3- project financial tools- 1
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PROJECT COST MANAGEMENTSession-3
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o Project prioritization or investment appraisal
o Financial tools forproject decision making
February 3, 2012 Sana Ullah Khan PE, PMP 2
Session Objectives
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Someone said
Success in life often depends on theSuccess in life often depends on the
choices we make.choices we make.
Take advantage of best practices and available financial tools that can help youmake betterquality decisions
How do you make theright choice?
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Project selection is fundamentally a process of prioritization. When trying to
determine which projects have merit to qualify, a numberof selection criteria
involved and should be considered.
Typical criteria include:
o Technical merit
o Financial merit
o Production merit
o Marketing sales/merit
o Human resource management/merit
February 3, 2012 Sana Ullah Khan PE, PMP 4
Project PrioritizationProject Prioritization
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Optimal Connections, LLC
o These requires us to look at two aspects:
Spending money (cost)
Making money (revenues)
o Use a combination of financial tools to improve yourdecision making.
o AnsweryourQuestions regarding:
o Assessing whether an investment project is worthwhile?
o Do the benefits really justify the cost?
o How long will it take to recover our investment?
o Follow best-practices
o These tools are not new they have been used fordecades by organizations of all
kinds
Project Financial Tools: Why and How
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Optimal Connections, LLC
Project Prioritization: Benefits
o Minimize risk and costs through high quality decisions making
o Increased yourcredibility and authority
o Build strongerbusiness cases forproposals
o A more strategic approach aligned with the organizational business goals
o Help make sure successful business outcomes through improved services
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February 3, 2012 Sana Ullah Khan PE, PMP 7
Project Financial Tools
Investors use a numberof methods to evaluate investment projects, rank themInvestors use a numberof methods to evaluate investment projects, rank them
and select the most attractive among them to finance.and select the most attractive among them to finance.
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Payback period: Concept
o How long does it take for an investment to pay for itself?
OR
o How long does it take for incoming returns to cover costs
OR
o How long does it take for the investment to break even?
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Payback period: Project prioritization
o A viable project is one that is able to pay back the original investment as early
as possible.
o Project that take long time to achieve payback are less attractive than those
that achieve quick payback.
o Lengthy project restrict capital utilization fora long time.
o Forlengthy Projects many things can go wrong.
o From investment prospective the pay back indicates that we are finally out of
wood.
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Payback period: Calculations
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Payback period: Calculations
o Payback could occur during a year
o Only possible to give a rough estimate.
o One of the formulae is:
Duration x Investment
Payback = ------------------------------------------
Total Cash Received
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Payback example
Let us Consider
Cost of a machine = 60,000
Income streams from investment = 24,000/yr
Payback = 3 x 60,000/72,000
= 30 months (21/2 yrs)
Duration Income
Year 1 24,000
Year 2 24,000
Year 3 24,000
Amachine costs 50,000. It produces items that generate a profit of 5 eachon a production run of 25,000 units per year.Payback period will be 4 years
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Payback example
o Payback could occurduring a year
o In this case, payback can only be estimated through interpolation.
Investment Cash Flow Year1 Year2 Year3 Year4 Year5
Cash Inflows 300 300 300 300 300
Cash Outflows 800 150 0 0 0Net Cash Flow 500 150 300 300 300
Cumulative Cash Flow 500 350 50 250 550
Using the table above, where the payback year is clearly Year 4, payback period can
be calculated as follows;
Payback Period = Y + ( A / B ) Where,Y = The number of years before final payback year. In the example, Y = 3.0
A = Remaining to be paid at the start yr 3 to bring cumulative cash flow to 0. A = 50.
B = Total paid back in the entire payback year 4. In the example, B = 300.
For the example,
Payback Period = 3+ (50) / (300)
Payback Period = 3 + 1/6 = 3.17 Years
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February 3, 2012 Sana Ullah Khan PE, PMP 14
Payback analysis: Example
o When viewed from a payback
perspective, project A is more
attractive than project B.
o By achieving payback earlier,
Project A has funds that can bereleased after year 2 to exploit
another business opportunity.
Project B not provide this
opportunity before year 4.
o We are in better position to make
prediction and risk analysis forproject A.
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February 3, 2012 15Sana Ullah Khan P E, PMP
o A concept that suggests that a dollar today has different value than a
dollar one year from now.
o A number of factors effect the money value. Inflation is one of the
aspects.
o For a 10% inflation, a job of 10,0000/- promised in July 2011 will cost
you 11,000 if you are going to perform it in Jun 2012.
o In a case of no inflation, if you invested Rs 1000/- to a business at a
10% per annum interest rate.
o You would receive a payment ofRs 1100/- at the end of the year.
o Your initial investment ofRs 1000/- has grown to Rs 1100/- by 10%
over time.
Time value of money
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o When looking at your money that you
control today and take into account
how much it will be worth some time
in future, your are assessing the
future value of money.
o Take the case of money deposit in a
saving account that earn you 10% of
interest income per year over a five
year of time.
February 3, 2012 National Institute of Design andAnalysis 16
Future Value of Money
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February 3, 2012 National Institute of Design andAnalysis 17
Present Value of Money
o Future Value is calculated when you deposit money in saving
accounts. But when you invest in a project, you are doing the
reverse process.
o Suppose you started a new project and you invested Rs
10,000/- in it. After 5year you must have Rs 16,105/- at least to
have no loss.
o When you look at the future cash flow and assess it in terms of
today money, you are conducting a present value analysis.
o It is the reverse process of future cash flow.
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February 3, 2012 National Institute of Design andAnalysis 18
Present Value of Money
Considertwo five yearprojects A and B (UMT2003 series)
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February 3, 2012 National Institute of Design andAnalysis 19
NPV
o Both Projects A & B are making the same overall profit when stretched for5yrs.
o But On the basis present value associated with net flows, Project A is more
attractive because its discounted profit (533.0) is more then that ofProject
B(485.0).
o This Present value associated with net flows is called net present value (NPV).
o NPV is actually the present value of profit of a project future.
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February 3, 2012 National Institute of Design andAnalysis 20
NPV analysis
o ForPositive NPV, the project will be profitable.
o ForVe, it will lose money and should not be supported.
o Can be Computed automatically in most of the financial software.
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