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PROJECT SELECTION (CONTD.)
Broad Contents
Q-Sort Model
Pay-back Period
Average Rate of Return
Discounted Cash Flow
Internal Rate of Return (IRR)
12.1 Types of Project Selection Models (Continued):
•Non-Numeric
Models:
...
•Q-Sort Model:
...
Of the several techniques for ordering projects, the Q-Sort
(Helin and Souder,
1974) is one of the most straightforward. First, the projects
are divided into
three groups—good,
fair, and
poor—according
to their relative merits. If any
group has more than eight members, it is subdivided into two
categories, such
as fair-plus
and
fair-minus.
When all categories have eight or fewer members,
the projects within each category are ordered from best to
worst. Again, the
order is determined on the basis of relative merit. The rater
may use specific
criteria to rank each project, or may simply use general overall
judgment. (See
Figure 12.1 below for an example of a Q-Sort.)
Figure 12.1: Example of a Q-Sort
...
The process described may be carried out by one person who is
responsible for
evaluation and selection, or it may be performed by a committee
charged with
the responsibility. If a committee handles the task, the
individual rankings can
be developed anonymously, and the set of anonymous rankings can
be
examined by the committee itself for consensus. It is common for
such rankings
to differ somewhat from rater to rater, but they do not often
vary strikingly
because the individuals chosen for such committees rarely differ
widely on
what they feel to be appropriate for the parent organization.
Projects can then be selected in the order of preference, though
they are usually
evaluated financially before final selection.
There are other, similar nonnumeric models for accepting or
rejecting projects.
Although it is easy to dismiss such models as unscientific, they
should not be
discounted casually. These models are clearly goal-oriented and
directly reflect
the primary concerns of the organization.
The sacred cow model, in particular, has an added feature;
sacred cow projects
are visibly supported by “the powers that be.” Full support by
top management
is certainly an important contributor to project success
(Meredith, 1981).
Without such support, the probability of project success is
sharply lowered.
Numeric
Models: Profit/Profitability
As noted earlier, a large majority of all firms using project
evaluation and selection
models use profitability as the sole measure of acceptability.
We will consider these
models first, and then discuss models that surpass the profit
test for acceptance.
1. Payback Period:
The payback 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. For example, assume a project costs
$100,000 to
implement and has annual net cash inflows of $25,000. Then
This method assumes that the cash inflows will persist at least
long enough to
pay back the investment, and it ignores any cash inflows beyond
the payback
period. The method also serves as an (inadequate) proxy for
risk. The faster the
investment is recovered, the less the risk to which the firm is
exposed.
2. Average Rate of Return:
Often mistaken as the reciprocal of the payback period, 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.
Because average annual profits
are usually not equivalent to net cash inflows, the average rate
of return does
not usually equal the reciprocal of the payback period. Assume,
in the example
just given, that the average annual profits are $15,000:
Neither of these evaluation methods is recommended for project
selection,
though payback period is widely used and does have a legitimate
value for cash
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budgeting decisions. The major advantage of these models is
their simplicity,
but neither takes into account the time-value of money. Unless
interest rates are
extremely low and the rate of inflation is nil, the failure to
reduce future cash
flows or profits to their present value will result in serious
evaluation errors.
3. Discounted Cash Flow:
Also referred to as the 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 (also known as the hurdle
rate, cutoff rate,
and similar terms)
as follows:
To include the impact of inflation (or deflation) where
pt
is the predicted rate of
inflation during period
t,
we have
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,
A0.
If the project is
successful, however, cash flows 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. A simple example will suffice. Using
our $100,000
investment with a net cash inflow of $25,000 per year for a
period of eight
years, a required rate of return of 15 percent, and an inflation
rate of 3 percent
per year, we have
Because the present value of the inflows is greater than the
present value of the
outflow— that is, the net present value is positive—the project
is deemed
acceptable.
For example:
PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked
pots and other
cracked items, is considering the installation of a new
marketing software
package that will, it is hoped, allow more accurate sales
information concerning
the inventory, sales, and deliveries of its pots as well as its
vases designed to
hold artificial flowers.
The information systems (IS) department has submitted a project
proposal that
estimates the investment requirements as follows: an initial
investment of
$125,000 to be paid up-front to the Pottery Software.
