CHAPTER 2

CHAPTER 2

1. Project Selection Process

   • Starts before initiating
   • The company first examines the offer from different perspectives, weighs its pros and cons, and measures it up against other projects that the company might be having in the pipeline.

2. Project Selection Methods

   • Payback Period (PP)
     • The Payback Period refers to the time required to recover the costs on investment. Payback Period Method is based on the principle that every capital expenditure is recovered within a certain period of time. The investment that has a shorter Payback Period is considered to be a better one, as it recovers the costs quicker.
       • Following is the illustration of the formulae used to calculate the PP. For Projects that Generate Constant Cash Inflows Payback Period (PP) = Project Costs/Annual Cash Inflows:
         • For example: Investment on a Project = $50,000 Return from Investment = $10,000 every year. Therefore, PP = $50000 / 10000 = 5 years
       • For Projects that Generate Unequal Cash Inflows The PP for the projects that generate unequal cash inflows can be calculated by adding the periodic cash inflows, till the time when the whole investment costs have been recovered. For example: Investment on a Project = $30,000 Yearly Inflows from Investment (for first five years) = $2,000, $4,000, $6,000, $8,000 and $10,000 respectively Total returns after five years = $30,000 Therefore, PP = 5 years
     • This PP method is simple and discards the need of any complex analysis. But, the main disadvantage of this method is that it does not take into account the time value of money. According to this method, all the inflows are on a par with one another. It ignores the fact that the money received today has more importance than the money received next month or next year.
   • Discounted Cash Flow (DCF)
     • The Discounted Cash Flow method takes into account the present and future value of cash inflows.
       • Future Value of Money (FV) = PV(1 + i)n
         • For example, A bank lends to a client an amount = X (for a period of 5 years) Interest charged (on the amount) by the bank = I Thus, Amount received by the bank ( after 5 years) = X+I Hence, Future Value (after 5 years) of X = X+I Formula for calculating the Future Value of money is (FV) = PV(1 + i)n FV = Future Value PV = Present Value i = Interest rate in percentage n = Number of periods for which the interest is paid For example Future Value of $5000 after 3 years at an interest rate of 2% per annum will be $5306, as calculated below: FV = 5000(1 + 2/100)3 FV = 5000(1.02)3 FV = 5000 (1.061) = $5306 (pdf 2 second page)
       • Present Value of Money (PV) = FV / (1 + i)n
         • This formula can be applied to the earlier example (of 2 projects) to get the net present value of the cash inflows of the project in the context of the two projects, assuming that the Cost of capital = 9% & Total Investment on the project = $25,000. Yearly Inflows of Project A = $5,000, $6,000, $6,000, $4,000, $11,000 = $32,000 Yearly Inflows of Project B = $15,000, $13,000, $2,000, $1,000, $1,000 = $32,000 According to the Payback Period method, both the projects look equally profitable, as they both generate $32,000 each, at the end of 5 years. But, if the Net Present Value of the Inflows is calculated, Project B will emerge as a better project. The formula, Present Value = FV / (1 + i)n
           • Can be used for calculating the present value of all the cash inflows. Here are the calculations. Yearly Inflows of Project A = $5,000, $6,000, $6,000, $4,000, $11,000 = $32,000 Yearly Inflows of Project B = $15,000, $13,000, $2,000, $1,000, $1,000 = $32,000 Net Present Value of the Yearly Inflows of Project A = (5000 / (1 + 9/100)1), (6000/(1+9/100)2), (6000/(1+9/100)3), (4000/(1+9/100)4), (11000/(1+9/100)5) = 4587 + 5050 + 4633 + 2833 + 7149 = 24252 Net Present Value of the Yearly Inflows of Project B = (15000 / (1 + 9/100)1), (13000/(1+9/100)2), (2000/(1+9/100)3), (1000/(1+9/100)4), (1000/(1+9/100)5) = 13761 + 10941 + 1544 + 708 + 649 = 27603 These calculations show that the Net Present Value of the inflows of Project B is more than that of Project A. Moreover, the total inflows of Project B cover the project investment of $25,000. Therefore, Project A should be dropped, as it does not cover the project expenditure.
   • Internal Rate of Return (IRR)
