Unit 04 -Project SelectionOctober 2004 | Project Management | Wilhelm F. Neuhäuser©IBM Corporation 2003AgendaUnit 4: Project SelectionObjectivesNonnumeric selection modelsProject selection overviewLife-cost cycleProfitability measuresUsing financial measures to select projects andalternative strategiesKey messages -Unit 4ObjectivesAt the end of this module, you will be able to -Understand project selection and its role in theoverall projectUnderstand processes that drive the projectselection processesDescribe financial analysis approaches used forproject selectionNon-numeric Selection Models Sacred cowOperating necessityCompetitive necessityProduct line extensionsComparative benefit modelJust do it!Numeric Project Selection ModelsPortfolio AnalysisOpportunitiesFuturePerceivedWhy notProfitability measuresReturn on salesReturn on investments and return on assets (ROA)Net present value (NPV)Portfolio Analysis in Project SelectionAnalytical tool to determine investments inproducts, systems, businesses, and servicesResults in -Investment prioritiesAlternative strategiesPerformance improvement initiativesFinancial measurementsTypically used by corporate planning, businesssegments, and portfolio management/marketplanning teamsPortfolio Management -Logical ViewPortfolio ManagementCollect Market Segment Data Assess Capabilitiesby Segment Define Market Segments Priorities InvestmentsSegment Data Define customer market segments Select current and future markets Map current offerings into market segments Identify new market opportunitiesLink vision, mission, and goals to segmentsCollect and rank customer requirements Determine competitive environmentUnderstand market environment and trendsDetermine financial performance of segmentsAssess markets Assess market attractivenessAssess competitive positionAssess financial performancePerform strategic position analysis Perform financial performance analysisEvaluate alternative strategiesOptimize coverage by segment and businessOptimize financials Evaluate linkage to vision, mission, and goalsFinalize customer offerings portfolioCommit to businessLife-Cycle CostTechnique assesses "total cost" of project fromConcept to End-of-LifeNormalizes all risks to measure their effect onbaseline life-cycle cost (LCC)Usually uses computer modelGenerally used for complex projects that arerelatively expensive and multiyear in durationProfitability MeasuresAssess the relative levels of return to anorganization from various alternativesMay be applied to factors having nothing to do withmonetary profit or loss -are a means to evaluatethe relative desirability of a given optionAre selected for use based on the relative length ofan option, the level of investment, and the timing ofinflow and outflowProfitability Measures (continued)In order of increasing complexity, the mostcommon profitability measures are -Present valueReturn on sales (ROS) or simple profitReturn on assets (ROA) or return on investment(ROI)Economic value added (EVA)Using Financial Measures to select Projects and Alternative StrategiesPresent value = PVPayment today is worth more than paymenttomorrowPresent value is the value of a future paymentFor a given future payment t years from now -M tPV =(1 + r)tM t= amount of payment t years from nowr= interest rate (sometimes called "discount rate")Sample Calculation of Net Present Value (NPV)30,83917,9620.513235,00015,00050,000712,86722,5800.564540,00010,00050,0006-9,70327,9410.620945,0005,00050,0005-37,64423,9050.683035,0005,00040,0004-61,54918,7820.751325,0005,00030,0003-80,331-1,2400.8264-1,50015,00013,5002-79,091-29,0910.9091-32,00035,0003,0001-50,000-50,0001.0000-50,00050,0000Net Present Value V t d tDiscounted Cash Flow V t d tDiscount factor d tNet Cash Flow V tYear CostYear Revenue tYearReturn on Sales (ROS)ROS is a simple, non-time-dependent measure ofnet profit or return as a percentage of a project'stotal sales or revenue generatedNet ProfitROS =SalesNegative return on sales indicates a lossROS ExampleComponents of a compute system are purchased for$500,000. Additional systems integration andprogramming work is performed for $200,000.Indirect (overhead) expenses of 50% of labor costsare allocated to the project. Once assembled, thecomputer system is sold for $1 million. Income taxesare 40%.Calculate net profit and return on sales.ROS Example (continued)Sales =$1,000,000Material =500,000Labor =200,000Overhead =100,000Profit =200,000Taxes =80,000Net Profit=120,000Net Profit ROS =Sales=$120,000$1,000,000=12%Profit & Loss Calculation ExampleRevenue -Cost (royalties, warranty, maintenance, base manufacturing cost, goods,...) = Gross profit (GP); % GP (percentage from revenue)-Unique expenses (development expense, direct marketing and services,...)-SG&A (sales, general administration & allocations)= NEBT (net earnings before tax) = Profit contribution % NEBT (percentage from revenue)Return on AssetA relative measure of profitability comparing anorganization's return on an effort with its overallinvestment in assets required to perform the effortSometimes referred to as return on investment(ROI)Net ProfitROA =Total assetsROA ExampleIn the previous example, assume the computerassembly operation required an asset base of $2million to support its operation.Calculate ROA.Net Profit ROA =Total assets =$120,000 $2,000,000=6%Economic Value Added (EVA) andEconomic Value Loss (EVL)Approach that evaluates the return-on-capitalpercentage versus the cost-of-capital percentageCan be calculated using various methodsAssesses the effectiveness of creating value forshareholdersWhat is the Cost of CapitalRepresents the cost of financing an organization'soperationsReflects the minimum rate of return required byinvestorsDebt holders require interest and principle repaymentShareholders require dividends and stock priceappreciationFocusing on the cost of capital enables anorganization to identify development projects thatcreate value for shareholdersEVA Approach and ExampleEVA is used to measure financial value created forshareholdersEVA = net operating profits after taxes minus theweighted average cost of capital (NOPAT -WACC)Using the same information from the ROS and ROA examples,assume the weighted average cost of capital for your companyis determined to be 10%.Calculate EVA.EVA = NOPAT -WACC= $120,000-10% x $2,000,000= $120,000-$200,000= -$80,000Raising EVAThere's nothing fancy or complicated about how to make economic valueadded (EVA) go up. It's a fundamental measure of return on capital, and thereare just three ways to increase it:Earn more profit without using more capitalYou probably spend much of your time thinking of ways to do this; cost cutting is today's favorite method. Nothing wrong with that, but focusing on it often blindscompanies to other ways of raising EVA.Use less capitalIn practice, this is often the method that companies adopting EVA find mosteffective.Coke uses plastic containers for concentrate instead of costlier metal ones. CSX figures out how to operate with 100 locomotives instead of 150. Quakerreschedules production to require fewer warehouses.What to do with the capital saved? Companies can return it to shareholdersthrough higher dividends or stock buybacks, or can ...Invest capital in high-return projectsThis is what growth is all about. Just make sure you expect these projects to earn more than the total cost of the capital they require.From "The Real Key to Creating Wealth", Fortune, September 20, 1993Summary of Profitability Measurement Tools and Techniques Tool ROS Advantages Simplicity of use Simplicity of understanding Flexibility Reflects actual level of investment in effort Reflects time value of investment Easy method is relatively accurateMeasures value created Easy to understand Focuses decision making Disadvantages Does not evaluate relative levels of investment Does not consider length of project or effort Does not reflect time value of returnmeasurement No set formulas Difficult to compute EVA at project levelROA EVAKey MessagesProject success is often driven by the clarity ofproject definitionsPlan globally, think locallyThe individual project manager may or may not beinvolved in the project selection process for aspecific project。
