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I THINK, THEREFORE I PLAN

Mastering the Methods and Meditation of Project Management

Lecture 01 & 02 – Initiating the Project By Don Kim

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Initiating the Project • Transform the idea into a formally approved

project • Define the project at a high level • Identify all stakeholders

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4.1 Develop Project Charter • .1 Inputs

– .1 Project statement of work – .2 Business case – .3 Agreements – .4 Enterprise environmental factors – .5 Organizational process assets

• .2 Tools & Techniques – .1 Expert judgment – .2 Facilitation techniques

• .3 Outputs – .1 Project charter

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Financing a Project • Options to fund the project

– Self funding – Equity – Debt

• Finance options – Produce internally – Buy – Lease

• Profitability Measures (see next slide)

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Profitability Measures • Benefit/Cost Ratio (BCR)

– Compares the benefits to the cost of different projects – BCR>I, benefits are greater than the cost – BCR=I, benefits and costs are same – BCR<I, costs are greater than the benefits

• Payback period is the length of time it takes the company to get back the initial cost of producingthe product or service

• Net Present Value (NPV) – The Present value of the total benefits (income or revenue) less the costs. NPV allows calculating the accurate

value of the project. – If NPV calculation>0, then accept the project – If NPV calculation<0, then reject the project.

• Internal rate of return (IRR) – The rate at which the project inflows and project outflows are equal – Projects with higher IRR value are profitable – IRR is the discount rate when NPV = 0 – IRR assumes that cash inflows are reinvested at the IRR value

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Question Based on the information provided below, which project would you recommend pursuing?

Project I, with BCR (Benefit Cost ratio) of 1:1.6 Project II, with NPV of US $ 500,000 Project III, with IRR (Internal rate of return) of 15% Project IV, with opportunity cost of US $ 500,000

A. Project I B. Project III C. Either project II or IV D. Can not say from the data provided

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Answer Answer: B • Explanation: Project III has an IRR of 15%, which means the revenues

from the project equal the cost expended at an interest rate of 15%. – This is a definitive and a favorable parameter, and hence can be

recommended for selection. • Project I has an unfavorable BCR and hence cannot be recommended. • Information provided on projects II and IV is not definitive, and hence

neither of projects II and IV qualifies for a positive recommendation.

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Capital Budgeting • Capital budgeting is defined as the process of planning for projects on assets with cash

flows of a period greater than one year. • These projects can be classified as:

– Replacement decisions to maintain the business – Existing product or market expansion – New products and services – Regulatory, safety and environmental – Other, including pet projects or difficult to evaluate projects

• Additionally, projects can also be classified as mutually exclusive or independent: – Mutually exclusive projects indicate there is only one project among all possible projects that can

be accepted. – Independent projects are potential projects that are unrelated, and any combination of those

projects can be accepted.

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The Importance of Capital Budgeting

• Capital budgeting is important for many reasons: – Since projects approved via capital budgeting are long term,

the firm becomes tied to the project and loses some of its flexibility during that period.

– When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset.

– Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.

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Cost of Capital • The cost of funds used for financing a business • Cost of capital depends on the mode of financing used – it refers to the cost of equity

if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt

• Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC)

• Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.

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Payback Period

• Payback period (PP) is the number of years it takes for a company to recover its original investment in a project, when net cash flow equals zero.

• In the calculation of the payback period, the cash flows of the project must first be estimated.

• The payback period is then a simple calculation.

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Group Exercise

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Equation: The last period with negative cumulative cash flow + (The absolute value of cumulative cash flow at the end of the last period / The total cash flow after the last period)

Answer: 4 + ( | -1,000 | ÷ 2,500) = 4.40

Year Machine A0 -$5,000 Year 0 1 2 3 4 51 $500 Cash Flow Machine A -$5,000 $500 $1,000 $1,000 $1,500 $2,5002 $1,000 Cumulative Cash Flow -$5,000 -$4,500 -$3,500 -$2,500 -$1,000 $1,5003 $1,0004 $1,500 Fraction Calculations N/A N/A N/A N/A 0.405 $2,500

Excel Examples:

PP1 = 4.40PP2 = 4.40 Breaking it down:

The Integer: 4 =COUNTIF(I10:M10,"<0") -> Counts all the number of negative cash flows in the Cumulative cash flows line before it turns positive from years 1 to 5.

