteria
High
Project
Criteria
Project Demeter
Technology
Ease of Transition
Projected Cost Savings
Project Cairo
Technology
Ease of Transition
Time to Market
Medium
Low
X
X
X
X
X
X
On the basis of this checklist, and assuming that all criteria are equally weighted, Project
Cairo is marginally superior to Project Demeter. Cairo scores two highs and one
medium, while Demeter scores two highs and one low.
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2. Checklist. Consider the following information in choosing among the four project
alternatives below (labeled A, B, C, and D). Each has been assessed according to four
criteria:

Payoff potential

Safety

Lack of risk

Competitive advantage
Project A is rated:
Payoff potential
high
Safety
high
Lack of risk
low
Competitive advantage
medium
Payoff potential
low
Safety
medium
Lack of risk
medium
Competitive advantage
medium
Payoff potential
medium
Safety
low
Lack of risk
medium
Competitive advantage
low
Safety
medium
Competitive advantage
medium
Project B is rated:
Project C is rated:
Project D is rated:
Payoff potential
high
Lack of risk
high
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Construct a project checklist model for screening these four alternatives. Based on your
model, which project is the best choice for selection? Why? Which is the worst? Why?
22
Solution:
Performance on Criteria
High
Project
Criteria
Project A
Payoff Potential
Lack of Risk
Safety
Competitive Advantage
Project B
Project C
Project D
Low
X
X
X
X
Payoff Potential
Lack of Risk
Safety
Competitive Advantage
X
X
X
X
Payoff Potential
Lack of Risk
Safety
Competitive Advantage
Payoff Potential
Lack of Risk
Safety
Competitive Advantage
Medium
X
X
X
X
X
X
X
X
According to this checklist, it appears that Project D is the best option, as all ratings are
either High or Medium. Project C is the worst with only two Medium and two Low
ratings.
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3. Scoring Model. Suppose the information in Problem 2 was supplemented by
importance weights for each of the four assessment criteria as follows, where 1 = low
importance and 4 = high importance:
Assessment Criteria:
Importance Weights
1. Payoff potential
4
2. Lack of risk
3
3. Safety
1
4. Competitive advantage
3
Assume, too, that evaluations of high receive a score of 3, medium 2, and low 1. Recreate
your project scoring model and reassess the four project choices (A, B, C, and D). Now
which project alternative the best? Why?
Solution:
Project
Criteria
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
Project A
Payoff Potential
4
3
12
Lack of risk
3
1
3
Safety
1
3
3
Competitive Advantage
3
2
6
Total Score
24
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Project
Criteria
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
Project B
Payoff Potential
4
1
4
Lack of risk
3
2
6
Safety
1
2
2
Competitive Advantage
3
2
6
Total Score
18
Project C
Payoff Potential
4
2
8
Lack of risk
3
2
6
Safety
1
1
1
Competitive Advantage
3
1
3
Total Score
18
Project D
Payoff Potential
4
3
12
Lack of risk
3
3
9
Safety
1
2
2
Competitive Advantage
3
2
6
Total Score
Therefore: Choose Project D, which has the highest total score of 29.
29
25
4. Scoring Model. Now assume that for problem 2, the same importance weights are
altered as follows:
Assessment Criteria:
Importance Weights
Payoff potential
1
Lack of risk
1
Safety
4
Competitive advantage
2
How does this new information alter your decision? Which project now looks most
attractive? Why?
Solution:
Project
Criteria
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
Project A
Payoff Potential
1
3
3
Lack of risk
1
1
1
Safety
4
3
12
Competitive Advantage
2
2
4
Total Score
20
26
Project
Criteria
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
Project B
Payoff Potential
1
1
1
Lack of risk
1
2
2
Safety
4
2
8
Competitive Advantage
2
2
4
Total Score
15
Project C
Payoff Potential
1
2
2
Lack of risk
1
2
2
Safety
4
1
4
Competitive Advantage
2
1
2
Total Score
10
Project D
Payoff Potential
1
3
3
Lack of risk
1
3
3
Safety
4
2
8
Competitive Advantage
2
2
4
Total Score
Project A would be the best choice, with the highest weighted score.