     • The Internal Rate of Return method is a slightly complex method. This method takes into account the time value of money, that's why it is also referred to as the Time Adjusted Rate of Return or Discounted Rate of Return method.
     • This method requires that the discount rate be fixed internally, hence the name Internal Rate of Return. The Internal Rate of Return can be defined as the rate of discount at which the net present value of cash inflows is equal to the net present value of cash outflows.
     • How to calculate the Internal Rate of Return (IRR) C alculating the IRR involves two steps: 1) Determining the future net cash inflows for the entire economic life of the project. 2) Determining the rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. There can be two different scenarios for calculating the IRR, based on whether or not the annual cash inflows are equal throughout the life of the project.
       • i) IRR on Equal Cash Inflows The first step for calculating the IRR is to calculate the Present Value Factor, which is based on the following formula: Present Value Factor = Initial Project Investment / Annual Cash Inflow Then, refer to the Present Value Annuity Tables by choosing the years as equivalent to the life of the project. Find out the rate at which the present value factor is equal to the present value given in the Present Value Annuity Table. Present Value Annuity Tables are freely available and save a lot of time while making Present Value C alculations.
         • For example If a project has an initial outlay of $20,000, an asset life of 3 years, & an annual cash inflow of $7,000, what will be the IRR? The Present Value Factor = 20000/7000 = 2.8 Now, if we refer to the Annuity Table to choose 3 years and match the rate of return for a Present Value Factor of 2.8, it comes out to be 2% approximately (as shown in the table above.) Therefore, RR of the project = 2%.
       • ii) IRR on Unequal Cash Inflows: In case the cash flows are unequal over the life of the asset, the IRR is calculated by trial and error process. This starts by assuming any discount rate and calculating the total Present Value for all the cash flows, using the Present Value Anuity Tables. The rate at which the total Present Value of cash inflows is equal to the initial investment is the IRR.
         • The steps involved are: 1) Prepare a cash flow table using an assumed discount rate to discount the net cash flow to the present value. 2) Find out the net present value of all the cash inflows for the lifetime of the project (in the case above, it is 4 years.) 3) Using trial and error process, try to match the total cash inflow over the lifetime of the project with the project investment (in the case here, it's $95000.) A higher discount rate can be applied to reduce the Net Present Value. You may have to try the calculation with several discount rates until you reach the required total cash inflow figure for the lifetime of the project. In the example given above, discount rates of 5%, 8%, and 10% were tried. Finally, the total cash inflow figure at a discount rate of 8% approximately matched the project investment of $95,000, So, the IRR of the project is 8%.
   • Profitability Index Method/Cost Benefit Ratio Method The Profitability Index Method is also called the C ost Benefit Ratio method as well as the Time Adjusted method. This method calculates the project profitability as a ratio of the Present Value of the cash inflows and the Present Value of the cash outflows of the project.
     • Profitability Index (PI) = Present Value of C ash inflows / Present Value of C ash Outflows Profitability Index (PI) = Present Value of C ash Inflows / Initial Investment in the project A good rule of thumb is that the project is accepted if the PI > 1 and rejected if the PI < 1. PI can be used to compare different projects. A project with a higher PI is ranked higher than the one with a lower PI.
   • Cost Benefit Analysis This is a simple method to assess whether or not a project is good enough to be selected. C ost Benefit Analysis compares the costs of undertaking the project with the benefits of implementing it. If the benefits of the project outweigh the costs, the project can be considered viable. Different companies have different parameters for making these comparisons. Therefore, the C ost Benefit Analysis must include the subjective benefits of the project.