The Fraction: 0.40 =INDEX(I12:M12,,COUNTIF(I10:M10,"<0")+1) -> The first part involves calculating the fraction for each of the years which you will find in the Fraction calculations line and the second option is to use INDEX to pick the right year of the fraction.

Wikipedia explanation: https://en.wikipedia.org/wiki/Payback_period

Verify the analysis:1) If we get $2,500 by year 5 and assuming we get the money with equivalent payments.

2) $2,500 / 365 days = $6.85 per day

3) $1,000 / $6.85 = 146 days.

4) 146th day of the year is May 26

5) 146 / 365 (total days in the year) = 0.4

Therefore our payback period is 4 + 0.4 = 4.4 years.


Equation: The last period with negative cumulative cash flow + (The absolute value of cumulative cash flow at the end of the last period / The total cash flow after the last period)

Answer: 2 + ( | 0 | ÷ 1,500) = 2.00 OR 1 + ( |1,500| ÷ 1,500) = 2.00

Year Machine A0 -$2,000 Year 0 1 2 3 4 51 $500 Cash Flow Machine B -$2,000 $500 $1,500 $1,500 $1,500 $1,5002 $1,500 Cumulative Cash Flow -$2,000 -$1,500 $0 $1,500 $3,000 $4,5003 $1,5004 $1,500 Fraction Calculations N/A 1.00 0.00 1.00 2.005 $1,500

Excel Examples:

PP1 = 2.00PP2 = 2.00 Breaking it down:

The Integer: 1 =COUNTIF(I10:M10,"<0") -> Counts all the number of negative cash flows in the Cumulative cash flows line before it turns positive from years 1 to 5.

The Fraction: 1.00 =INDEX(I12:M12,,COUNTIF(I10:M10,"<0")+1) -> The first part involves calculating the fraction for each of the years which you will find in the Fraction calculations line and the second option is to use INDEX to pick the right year of the fraction.

Wikipedia explanation: https://en.wikipedia.org/wiki/Payback_period


Tier 2: Strategic Thinking

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SuperSoda Launch of Electro-Light • SuperSoda, Inc. is the second largest beverage

producer in the US. • Their desire is to penetrate the sports drink market

and to do so they want to launch a new product called “Electro-Light”.

• You are the product manager in charge of this project. • What key factors should SuperSoda consider in deciding

whether or not to launch Electro-Light?

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Possible Answers • A good answer would include the following:

– Consumers. Who drinks sports drinks? Are there specific market segments to address? – Cost/price. Is the sports drinks market more profitable than those markets for SuperSoda’s current

products? Is it possible to profitably sell (price set by the market, internal production costs) Electro-Light? Given the fixed costs involved, what would be the break-even point for Electro-Light?

– Competitors. Which products will Electro-Light compete with? Which companies are key players and how will they react?

• A very good answer might also include multiple additional key factors SuperSoda should consider. For example: – Capabilities and capacity. Are the required marketing and sales capabilities available within SuperSoda?

Does the product require specialized production, packaging, or distribution? Is it possible to accommodate Electro-Light in the current production and distribution facilities? What impact does geography have on the plant selection?

– Channels. What is the ideal distribution channel for this product? Are current retail outlets willing to add Electro-Light to their product catalogue?

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Strategic Payback Question • Your team has gathered the following information on the US sports-drink market. The

information shows an estimate for the share of electrolyte drinks, as well as the current share for the two main electrolyte products: CoolSweat and RecoverPlus.

