1. PROJECT EVALUATION/SELECTION
Project Management
M.Tech – III Sem

2. Steps in project evaluation
Estimate project cash – flows.
Establish the cost of capital.
Apply a suitable decision or appraisal criterion.

3. Project cash flow

4. Project Cash Flow
Basic principles
Components
Example

5. Basic Principles Incremental principles Long-term funds principles
Exclusion of financial cost principles
Post-tax principle.

6. Incremental principles
Project cash flow for ith year
= {cash flow of the firm with the project for ith year }
– {cash flow of the firm without the project for ith year }
Guidelines:
Consider all incidental effects – profitability/loss due to the project on other activities.
Ignore sunk costs – already spent for preliminary works, but not directly connected to the project.(R&D, Market Research, Consultant’s Fees)
Include Opportunity cost – resources already available with the firm like land, equipment can be used for project with opp. Cost.
Allocation of Overhead: indirect expenses.

7. Net Working Capital
Change in Net Working Capital--Net working capital is defined as current assets minus current liabilities.
Investment in working capital is a cash outflow during the year in which investment takes place
Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

8. Long – term funds principle
Focused on the profitability of long term funds like equity stockholders, preference stockholders, debentures etc.,
The sacrifice made by suppliers of long term funds is equal to the outlays on fixed assets and net working capital.
Benefits: Operational cash inflows after taxes and salvage value of fixed assets and net working capital.

9. Exclusion of Financial Costs
The interest on long term debt is ignored, while computing profit.
The expected dividends are deemed irrelevant in cash flow analysis.

10. Post-tax principle
Tax must be properly deducted in deriving the cash flow.
Cost of capital is also included in post-tax terms.

11. Components of cash flow
Initial Investment
Operating cash inflows
Terminal Cash flow

12. Initial Investment New Project Replacement Project
Cost of capital assets + Installation costs + working capital Margin + preliminary and pre-operative expenses – Tax shield on capital assets
Cost of replacement capital assets + Installation costs – post tax proceeds from the sale of old capital assets + change in working capital Margin + preliminary and pre-operative expenses* – Tax shield on replacement capital assets
* Usually NA for replacement projects

13. Operating cash inflows
New Project
Replacement Project
Profit after Tax + Depreciation + Other non-cash charges
+Interest on long term debt(1-tax rate)
Change in Profit after Tax + Change in Depreciation + Change in Other non-cash charges + Change in Interest on long term debt(1-tax rate)

14. Terminal Cash flows
New Project
Replacement Project
Post tax proceeds from the sale of capital assets + Net recovery of working capital margin
Post tax proceeds from the sale of replacement capital assets + Net recovery of working capital margin- Post-tax proceeds from the sale of present capital assets.

15. Developing Project Cash Flow Statement
+ Net income
+Depreciation
Capital investment
+ Proceeds from sales of
depreciable assets
Gains tax
Investments in working
capital
+ Working capital recovery
+ Borrowed funds
Repayment of principal
Net cash flow
Operating
activities
Income statement
Revenues
Expenses
Cost of goods sold
Depreciation
Debt interest
Operating expenses
Taxable income
Income taxes
Net income +
Investing
activities +
Financing
activities

16. EXAMPLE

17. Cost of capital

18. Cost of Capital
Rate of return on investments for the market value of the firm to remain unaffected.
Components:
Equity capital
Preference capital
Long-term debt capital
Firm’s cost of capital is the weighted arithmetic average of the post tax cost of various sources of long term finance used by it.

19. Conditions to evaluate new investments
Risk of new investment proposal is the same as the risk of existing investments.
Capital structure of the firm will not be affected by the investment proposal.

20. Miscoceptions This concept is too academic or impractical.
Cost of equity is equal to dividend rate or return on equity.
Retained earnings are cost free/lesser than external equity.
Depreciation has no cost.
Cost of capital can be defined in terms of an accounting based measure.
If a project is heavily financed by debt , its weighted average cost of capital is low.

