2.5.3 Method Three: Profile Models

Profile models are another method for visually representing and comparing project alternatives. Specifically, profile models allow the organization to plot risk/return options for various project alternatives, and then select the project that maximizes return while staying within minimum acceptable risk.

Certainly, it should be noted that "risk" is a subjective assessment; that is, it may be difficult to establish an overall agreement on the level of risk associated with various projects. Nevertheless, the risk/return model offers another way for evaluating and screening projects in relation to each other. Consider the example shown in Figure 2.5 below. The four project alternatives we have been using are plotted on a graph with perceived risk on the y-axis and potential return on the x-axis. Because of the cost of capital to our firm, we would specify some minimum desired rate of return, most likely based on our internal rate of return requirements. Likewise, all projects would be assigned some risk factor and plotted relative to the maximum risk our firm is willing to take on. In following this logic, Figure 2.5 shows the graphic representation of each of the four project alternatives on the profile model. Note that these project risk values have been created here simply for illustrative purposes.

We can see that Project Alpha and Project Beta have similar expected rates of return. However, Project Alpha represents a far better selection choice, all else being equal. Why? Because the company can achieve the same rate of return with Project Alpha as it can with Project Beta for appreciably less risk. Likewise, Project Gamma offers a marginally greater return for some additional risk. Finally, Project Delta offers the most potential return, but at the highest level of risk.

The beauty of the profile model is that it offers another alternative for comparing project alternatives, this time in terms of the risk/return tradeoff. It is sometimes difficult to evaluate and compare projects on the basis of scoring models or other qualitative approaches. The profile model, however, gives project managers a chance to map out the potential returns that are available, while taking into consideration the concomitant risk for each choice. Thus, profile models give us another method for eliminating some project alternatives because they offer either too much risk or too little return relative to other choices.

Figure 2.5 Profit Model Evans, D. A., and Souder, W. (1998). Methods of selecting and evaluating projects. In J. K. Pinto (Ed.), Project Management Handbook. San Francisco, CA: Jossey-Bass. Copyright ©1998. This material is used by permission of John Wiley & Sons, Inc.