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• Based on the target price and up-front fixed costs, what share of the electrolyte drink market would Electro-Light need to capture in order to break even?

• Here is some additional information for you to consider as you form your response:

– Electro-Light would launch in a 16-ounce presentation (one-eighth of a gallon) with a price of $2.00 to retailers.

– In order to launch Electro-Light, SuperSoda would need to incur $40 million as total fixed costs, including marketing expenses as well as increased costs across the production and distribution network.

– The vice president of operations estimates that each bottle would cost $1.90 to produce and deliver in the newly established process.

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Answer • Figure out how many units of Electro-Light you would need to sell to break even:

– Variable profit per unit = $2.00 – $1.90 = $0.10 – Break even units = Total fixed costs/Variable profit per unit = $40m/$0.10 per unit = 400

million units • With the above result, you can compute the market share needed to break even:

– Electrolyte drinks market = 5% x 8,000 million gallons = 400 million gallons – Electro-Light sales in millions of gallons = 400 million units/8 units per gallon = 50 million

gallons – Market share = 50 million gallons/400 million gallons = 12.5%

• What is the strategic impact? • Since Electro-Light would need to capture a 12.5 percent market share of electrolyte drinks in

order to break even, it would need to be the number-two product in the market… How feasible is that?

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Portfolio Strategy Quadrant

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Market Share Profit

Cost Reduction

Operational Optimization


Net Present Value (NPV)

• Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows.

• Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows minus the original investment.

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Group Exercise Consider the Hoofdstad Project, which requires an investment of $1 billion initially, with subsequent cash flows of $200 million, $300 million, $400 million, and $500 million. We can characterize the project with the following end-of-year cash flows: What is the net present value of the Hoofdstad Project if the discount rate of this project is 5%?

Period Cash Flow (millions)

0 –$1,000 1 200 2 300 3 400 4 500


Example: NPV

Solving for the NPV:

NPV = –$1,000 +$200

1 + 0.05 1 + $300

1 + 0.05 2 + $400

1 + 0.05 3 + $500

1 + 0.05 4

NPV = −$1,000 + $190.48 + $272.11 + $345.54 + $411.35 (or - $1,000 + $1,219.48) NPV = $219.48 million

0 1 2 3 4 | | | | | | | | | |

–$1,000 $200 $300 $400 $500

Time Line


Benefits to Cost Ratio (BCR using NPV) • The BCR, like BCA, can use NPV to attempt to identify the

relationship between the cost and benefits of a proposed project

• The equation is: – Sum of the present value of the cash inflows ÷ the present value of the

cash outflows – Where if:

• BCR>I, benefits are greater than the cost • BCR=I, benefits and costs are same • BCR<I, costs are greater than the benefits

• What is then, the BCR of the Hoofdstad Project?

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Answer • Cash inflows = $200

1 + 0.05 1 + $300

1 + 0.05 2 + $400

1 + 0.05 3 + $500

1 + 0.05 4

• Or $190.48 + $272.11 + $345.54 + $411.35

• Cash outflow = $1,000 • BCR = $1,219.48 ÷ $1,000 = 1.2 • BCR > 1, do the project still!

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Internal Rate of Return (IRR) • The internal rate of return (IRR) on a project is the rate of return at

which the projects NPV equals zero. • At this point, a project's cash flows are equal to the project's costs. • Similar to how management must establish a maximum payback

period, management must also set what is known as a "hurdle rate", the minimum rate of return a company will accept for a project.

• When a project is reviewed with a hurdle rate in mind, the greater the IRR is above the hurdle rate, the greater the NPV, and conversely, the further the IRR is below the hurdle rate, the lower the NPV.

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Formal (Math!) definition of IRR • An IRR is obtained by finding the root of a polynomial

where each coefficient is the amount of one transaction in the cash flow, and the power of the corresponding coefficient is the number of days between that transaction and the first transaction divided by 365 (one year) – Note that it isn't a polynomial in the traditional meaning since its

powers may have decimals or be less than 1 • There is no universal way to solve this equation analytically • Instead, we have to find the polynomial's root with various

root finding algorithms

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Newton-Raphson Method for IRR

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The function ƒ is shown in blue and the tangent line is in red. We see that xn+1 is a better approximation than xn for the root x of the function f.