Corporation; an additional investment of $100,000 to modify and
install the
software; and another $90,000 to integrate the new software into
the overall
information system. Delivery and installation is estimated to
take one year;
integrating the entire system should require an additional year.
Thereafter, the IS department predicts that scheduled software
updates will
require further expenditures of about $15,000 every second year,
beginning in
the fourth year. They will not, however, update the software in
the last year of
its expected useful life.
The project schedule calls for benefits to begin in the third
year, and to be upto-
speed by the end of that year. Projected additional profits
resulting from
better and more timely sales information are estimated to be
$50,000 in the first
year of operation and are expected to peak at $120,000 in the
second year of
operation, and then to follow the gradually declining pattern
shown in the table
12.1 below.
Project life is expected to be 10 years from project inception,
at which time the
proposed system will be obsolete for this division and will have
to be replaced.
It is estimated, however, that the software can be sold to a
smaller division of
PsychoCeramic Sciences, Inc. (PSI) and will thus, have a salvage
value of
$35,000. The Company has a 12 percent hurdle rate for capital
investments and
expects the rate of inflation to be about 3 percent over the
life of the project.
Assuming that the initial expenditure occurs at the beginning of
the year and
that all other receipts and expenditures occur as lump sums at
the end of the
year, we can prepare the Net Present Value analysis for the
project as shown in
the table 12.1 below.
The Net Present Value of the project is positive and, thus, the
project can be
accepted. (The project would have been rejected if the hurdle
rate were 14
percent.) Just for the intellectual exercise, note that the
total inflow for the
project is $759,000, or $75,900 per year on average for the 10
year project. The
required investment is $315,000 (ignoring the biennial overhaul
charges).
Assuming 10 year, straight line depreciation, or $31,500 per
year, the payback
period would be:
A project with this payback period would probably be considered
quite
desirable.
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Table 12.1: Net Present Value (NPV) Analysis
4. Internal Rate of Return (IRR):
If we have a set of expected cash inflows and cash outflows, 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 outflow in the
period t
and
Rt
is the expected
inflow for the period
t
, the internal rate of return is the
value of k
that satisfies
the following equation (note that the
A
0 will be positive in this formulation
of
the problem):
The value of k
is found by trial and error.
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.
(Some firms do not discount the cash flows in making this
calculation.) If this
ratio is greater than 1.0, the project may be accepted.
6. Other Profitability Models:
There are a great many variations of the models just described.
These variations
fall into three general categories. These are:
a) Those that subdivide net cash flow into the elements that
comprises the
net flow.
b) Those that include specific terms to introduce risk (or
uncertainty,
which is treated as risk) into the evaluation.
c) Those that extend the analysis to consider effects that the
project might
have on other projects or activities in the organization.
12.1.1 Advantages of Profit-Profitability Numeric Models:
Several comments are in order about all the profit-profitability
numeric models. First,
let us consider their advantages:
- The
undiscounted models are simple to use and understand.
- All use readily
available accounting data to determine the cash flows.
- Model output is
in terms familiar to business decision makers.
- With a few
exceptions, model output is on an “absolute” profit/profitability scale and allows “absolute” go/no-go decisions.
- Some profit
models account for project risk.
12.1.2 Disadvantages of Profit-Profitability Numeric Models:
The disadvantages of these models are the following:
- These models
ignore all non-monetary factors except risk.
- Models that do
not include discounting ignore the timing of the cash flows and the time–value of money.
- Models that
reduce cash flows to their present value are strongly biased toward the short run.
- Payback-type
models ignore cash flows beyond the payback period.
- The internal
rate of return model can result in multiple solutions.
- All are
sensitive to errors in the input data for the early years of the project.
- All discounting
models are nonlinear, and the effects of changes (or errors) in the variables or parameters are generally not obvious to most
decision makers.
- All these
models depend for input on a determination of cash flows, but it is not clear exactly how the concept of cash flow is properly defined
for the purpose of evaluating projects.
12.1.3 Profit-Profitability Numeric Models – An Overview:
A complete discussion of profit/profitability models can be
found in any standard work
on financial management—see Ross, Westerfield, and Jordan
(1995), for example.