18
27
5. Screening Matrix. Assume that the following information is relative to the process of
screening various project opportunities. Our relevant criteria (including importance
weightings) include the following:
Quality (5)
Cost (3)
Speed to Market (7)
Visibility (5)
Reliability (1)
Our company has four project alternatives, which satisfy the key features listed above as
follows:
Alpha
Beta
Gamma
Delta
Quality
1
3
3
5
Cost
7
7
5
3
Speed
5
5
3
1
Visibility
3
1
5
3
Reliability
5
5
7
7
Construct of project screening matrix to identify among these four projects the most
likely candidate to be implemented.
28
Solution:
Project
Criteria
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
Project Alpha
Quality
5
1
5
Cost
3
7
21
Speed
7
5
35
Visibility
5
3
15
Reliability
1
5
5
Total Score
81
Project Beta
Quality
5
3
15
Cost
3
7
21
Speed
7
5
35
Visibility
5
1
5
Reliability
1
5
5
Total Score
81
29
Project
Criteria
Project Gamma
Quality
(A)
Importance
Weight
(B)
Score
(A) x (B)
Weighted
Score
5
3
15
Cost
3
5
15
Speed
7
3
21
Visibility
5
5
25
Reliability
1
7
7
Total Score
83
Project Delta
Quality
5
5
25
Cost
3
3
9
Speed
7
1
7
Visibility
5
3
15
Reliability
1
7
7
Total Score
Project Gamma represents the best choice, using the weighted scoring model.
63
30
6. Profile Model. Assume the project profile model in Figure 3.10:
Fig. 3.10 – Project Profile Model
Define the efficient frontier. The dotted lines represent the minimum return and the
maximum risk that the company will accept. Which projects would be suitable for
retaining and which should be dropped from the company’s portfolio? Why?
Solution:
The efficient frontier would be a line running between Project B and Project E. Other
project options in the portfolio either offer lower potential returns for similar levels of
risk (Projects F and C) or are outside the acceptable boundaries for risk and/or return
(Projects A and D).
31
7. Using the information from the profile model in problem #6, construct an argument as
to why project B is preferable to project C.
Solution:
Project B gives a similar level of potential return while offering significantly lower risk;
thus, because profit (return) is similar across the two project options, it would make more
sense to adopt the project with a lower overall risk level.
8. Discounted Payback. Your company is seriously considering investing in a new
project opportunity but cash flow is tight these days. Top management is concerned
about how long it will take for this new project to pay back the initial investment of
$50,000. You have determined that the project should generate inflows of $30,000,
$30,000, $40,000, $25,000, and $15,000 for the next five years. Your firm’s required
rate of return is 15%. How long will it take to pay back the initial investment?
Solution:
We can set up a discounted cash flow table to calculate the time needed to pay back the
initial $50,000 investment. Remember that:
Total outflow = $75,000
Required rate of return = 10%
Discount factor = 1/(1+.15)t
Year
Cash Flow
Discount Factor
New Inflows
0
($50,000)
1.0
($50,000)
1
30,000
.87
26,100
32
2
30,000
.76
22,800
3
40,000
.66
26,400
4
25,000
.57
14,250
5
15,000
.50
7,500
Payback = 2.1 years
Conclusion: You will be able to pay off the initial investment is slightly more than two
years.
9. Net Present Value. Assume that your firm wants to choose between two project
options:

Project A offers the following opportunity: $450,000 invested today will yield an
expected income stream of $150,000 per year for 5 years.

Project B requires an initial investment of $400,000, but its expected revenue
stream is: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000,
and Year 5 = $200,000.
Assume that a required rate of return for your company is 12% and that inflation is
currently expected to remain steady at 5% for the life of the project. Which is the better
investment? Why?
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Solution:
First, our required rate of return is 5% + 12% = 17%
Next, using the formula from the chapter, we can calculate the discount factors for the
time periods:
(1/(1 + k + p)t)
Then, the formula for Net present Value allows us to test each option:
NPV = I0 + Σ Ft/(1 + r + p)t
We can construct a table that demonstrates projected inflows and outflows for the two
projects.
34
Project A
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
450,000
(450,000)
1.000
(450,000)
1
150,000
150,000
0.85
127,500
2
150,000
150,000
0.73
109,500
3
150,000
150,000
0.62
93,000
4
150,000
150,000
0.53
79,500
5
150,000
150,000
0.46
69,000
Total
$28,500
Project B
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
400,000
(400,000)
1.000
(400,000)
1
0
0
0.85
0
2
50,000
50,000
0.73
36,500
3
200,000
200,000
0.62
124,000
4
300,000
300,000
0.53
159,000
5
200,000
200,000
0.46
92,000
Total
$11,500
35
Conclusion: In this case, even though both projects offer a positive NPV, the highest
NPV is Project A. Therefore, if we can only select one project to fund, Project A offers
higher returns.