Group Exercise Consider the Hoofdstad Project that we used to demonstrate the NPV calculation: The IRR is the rate that solves the following:

Period Cash Flow

(millions) 0 –$1,000 1 200 2 300 3 400 4 500

$0 = −$1,000 + $2001 + IRR 1 + $300

1 + IRR 2 + $4001 + IRR 3 + $500

1 + IRR 4

What is the IRR?


A note on solving for IRR

$0 = −$1,000 + $200

1 + 0.12826 1 + $300

1 + 0.12826 2 + $400

1 + 0.12826 3 +$500

1 + 0.12826 4

• The IRR is the rate that causes the NPV to be equal to zero.

• The problem is that we cannot solve directly for IRR, but rather must either iterate (trying different values of IRR until the NPV is zero) or use a financial calculator or spreadsheet program to solve for IRR.

• In this example, IRR = 12.826%:


NPV Profile: Hoofdstad Capital project

$400

$3

61

$323

$2

87

$253

$2

19

$188

$1

57

$127

$9

9 $7

2 $4

6 $2

0 –$

4 –$

28

–$50

–$

72

–$93

–$

114

–$13

3 –$

152

-$200-$100

$0$100$200$300$400$500

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

NPV (millions)

Required Rate of Return


The NPV Profile

• The NPV profile is a graph that illustrates a project's NPV against various discount rates, with the NPV on the y-axis and the cost of capital on the x-axis.

• To begin, simply calculate a project's NPV using different cost-of-capital assumptions. Once these are calculated, plot the values on the graph.

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Popularity and usage of capital budgeting methods

• In terms of consistency with owners’ wealth maximization, NPV and IRR are preferred over other methods.

• Larger companies tend to prefer NPV and IRR over the payback period method.

• The payback period is still used, despite its failings. • The NPV is the estimated added value from investing in the

project; therefore, this added value should be reflected in the company’s stock price.


Toilet Paper vs. Paper Napkin Paradox

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4.1 Develop Project Charter

• Process of developing a document that formally authorizes a project or a phase and documenting initial requirements that satisfy the stakeholders’ needs and expectations.

• Establishes a partnership between the performing organization and the requesting organization.

• Approved project charter formally initiates the project.

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Typical Charter Contents • Objective – A paragraph or two that clearly articulates what the intent of the project is and that outlines what is to be delivered. • Benefits – What business benefits is this project supposed to deliver? • Scope

– In Scope: A clearly bulleted outline of scope items. If you did your job right in obtaining this, it will directly map to the second level of the Work Breakdown Structure (WBS). We will go into what this means later. In my opinion, you should have at most 5 (plus or minus 2) scope items in your Project Charter (Any more than this and you have a project that is already in a state of “scope creep”).

– Out of Scope: Just as important as including what is in scope is what is not in scope! You should attempt to nail this down as much as possible, going in the opposite direction of listing in-scope items.

• Assumptions – What are some of the assumptions you, your team and your stakeholders are under with regard to how the project will be delivered?

• Constraints – What are some of the things you already know or anticipate will hold you back? • Risks – What are some of the immediate high-level risks you anticipate for the project? • Present vs. Future State (optional) – Though this is optional in my opinion, it is sometimes helpful if you can show what the current state

is and what the expected future state will be like when your project is complete. A diagram is most effective.

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4.1 Develop Project Charter .1 Inputs

.1 Project statement of work

.2 Business case

.3 Agreements

.4 Enterprise environmental factors

.5 Organizational process assets .2 Tools & Techniques

.1 Expert judgment

.2 Facilitation techniques .3 Outputs

.1 Project charter

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Questions?

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