3. Project Initiation

   • Project Initiation means beginning or kicking-off a new project by formally accepting its existence. Apart from referring to the beginning of a new project, the Initiation Process can also imply a formal recognition of the continuation of an existing project into its next phase. But, the Initiation Process is usually associated with the beginning of a new project.
   • This beginning doesn't mean starting on the first activity with regard to producing the project deliverable. For example: A furniture company that is going to undertake a project of making 500 computer tables for an IT group will begin the project not by purchasing the wood, but by deliberating on the pros and cons of the project. A company has the option to undertake hordes of projects, but it does not take all of them. A company wisely picks the projects that best suit its interests, objectives, capabilities, and resources. The process of rightly choosing the projects and aptly prioritizing them is called Project Selection Process.
   • the Initiation Process establishes the identity of the project. A first process of project life cycle
   • A project starts existing officially after this process. However, the process is not restricted to mere acceptance and approval of the project. It's a holistic process which involves the whole gamut of activities, as mentioned below:
     • 1) Defining the Project Scope 2) Setting the Project Objectives 3) Marking down the responsibilities 4) Planning the different processes 5) Allocating the funds and resources 6) Identifying the risks 7) Assessing the gains 8) Determining the needs and expectations 9) Calculating the organizational capabilities 10) Assigning the roles 11) Selecting the Project Manager 12) Finalizing the Reporting System
       • Project Initiation is a crucial phase on which hinges the future of the project. Therefore, it's important to start this phase in the right manner. The Initiation Process has to be craftily carved out to set the tone for the whole project. This is done through a vital document called PID. The exact meaning and components of PID have been discussed below.
         • What is PID (Project Initiation Document)
           • Is like Project Charter. It defines scope and other important aspect of the project. PID is not necessarily a single document report. It can comprise a set of documents explaining different aspects of the project. it's not a static unchangeable draft. In fact, as the project moves on, there can be additions and alterations in this document, according to the needs and requirements of the project. The main objective of this document is to clearly mark down the right path for the project.
             • The important areas that PID covers:
   • Inputs into Project Initiation Process
     • Product Description
       • Project Initiation requires information in the form of a product description, which clearly specifies the kind and nature of the deliverable to be produced by the project. This information also depicts the correlation between the product deliverable and the business requirements, which can be used as a means of pricing the contract and as a tool to measure the results of the various project processes. Therefore, it is essential to specify every detail of the deliverable in the Project Description Report.
     • Strategic Plan
       • What are the goals of the organization? This is the question that needs to be answered before undertaking any project. The answer to this question answers many other questions related to the Project Initiation Process.
     • Project Selection Criteria
       • Project Selection Criteria act as a vital input to the Project Initiation Process, as they elucidate various factors like the financial gains, market share, and product specifications.
     • Historical Information
       • Historical Information refers to the previous projects undertaken by the organization. It's a vital input to the Project Initiation Process, as it sheds light on the previous projects in the context of the effects of the various decisions regarding those projects.
   • Outputs from Initiation Process
     • PID As described earlier, PID is the Project Initiation Document, which formally recognizes the existence of a project. Besides, it portrays the vital aspects of the project like Project Background, Project Scope, and Project Objectives.
     • Project Manager Identification. Project Manager is a key figure in a project's scheme of things. That's why it is essential to identify the Project Manager for a project as early as possible. Ideally, a Project Manager should be brought in, while the project planning process is on.
     • Constraints When the project is on, a lot of factors tend to impede its progress. Such impediments are called constraints.
       • Some of the most common constraints are: Financial Constraints Time Constraints Quality Constraints Technological Constraints Procurement Constraints Management Constraints
     • Assumptions Every project is based on certain calculated assumptions. These assumptions are made with reference to the different processes or activities of the project.
   • Tools and Techniques for Initiation
     • Project Selection Methods: Project Selection Methods assess the prospective gains from the project. According to A GUIDE TO THE PMBOK,Project selection methods generally fall into one of two broad categories:
       • Benefit Measurement Methods: Comparative approaches, scoring models, benefit contribution, or economic models.
       • Constrained Optimization Methods: Mathematical models using linear, nonlinear, dynamic, integer, and multi-objective programming algorithms.
     • Expert Judgment A project is a huge task, which calls for strenuous efforts and wise decision making. To ensure that the decisions made with regard to the different processes and activities of the project are judicious, there arises a need for expert judgment. The experts calculate and evaluate the inputs to the Project Initiation process. The experts can be identified from within the organization or from any outside source like customers, consultants, and other professionals.

4. Review Questions

   • 1. Explain the Project Initiation Process in 4 lines.
   • 2. Explain the Inputs to Project Initiation Process.
   • 3. Describe the PID in 4 lines.
   • 4. Explain the various Project Selection Methods.

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