In general, the net present value models are preferred to the
internal rate of return
models. Despite wide use, financial models rarely include
non-financial outcomes in
their benefits and costs. In a discussion of the financial value
of adopting project
management (that is, selecting as a project the use of project
management) in a firm,
Githens (1998) notes that traditional financial models “simply
cannot capture the
complexity and value-added of today’s process-oriented firm.”
The commonly seen phrase “Return on Investment,” or ROI, does
not denote any
specific
method of calculation. It usually involves Net Present Value (NPV) or Internal
Rate of Return (IRR) calculations, but we have seen it used in
reference to
undiscounted average rate of return models and (incorrectly)
payback period models.
In our experience, the payback period model, occasionally using
discounted cash flows,
is one of the most commonly used models for evaluating projects
and other investment
opportunities. Managers generally feel that insistence on short
payout periods tends to
minimize the
risks associated with
outstanding monies over the passage of time. While
this is certainly logical, we prefer evaluation methods that
discount cash flows and deal
with uncertainty more directly by considering specific risks.
Using the payout period as
a cash-budgeting tool aside,
its primary virtue is its simplicity.
Real Options:
Recently, a project selection model was
developed based on a notion
well known in financial markets. When one invests, one foregoes
the value of
alternative future investments. Economists refer to the value of
an opportunity foregone
as the “opportunity cost” of the investment made.
The argument is that a project may have greater net present
value if delayed to the
future. If the investment can be delayed, its cost is discounted
compared to a present
investment of the same amount. Further, if the investment in a
project is delayed, its
value may increase (or decrease) with the passage of time
because some of the
uncertainties will be reduced. If the value of the project
drops, it may fail the selection
process. If the value increases, the investor gets a higher
payoff. The real options
approach acts to reduce both technological and commercial risk.
For a full explanation
of the method and its use as a strategic selection tool, see
Luehrman (1998a and 1998b).
An interesting application of real options as a project
selection tool for pharmaceutical
Research and Development (R and D) projects is described by
Jacob and Kwak (2003).
Real options combined with Monte Carlo simulation is compared
with alternative
selection/assessment methods by Doctor, Newton, and Pearson
(2001).
PROJECT PROPOSAL
12.2 Introduction:
Project Proposal is the initial document that converts an idea
or policy into details of a potential
project, including the outcomes, outputs, major risks, costs,
stakeholders and an estimate of the
resource and time required.
To begin planning a proposal, remember the basic definition: a proposal is an offer or bid
to do
a certain project for someone.
Proposals may contain other elements –
technical background,
recommendations, results of surveys, information about
feasibility, and so on. But what makes a
proposal a proposal is, that it asks the audience to approve,
fund, or grant permission to do the
proposed project.
If you plan to be a consultant or run your own business, written
proposals may be one of your
most important tools for bringing in business. And, if you work
for a government agency, nonprofit
organization, or a large corporation, the proposal can be a
valuable tool for initiating
projects that benefit the organization or you the employee
proposed (and usually both).
A proposal should contain information that would enable the
audience of that proposal to decide
whether to approve the project, to approve or hire you to do the
work, or both. To write a
successful proposal, put yourself in the place of your audience
– the recipient of the proposal,
and think about what sorts of information that person would need
to feel confident having you
do the project.
It is easy to get confused about proposals. Imagine that you
have a terrific idea for installing
some new technology where you work and you write up a document
explaining how it works
and why it is so great, showing the benefits, and then end by
urging management to go for it. Is
that a proposal? The answer is “No”, at least not in this
context. It is more like a feasibility
report, which studies the merits of a project and then
recommends for or against it. Now, all it
would take to make this document a proposal would be to add
elements that ask management
for approval for you to go ahead with the project. Certainly,
some proposals must sell the
projects they offer to do, but in all cases proposals must sell
the writer (or the writer's
organization) as the one to do the project.
12.3 Types of Project Proposals:
Consider the situations in which proposals occur. A company may
send out a public
announcement requesting proposals for a specific project. This
public announcement, called a
Request for Proposal (RFP),could be issued through newspapers, trade journals, Chamber of
Commerce channels, or individual letters. Firms or individuals
interested in the project would
then write proposals in which they summarize their
qualifications, project schedules and costs,
and discuss their approach to the project. The recipient of all
these proposals would then
evaluate them, select the best candidate, and then work up a
contract.
