Chapter 2

Project selection

Project selection and criteria of choice

Project selection is a process of evaluating individual projects or group of
projects and then choosing to implement some set of them so that the objectives
of the parent organization will be achieved.
Since projects in general require a substantial investment in terms of money and
resources both of which are limited, it is of vital importance that the project that
an organization selects provide good returns on resources and capital invested.
For solving different problems or for answering different questions regarding
projects, we select model.
1. Model: A model is an object or concept which attempts to capture certain
aspects of the real world.
The definition of Model
A model is an explicit statement of our image of reality. It is a representation of
the relevant aspect of the decisions with which we are concerned. It represents
the decision area by structuring and formalizing the information we posses about
the decision and in doing so, presents reality in a simplified organized form. A
model therefore, provides us with an abstract of a more complex reality.

Project selection model:

Why Models
1. for initial selection and ongoing evaluation.
2. Increased profits or reduce costs
3. Capital resources limited so selected investment
4. Improve competitive position of organization.
5. Key to allocation and re-allocation of resources.
Model represents a problems structure, its form;
1. Every problem has a form. Modules can be a graph, analogies, diagrams, flow
graph and network models to help solve scheduling problems.
2. Models may be simple or extremely complex.

Criteria for project selection model

1. Realism: Model should reflect reality of managers decisions. It should
consider realities of organization limitations on:
1. Facilities 2. Capital 3. Personnel.
Model risk includes
a. Technical risk 1. Performance 2.cost 3. time
b. Market risk 1. Customer rejection 2. implementation risk

2. Capability: Project model should be sophisticated enough to deal with:

(a)Multiple time periods
(b) Simulate various situations - internal/external to project (strikes, interest
rate changes)
(c) Optimization decision 1.Tisk and constrains. 2. Select best overall project
3. Flexibility: Its ability to modify, self adjusting in response to changes in
environment, tax law changes, new technological advancements alter risk
levels.
4. Ease to use: Reasonably convenient, not take a long time to execute, easy
to simulate, easy to use and understand, data is not difficult to acquire.
5. Cost of data gathering and modeling
A. project costs considered
B. costs of data management
C. running the model
6. Easy computerization: It should be easy and convenient to
A. transferring information
B. manipulate data
C. Gather and store information in a database.

Project evaluation factors

There are two basic types of project selection
models numeric and non-numeric. Before
examining specific kinds of models within the two
basic types let us consider just what we wish the
model to do for us.
1. Models do not make decisions, people do. The
manager, not the model bears responsibility for the
decision. The manager may delegate the task of
making decision to a model, but responsibility
cannot be abdicated.
2. All models, however sophisticated, are only
partial representation of the reality.

Project Evaluation factors

(a) production factors

(b) Marketing factors

1. Time until ready to install.

2. Length of disruption during installation.
3. Learning curve-time until operating as
desired.
4. Effects on waste and rejects.
5. Energy requirements.
6. Facility
and
other
equipment
requirements
7. Safety of process
8. Other application of technology
9. Availability of raw material
10. Required development time and cost
11. Impact on working conditions.

1. Size of potential market for output.

2. probable market share of output
3. Time until market share is acquired.
4. Consumer acceptance.
5. Patent and trade secret protection.
6. Impact on image with customers,
suppliers and competitors.
7. Degree to which we understand
new technology.
8. Managerial capacity to direct and
control new process.

Types of project selection Models;

There are two types Numeric and Non-Numeric models. The two models are
widely used. Many organizations use both at the same time, or they use models
that are combination of two.