10. Net Present Value. Your Vice President for MIS informs you that she has
researched the possibility of automating your organization’s order-entry system. She has
projected that the new system will reduce labor costs by $25,000 each year over the next
five years. The purchase price (including installation and testing) of the new system is
$105,250. The system is expected to have a useful life of 5 years, after which time (in
year 6) it can be sold in the secondary computer systems market for $10,250.
What is the Net Present Value of this investment if the discount rate is 8.5% per year?
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Solution:
Using the formulae shown in problem 8 above, we can construct a discounted cash flow
table:
Discounted Cash Flows and NPV
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
105,250
(105,250)
1.000
(105,250)
1
25,000
25,000
0.92
23,000
2
25,000
25,000
0.85
21,250
3
25,000
25,000
0.78
19,500
4
25,000
25,000
0.72
18,000
5
25,000
25,000
0.67
16,750
6
10,250
10,250
0.61
6,253
Total
$(497)
Conclusion: Based on this analysis, the NPV for the project is negative ($-497),
suggesting that the project would not be a good investment.
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11. Net Present Value. A company has four project investment alternatives. The
required rate of return on projects is 20%, and inflation is projected to remain at 3% into
the foreseeable future. The pertinent information about each alternative is listed as
follows:
Project Carol
Project George
Year
Investment
0
$500,000
Revenue Streams
0
1
50,000
2
250,000
3
350,000
Year
Investment
0
$250,000
Revenue Streams
0
1
75,000
2
75,000
3
75,000
4
50,000
Project Thomas Year
0
Investment
Revenue Streams
$1,000,000
0
1
200,000
2
200,000
3
200,000
4
200,000
5
200,000
6
200,000
38
Project Anna
Year
Investment
0
$75,000
Revenue Streams
0
1
15,000
2
25,000
3
50,000
4
50,000
5
150,000
Which project should the firm’s first priority? Why? If the company could invest in more
than one project, indicate the order in which it should prioritize these project alternatives.
Solution:
Project Carol
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
500,000
(500,000)
1.000
(500,000)
1
50,000
50,000
0.81
40,500
2
250,000
250,000
0.66
165,000
4
350,000
350,000
0.54
189,000
Total
$(105,500)
39
Project George
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
250,000
(250,000)
1.000
(250,000)
1
75,000
75,000
0.81
60,750
2
75,000
75,000
0.66
49,500
3
75,000
75,000
0.54
40,500
4
50,000
50,000
0.44
22,000
Total
$(77,250)
Project Thomas
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
1,000,000
(1,000,000)
1.000
(1,000,000)
1
200,000
200,000
0.81
162,000
2
200,000
200,000
0.66
132,000
3
200,000
200,000
0.54
108,000
4
200,000
200,000
0.44
88,000
5
200,000
200,000
0.36
72,000
6
200,000
200,000
0.29
58,000
Total
$(380,000)
40
Project Anna
Year
Inflows
0
Outflows
Net flow
Discount Factor
NPV
75,000
(75,000)
1.000
(75,000)
1
15,000
15,000
0.81
12,150
2
25,000
25,000
0.66
16,500
3
50,000
50,000
0.54
27,000
4
50,000
50,000
0.44
22,000
5
150,000
150,000
0.36
54,000
Total
$56,650
Conclusions:
The only project worth investing in is Project Anna, because it is the only project with a
positive projected NPV. Each of the other three will not pay back the initial investment
due to the high cost of capital (discount rate) the firm uses.
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12. Options Model. A heavy manufacturing company wants to decide whether to initiate
a new project. The success of the project depends heavily on the state of the economy,
which has a 50/50 chance of being strong enough to support the venture. The project will
require an initial investment of $1 million dollars, and the company expects to earn
$500,000 in annual revenues from the project—unless the economy goes into recession,
in which case the project will return only $100,000 per year. The company requires a
12% return on its investments. Should it undertake the project?
If the company decides to wait a year, the economy has a 75% chance of improving
sufficiently to ensure $500,000 in annual returns. Does it make sense to wait for a year
before making the investment? Use the options model approach to project evaluation to
answer these two questions.
