pm financila perspective

7/29/2019 PM Financila perspective

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Project Management:The Financial Perspective

Muhammad Umer


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Agenda

The big picture

Why bother with financial analysis?

Conducting financial analysis

A practical example


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The bewildering range of potential projects

Wind powerHydro power

Animal waste

Sewage /wastewater

Landfill

Forestry

Bio-fuels

Transport

Heavy Industry


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So, to summarize

Different project-types (and different projects) generatedifferent volumes of cash flows and outputs

Some projects rely solely on initial revenues

Many projects combine initial revenues with other sources

of revenue

Financial analysis is vital to understanding a project,both in advance and during the projects lifetime


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Agenda

The big picture



A practical example


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Three uses for financial analysis

Is the project going to make money?1


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A project costs money. Is it worth the effort?

Assumes a n-yearproject.

Recurrent costsdiscounted at n%

annual rate to expressin present-value

terms.

Registration costs,

Administration Feenot included.

Indicative Cost Profile For ATypical Project

13,000

38,000

16,500

10,000

34,000

53,000

Validation

InitialMonitoring

OngoingVerifications

Ongoing

AnnualMonitoring

Pre-LaunchCosts

Post-Launch Costs

US$

51,000

67,500

77,500

111,500

164,500


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Demonstrating additionality2



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Demonstrating additionality investment comparison analysis

Project withoutsufficientrevenue is

unprofitable

Project withoutadditionality

element

Project withadditionality

element

Sustainablerevenue makes

the projectworthwhile

Break-even point

Revenue/NPV

/IR

R

Choose an appropriate financial indicator, such as IRR, NPV or benefit-cost ratio, to demonstrate additionality


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Demonstrating additionality benchmark analysis

Choose an appropriate financial indicator and compare it with a relevantbenchmark value: e.g. required return on capital or internal company

benchmark

Project withoutsufficientrevenue is

profitable butnot sufficiently

profitablecompared with

alternatives

Project withoutadditionality

element

Project withadditionality

element

Consistentrevenue makes

the projectattractive

relative toinvestmentalternatives

Investmentthreshold

Revenue/NPV

/IRR


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Demonstrating additionality2


Structuring the project3


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Revenue flows determine more than just profits

Future revenue flows can be used as collateral forobtaining loans from financial institutions

Future revenue flows can be used to negotiate forwardpayment from the buyer. This up-front payment can then

be used to pay for project establishment costs


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Agenda

The big picture



A practical example


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Investment appraisal techniques

Payback period

Net present value (NPV)

Internal rate of return (IRR)

Benefit-cost ratio (BCR)


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Payback period

The payback period is the length of time taken for the

inflows of cash (i.e. revenue) to equal the original cost ofinvestment

Measures the length of time it takes for a project to repayits initial capital cost:

E.g. a piece of machinery costs $10,000 and it earns acash flow of $10,000 over a 12-month period. Thepayback period is 1 year

Acts as a proxy for risk: the shorter the payback period,

the lower the risk


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Payback period - example

A CPD Grantee is providing HOME funds to ABCDevelopment to rehabilitate Vista Garden Apartments.Although the apartment's furnace is rather old andinefficient, it is still in working condition. Currently, theannual energy costs for the existing furnace is $1,000.

ABC Development wants to assess whether to replace theexisting furnace with an energy efficient model. Theyhave determined that the annual energy cost for the newenergy efficient furnace is $750. The cost of purchasing(and installing) a new inefficient furnace is about $1,200.The cost of purchasing a new high efficiency furnace is

about $1,600.


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Net present value (NPV)The weakness of the payback period is that it does not

consider the time value of money

More immediate cash flows are more valuable than moredistant cash flows

E.g. if a company puts $1,000 into a bank account earning5% interest per year, in one years time the bank will pay

$1,050. The future value of $1,000 today is $1,050 in oneyears time

The present valueof $1,050 at 5% interest rate in one yearstime is $1,000

In effect, a dollar is worth more now than a dollar in one

years time

Why? Because there is an opportunity cost associated withinvesting money in a bank account. The company has to berewarded for investing in the form of interest


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NPV calculation : single period case

r

CCNPV

1

10

0C

r

C

1

1

1C

initial cash outflow

cash inflow in one period

present valueof next periods cash flow


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NPV calculation : multiple periods, annual compounding

The interestcompounds when the yield on an investment is reinvested

18811$0910911$ ...

FVof$1 invested for2 years at the compoundinterest rate of9% per year

842.0$0911

09111$

..

