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LESSON 12
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,
- 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 docsity.com
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, t he 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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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 up- to-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. docsity.com
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, non- profit 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.
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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.
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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).
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