But proposals come about much less formally. Imagine that you
are interested in doing a project
at work (for example, investigating the merits of bringing in
some new technology to increase
productivity). Imagine that you visited with your supervisor and
tried to convince her of this.
She might respond by saying, "Write me a proposal and I will
present it to upper management."
As you can see from these examples, proposals can be divided
into several categories:
1. Internal Proposal:
If you write a proposal to someone within your organization (a
business, a government
agency, etc.), it is an internal proposal.
With internal proposals, you may not
have to
include certain sections (such as qualifications), or you may
not have to include as
much information in them.
2. External Proposal:
An external proposal is one written by a separate, independent
consultant proposing to
do a project for another firm.
It can be a proposal from organization
or individual to
another such entity.
3. Solicited Proposal:
If a proposal is solicited, the recipient of the proposal in
some way requested the
proposal.
Typically, a company will send out requests for proposals (RFPs) through the
mail or publish them in some news source. But proposals can be
solicited on a very
local level. For example, you could be explaining to your boss
what a great thing it
would be to install a new technology in the office; your boss
might get interested and
ask you to write up a proposal that offered to do a formal study
of the idea.
4. Unsolicited Proposal:
Unsolicited proposals are those in which the recipient has not
requested proposals.
With unsolicited proposals, you sometimes must convince the
recipient that a problem
or need exists before you can begin the main part of the
proposal.
105
Table 12.2: Solicited Versus Unsolicited Proposals
12.3.1 Request for Proposal:
A Request for Proposal (referred to as RFP) is an invitation for
suppliers, through a
bidding process, to submit a proposal on a specific product or
service.
106
A Request for Proposal (RFP) typically involves more than the
price. Other requested
information may include basic corporate information and history,
financial information
(can the company deliver without risk of bankruptcy), technical
capability (used on
major procurements of services, where the item has not
previously been made or where
the requirement could be met by varying technical means),
product information such as
stock availability and estimated completion period, and customer
references that can be
checked to determine a company's suitability.
In the military, Request for Proposal (RFP) is often raised to
fulfill an Operational
Requirement (OR), after which the military procurement authority
will normally issue a
detailed technical specification against which tenders will be
made by potential
contractors. In the civilian use, Request for Proposal (RFP) is
usually part of a complex
sales process, also known as enterprise sales.
Request for Proposals (RFPs) often include specifications of the
item, project or service
for which a proposal is requested. The more detailed the
specifications, the better the
chances that the proposal provided will be accurate. Generally
Request for Proposals
(RFPs) are sent to an approved supplier or vendor list.
The bidders return a proposal by a set date and time. Late
proposals may or may not be
considered, depending on the terms of the initial Request for
Proposal. The proposals
are used to evaluate the suitability as a supplier, vendor, or
institutional partner.
Discussions may be held on the proposals (often to clarify
technical capabilities or to
note errors in a proposal). In some instances, all or only
selected bidders may be invited
to participate in subsequent bids, or may be asked to submit
their best technical and
financial proposal, commonly referred to as a Best and Final
Offer (BAFO).
12.3.2 Request for Proposal (RFP) Variation:
The Request for Quotation (RFQ) is used where discussions are
not required with
bidders (mainly when the specifications of a product or service
are already known), and
price is the main or only factor in selecting the successful
bidder. Request for Quotation
(RFQ) may also be used as a step prior to going to a full-blown
Request for Proposal
(RFP) to determine general price ranges. In this scenario,
products, services or suppliers
may be selected from the Request for Quotation (RFQ) results to
bring in to further
research in order to write a more fully fleshed out Request for
Proposal (RFP).
Request for Proposal (RFP) is sometimes used for a Request for
Pricing.
12.3.3 Request for Information (RFI):
Request for Information (RFI) is a proposal requested from a
potential seller or a
service provider to determine what products and services are
potentially available in the
marketplace to meet a buyer's needs and to know the capability
of a seller in terms of
offerings and strengths of the seller. Request for Information
(RFIs) are commonly used
on major procurements, where a requirement could potentially be
met through several
alternate means. A Request for Information (RFI), however, is
not an invitation to bid,
is not binding on either the buyer or sellers, and may or may
not lead to a Request for
Proposal (RFP) or Request for Quotation (RFQ). |