21. Project selection

22. Strategic Management and Project Selection
Maturity of Project Management
Criteria for PS Models
Nature of PS Models
Types of PS Models
Uncertainty Analysis and Risk Management
Information Base for PS Models
Project Portfolio Process (PPP)
Project Proposal

23. Overview of PS Process
Project Management Office (PMO): Aligning corporate needs and project goals
Project Selection: Choose candidate project using Evaluation Criteria
Dealing with Uncertainty: Risk Analysis
Strategically selecting best Projects: Project Portfolio Process (PPP)
Locking up the deal: Writing a Project Proposal

24. PS Models Idealized view of reality
Representing the STRUCTURE of the problem, not the detail
Deterministic or stochastic

25. Criteria for Project Selection models
Realism (technical-, resource-, market-risk)
Capability (adequately sophisticated)
Flexibility (valid results over large domain)
Ease of Use (no expert needed to run model)
Cost (much less than project benefit)
Easy Computerization (use standard software)

26. Nature of PS models: Caveats
Project decisions are made by PM --- NOT by PS model!
A PS model APPROXIMATES, but does NOT DUPLICATE reality!

27. Nature of PS Models: Methodology
Start with detailed list of firm’s goals
Create list of project evaluation factors (PEF’s)
Weigh every element in PEF list
Compute an overall score for project based on weighted PEF’s
Select project that has the closest alignment with firm’s goals

28. Project Evaluation Factors (PEFs)
Production Factors
Marketing Factors
Financial Factors
Personnel Factors
Administrative and Misc. Factors

29. Types of PS Models: Nonnumeric
Sacred Cow
Operating Necessity
Competitive Necessity
Product Line Extension
Comparative Benefit Model

30. Numeric PS Models: Profit / Profitability
Payback Period (PB)
Average Rate of Return
Discounted Cash Flow (NPV-net present value)
Internal Rate of Return
Profitability Index
Other Profitability Models

31. Numeric PS Models: Scoring
Unweighted 0-1 Factor Model
Unweighted Factor Scoring Model
Weighted Factor Scoring Model
Constrained Weighted Factor Scoring Model
S = ∑(x)
S = ∑(s)
S = ∑(s·w)
S = ∑(s·w) ∏(c)

32. Choosing the PS Model Dependent on wishes and philosophy of management
80% of Fortune 500 firms choose “nonnumeric” PS models
Firms with outside funding often chose scoring PS models
Firms without outside funding often chose profit / profitability PS models

33. Management of Risk: Terminology
Risk: Decision based on complete information about the probability of each possible outcome.
Uncertainty: Decision based on incomplete or insufficient data.
Game: Decision based under conditions of conflict.

34. Areas of Uncertainty Project timing & expected cash flow.
Direct outcome of project, i.e. what exactly will the project accomplish
Side effects and unforeseen consequences of project

35. Window-of-Opportunity Analysis
Estimate IN ADVANCE economic impact of innovation before R&D is undertaken
Set up a baseline of current process as the sum of all current sub processes
Compute cost / performance of new innovation as a multiple of each sub process in the baseline system

36. Problems Affecting Data Used in PS Models
Accounting: arbitrary assignment of overhead costs, linear cost and revenue forecasts
Measurements: (subjective vs. objective), (quantitative vs. qualitative), (reliable vs. unreliable), (valid vs. invalid)
Technology shock: New technology has to overcome initial resistance threshold.

37. Project portfolio

38. Project Portfolio Process (PPP)
Step 1: Establish a Project Council
Step 2: Identify Project Categories & Criteria
Step 3: Collect Project Data
Step 4: Assess Resource Availability
Step 5: Reduce Project and Criteria Set
Step 6: Prioritize Projects within Categories
Step 7: Prioritize the projects within categories
Step 8: Implement the Process

39. Project Proposal: Content
Cover letter
Executive summary
Description and past experience of project team
Nature of technical problem to be solved
How to approach solution of technical problem
Plan for implementation of project
Plan for logistic support and administration

40. Project Proposal: Cover letter & Executive summary
Compose a cover letter as key marketing instrument
Explain fundamental nature and general benefits of project
Minimally technical language

41. Project Proposal: Past Experience of Project Team
List all key project personnel with titles and qualifications
Include full resume of each principal
Provide all pertinent references

42. Project Proposal: Technical Approach
General description of problem to be addressed or project to be undertaken
Major subsystems of problem or project
Methodology of solving the problem
Special client requirements
Test and inspection procedures

43. Project Proposal: Implementation Plan
Estimates of time, cost and materials for each subsystem and the whole project
Establish major milestones to break project into phases
List equipment, overhead and administrative cost
Develop contingency plans (incl. slack time)

44. Project Proposal: Plan for Administration and Logistic Support
Control over subcontractors
Nature and Timing of all reports (progress, budget, audits)
Change management
Termination Procedures
“touch of class” capabilities (artist’s renderings, meeting facilities, video conferencing, computer graphics)