Selecting the right project

In late 1986 the main board of UK carmaker Rover Group had to make a big investment decision.  Should it back a new MG sports car to rebuild the international market for nippy and stylish British sports cars, or invest in a new Land Rover model aimed at bringing four-by-four motoring to young executive families?  Find out how project selection techniques might have been used to guide the firm to its decision – which produced the very successful Land Rover Discovery.

Deciding what should be in the portfolio

An organisation will often have a portfolio of projects and perhaps programmes, each with a different objective.  Large commercial firms seek to have a balanced portfolio which includes sensible shares of breakthrough projects, which are highly inventive but may bring huge returns, platform projects, which can be very innovative but are substantially based on something which has already been developed, and derivative projects which make improvements to existing products or services to keep them competitive.  Sustaining this balance is one consideration in deciding what new projects to approve.  Three important ways to test the viability of potential projects of any kind are numerical methods, like weighted scorecards, financial methods, like net present value analysis, and what I call advocacy and argument, where individuals will make the case for a project based on emotional rather than rational criteria.

Weighted scorecard

When considering different options for how best to do a project, certain criteria might be considered more important than others.  In the Land Rover case, Rover Group had to decide between Land Rover’s proposal for a new car and MG’s.  Four criteria have been identified in our fictional example below, and each one is given a weighting score out of ten.  Thus use of existing parts is considered more important than global sales prospects.  Each option is scored out of ten on how it matches up to each criteria.  To get an overall score for each option we multiply the criterion score by the option score to get a sub-total.  We repeat that for each criterion and add up the sub-totals to get an overall score for each option.  Thus for Land Rover, the total is (5 x 6) + (5 x 6) + (7 x 8) + (7 x 8) = 172.

Payback analysis

When investing money in a commercial project, we are interested in how long the revenues in the future will take to pay back that investment.  The example below looks at the case of a business proposing to open a gym.  The investment is made in Year 0 and we start earning revenues (less expenses for maintenance, wages, etc.) in Year 1.  The project pays back when the cumulative net cashflow goes positive.  This occurs in slightly less than 4 years and 9 months.

Net present value (discounted cashflow)

The trouble with the simple payback calculation is that it takes no account of the fact than any sum of money in the future is worth less than today, due to inflation.  NPV takes this, and other factors, into account to give a truer reflection of how long the project will take to pay off – using what is known as discounted cashflow.  We combine the anticipated average inflation rate, a figure for the required rate of return (because the project must compete for funds against other contenders or with investing the money elsewhere), and a figure for risk (a kind of handicap for projects depending on how risky they are perceived to be).  This produces the discount rate.  Using this in a formula, we calculate the discount factor that must be applied to the simple cashflow in each year to get a more realistic value.  Adding up all these annual net cashflows across the analysis period (in this case 5 years) gives us the net present value.  When we are considering options we are generally looking for the option with the highest positive NPV, although with projects about say complying with new regulations, the one with the least negative NPV is probably the most attractive.

There is a simpler formula for the discount factor, which is easy to use, and slightly more conservative.  Here is the NPV it gives using the same input figures.

What these three charts show is that, whereas a simple payback analysis indicates that the gym is a good investment, net present value analysis shows it is quite the opposite.

There are more examples of how to use discounted cashflow techniques in More about discounted cashflow – Zavanak

Main source

Taylor, J. (2014). Land Rover Discovery – 25 years of the family 4 x 4. Ramsbury, UK: Crowood Press.