PV of$1 to be received in 2 years with 9%annualinterest rate

FV of an investmentC afterT years of earning compoundinterestr

TrCFV 1

PV of a cash flowC to be received T years into future

TT rC

r

CPV

1

1

1


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NPVof a stream of cash flows

T

i

i

i

T

T

r

CC

r

C

r

C

r

CCNPV

1

0

2

21

0

1

111

TCCCC,,,, 210

Present value factor

Tr11

NPV calculation :multiple periods, annual compounding (continued)


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NPV calculation :multiple periods, within year compounding

Compounding for m periods within the year

r

m

r

Stated Annual Interest Rate (SAIR)

Interest for each of m periods

m

m

rC

1

2

1

m

rC

m

rC 1C

m periods Next yearNow

FV of an investment CafterT years

Tm

m

rCFV

1


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Example

89.47

09.1

700

09.1

5001000

2NPV

What happens if the interest is compounded semi annually?

89.4786.44

045.1

700

045.1

500

1000

2

09.01

700

2

09.01

5001000

42

222

NPV

Consider an investment of$1,000 that is expected to yield $500 in 1

year and $700 in 2 years. What is the NPV of the investment at anannual discount rate of9% ?

A project with a positive NPV is profitable; a project with anegative NPV should not be undertaken


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An Apartment is available to a person on a 6years lease period with annual payment of

20,000 rupees. The discount rate throughoutthis period is 3.5%. The initial cost forrenovation is 200,000 rupees. Should theperson undertake this project?

What if the person doesnt decide to renovateinitially?

NPV EXAMPLE


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The internal rate of return is the discount rate thatproduces a net present value (NPV) of zero

The IRR is the break-even discount rate. It represents the

maximum cost of finance at which the project remainsviable

How to calculate the IRRUse a computer!

The IRR is determined through an iteration process,using different discount rates until an NPV of zero isproduced


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What is IRR?

The discounted rate that equates the present value of a projects expected

cash inflows to the present value of the projects costs


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What is IRR?

The discount rate which sets the

NPV of all cash flows equal to 0.Helps to determine the YIELDon an investment.


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How do we calculate IRR?

NPV = Net Present Value of the project

Initial InvestmentCt=Cash flow at time tIRR = Internal Rate of Return


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Calculating IRR

Set the NPV = 0

Plug in your Cash Flows & Initial InvestmentSolve for IRR!This is the same equation used for NPV, except you know yourinterest rate, i.


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Once the IRR is found, it is compared with the companyspre-set threshold investment rate (the hurdle rate)

The hurdle rate is usually the companys opportunity costof capital e.g. the interest it could make on money saved

in a bank account

The IRR decision rule:

IRR > COST OF CAPITAL acceptIRR < COST OF CAPITAL reject

The IRR provides a simple investment decision frameworkfor managers


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So now what?

Once youve calculated IRR

If IRR is greater than the cost of capital, then youve got a GOOD projecton your hands (go for it!).

If IRR is less than the cost of capital, then youve got a BAD project onyour hands (dont undertake the project).

If the IRR and cost of capital are equal, then you should use anothermethod to evaluate the project!

Basically, the higher the IRR, the better the project


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Example IRR Problem

You are debating whether or not to invest in your bestfriends business idea, so use IRR to evaluate the project:

Initial Investment: -$200Cash Flows over the past 5 years:

Years 1 & 2: $50 Years 3 & 4: $100 Year 5: $125

Cost of capital:10%


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Why do we use IRR?

IRR is necessary from a capital budgeting standpoint.Just as NPV is a way to evaluate an investment, IRRprovides more insight into whether or not a

project/investment should be undertaken.

?


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NPV vs. IRR?

The NPV calculation will usually always provide amore accurate indication of whether or not aproject should be undertaken or not.

However, since IRR is a percentage, and NPV isshown in $$, it is more appealing for a managerto show someone a particular rate of return, asopposed to $$ amounts.


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According to finance theory, any project offering apositive NPV should be undertaken

However, investment capital is often scarce when

confronted with 2 NPV-positive projects, a company maynot have sufficient money to undertake both projects

The IRR represents one way of distinguishing betweenprofitable projects. However, the IRR measures % returns

not absolute financial returns


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The benefit-cost ratio (BCR) provides a means ofdistinguishing between profitable projects in an absolute

sense

Present value of future cashflow(Benefit)

Value of initial capital invested(Cost)BCR =

The project with the highest BCR represents the mostattractive investment

The minimum typical BCR of an attractive project isapproximately 1.3

BCR EXAMPLE


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NPV vs. IRR

NPV profiles of projects can cross when project sizedifferences exist (the cost of one project is larger thanthat of the other) or when timing differences exist

(most of the cash flows from one project come in theearly years, while most of the cash flows from the otherproject come in the later years)


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NPV vs. IRR

If the cost of capital isgreater than thiscrossover rate, the twomethods give sameanswer

If the cost of capital is lessthan crossover rate, twomethods give separateanswers

NPV

Cost of capital

Crossover rate

NPVA

NPVB

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