Solution:
We can first calculate the NPV of the proposed investment as follows:
Cash Flows = .5($500,000) + .5($100,000) = $300,000
NPV = - $1,000,000 +  $300,000/(1.12)t
= - $1,000,000
+ ($300,000/.12)
= - $1,000,000 + $2,500,000
= $1,500,000
The results show a positive NPV, suggesting that the project is a good investment;
however, by waiting an additional year, we have a greater chance of the economy
improving. We have to reassess the value of the investment in light of the option of
waiting one year. We can calculate this value as follows:
42
Expected Cash Flow = 0.75 ($500,000) + 0.25 ($100,000) = $400,000
NPV = [- $1,000,000/1.12 + Σ $400,000/(1.12)t]
= [ - $1,000,000/1.12 + ($400,000/.12)]
= (- $892,857 + $3,333,333)
= $2,440,476
Therefore, the project is still a good investment. Waiting the additional year will raise
the NPV of the project by almost $1 million dollars.
13. Options Model. Massivesoft Corporation is trying to decide whether or not to invest
in a new software project. The initial investment will be $5 million dollars. The project
has a 40% chance of returning $1 million per year into the future and a 60% chance of
generating only $100,000 in revenues. Assuming that Massivesoft requires 15% return on
capital investments, determine whether or not this is a viable project.
If Massivesoft decides to wait one year before investing in the project, its odds of
returning $1 million per year improve to 70%. Should Massivesoft wait two years to
initiate the project?
43
Solution:
We can first calculate the NPV of the proposed investment as follows:
Cash Flows = .4($1,000,000) + .6($100,000) = $460,000
NPV = - $5,000,000 +  $460,000/(1.15)t
= - $5,000,000
+ ($460,000/.15)
= - $5,000,000
+ $3,066,667
= - $1,933,333
The initial NPV is negative, suggesting that the project is not a good investment under the
economic conditions expected; however, if we decide to wait the additional year, when
the odds are better for stronger returns, the formula is calculated as follows:
Expected Cash Flow = 0.70 ($1,000,000) + 0.30 ($100,000) = 730,000
NPV = [- $5,000,000/1.15 + Σ $730,000/(1.15)t]
= [ - $5,000,000/1.15 + ($730,000/.15)]
= (- $4,347,826 + $4,866,667)
= $518,841
Therefore, by waiting an additional year, the value of this investment is positive,
suggesting that Massivesoft should hold off on the project for one year.
14. Portfolio Management. Crown Corporation is interested in expanding its project
portfolio. Currently, the firm specializes in water-conservation and land-reclamation
projects. It anticipates, however, a huge increase in the demand for home fuel cells as an
alternative to current methods of energy generation and usage. Although fuel-cell projects
involve different technologies than those in which Crown currently specializes, the profit
44
potential is very large. Develop a list of benefits and drawbacks associated with this
potential expansion of Crown’s project portfolio. In your opinion, do the risks outweigh
the advantages from such a move? Justify your answer.
Solution:
This problem is intended to get students thinking of the various factors that could be
considered when a new project opportunity is available. In this case, the major drawback
would be the lack of fit with the firm’s current project portfolio; therefore, instructors
should ask students to consider benefits and drawbacks of pursuing opportunities that lie
outside of the current strategic project portfolio. A reasonable argument can be made for
either pursuing this new venture or passing on it, depending upon how the instructor
guides the discussion.
15. Project Screening. Assume you are the IT manager for a large urban health care
system. You have lately found yourself bombarded with requests for new projects,
including system upgrades, support services, automated record keeping, billing, and so
forth. With an average of 50 software and hardware support projects ongoing at any
point in time, you have decided that you must create a system for screening new project
requests from the various departments within the healthcare system. Develop a project
selection and screening system similar to GE’s Tollgate process. What elements would
you include in such a system? How many steps would you recommend? At what points in
the process should “gates” be installed? How might a tollgate system for a software
development company differ from one used by an architectural firm specializing in the
development of commercial office buildings?
Solution:
This question is intended to get the students to consider how an organization can create
decision gates to better screen project opportunities, develop prioritization schemes, and
45
so forth. It is particularly useful to get students to identify a number of reasonable
decision gates at which point projects should be reviewed. A key element in this
discussion is for students to realize that just because a project was originally accepted, it
does not necessarily follow that it should be pursued to completion, depending upon
various environmental factors that may render the project no longer necessary. Again, in
developing these decision gates, the instructor should try and get students to think of
reviews for ongoing projects, as well on new opportunities. What sort of questions
should be asked at each stage? What about sunk costs? Should that factor into the
decision to maintain the project?