Nun-Numeric Models
These includes the following
1.The sacred Cow; In this case, the project is suggested by a senior and
powerful official in the organization. Often this project in imitated with a
simple comment such as If you have a chance, why dont you look into
it.. and then follows an underdeveloped idea for a new
product, for development of new market, or for some other project requiring
an investment of the firms rescores. The project is sacred in the sense that
it will be maintained until successfully concluded or until the boss personally
recognizes the idea as a failure and terminates it.
2.The operating Necessity;
If a flood is threatening the plant, a project to build protective dike does not
requires much formal evaluation, which is an example of this scenario. If the
projects is required in order to keep the system operating, the primary question
be comes is the system worth saving at the estimated cost of the project? If
the answer is yes, projects will be funded.

3.The competitive Necessity;

Some time a new project is launched to stay competitive in the market e.g.
many universities have started BBA and MBA programs. Investment in an
operating necessity project takes precedence over competitive necessity
project but both types of projects may bypass the move careful numeric
analyses.
4.The Product Line Extension;
In this case , a project to develop and distribute new products would by
judged on the degree to which it fits the firms existing product lime, fills a gap,
strengthens a weak link, or extends the line in a new desirable direction.
Sometimes careful calculation of profitability are not required if project will have
a positive impact.
5.Comparative benefit model: Assume that an organization has many
projects to consider, perhaps several dozen. Senior management would like to
select a subset of the projects that would most benefit the firm but the projects
do not seem to be easily comparable. For example some projects concern
potential new products, some concern changes in production methods, and
other concern computerization of certain records.
The organization has no formal method for selecting projects. But members of
the selection committee think that some projects will benefit the firm more than
others.

Numeric models
A large majority of all firms using project evaluation and
selection models use profitability as the sole measure of
acceptability.
1. Pay back period: The pay back period for a project is the
initial fixed investment in the project divided by the estimated
annual net cash inflows from the project. The ratio of these
quantities is the number of years required for the project to
repay its initial fixed investment.
Payback period = 100000\25000=4years
2. Average rate of return: The average rate of return is the
ratio of the average annual profit (either before or after tax) to
the initial or average investment in the project. Assume the
initial investment is $100000 and average annual profit is
$15000
Average rate of return =15000\100000=0.15or 15%

3. Discounted cash flow: Also known as net present value (NPV)

method, the discounted cash flow method determines the net present
value of all cash flows by discounting them by the required rate of return
as follows
a
NPV (project) =A =
_
Ft ____
t=1
(1+k+Pt) t
Where Ft= the net cash flow in period t
K= the required rate of return, and
A= initial cash investment (because this is an outflow it will be negative)
To include the impact of inflation (deflation) where Pt is the predicted rate
of inflation during period T we have
n
NPV= (project) = A+
_ Ft ___
t=1
(1+k+Pt) t
Early in the life of a project net cash flow is likely to be negative, the
major outflow being the initial investment in the project A. If the project is
successful, however, cash flow will become positive; 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.

4. Internal Rate of Return (IRR): If we have a set of expected cash in flows and
cash out flows, the internal rate of return is the discount rate that equates the
present values of the two sets of flows. If At is an expected cash out flow in the
period T and Rt is the expected inflow for the period t the IRR is the value of K that
satisfies the following equation(Note that Ao will be positive in this formulation of
problem)
Ao+A1/(1+k)+A2/(1+k)2+.+An/(1=k)n=R1/(1+k)+R2/(1+k)2++Rn/
(1+k)n
The value of K is found by trial and Error
IRR

where NPV=0

IRR> RRR

IRR<RRR

Accept project

Reject project

5. Profitability Index; Also known as the benefit- cost Ratio

the profitability index is the net present value of all future
expected cash flows divided by the initial cash investment. If
this Ratio is greater than 1.0 the project may be accepted.
Those projects which are ranked acceptable using NPV would
also be acceptable on the profitability index criteria.
6. Other profitability index models: There are a great many
variations of the models just described. These variations fall
into three general categories. 1. Those that subdivide net cash
flow into the elements that comprises the net cash flow 2.
Those that include specific terms to include risk into the
evaluation and 3. Those that extend the analysis to consider
effects that the project might have on other projects or
activities in the organization.