Tathagat Varma

Tathagat Varma Session 7/12: 22-Jun-2010

  A Project can be viewed as a series of cash flows   This cash flow can be used to analyze a project’s

viability, ROI, etc.   Project involves

  Some initial investment (capex, infrastructure costs, etc.)   Some recurring expenses

o  Salaries to workforce o  Buy additional raw material o Cost of project site (rental, utilities, data communication, etc.)

  Returns over a period of time o  Interim returns o  End-project returns o  Lifetime returns

  Rs. 100 today ≠ Rs. 100 tomorrow  Your money earns interest o Simple interest o Compound interest

 Also, inflation makes cost of buying higher (generally speaking)

  Present Value (PV) is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk.

  Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.

  Future value (FV) measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is the present value multiplied by the accumulation function.

  Compound interest (or compounding of earnings) is simply the ability of interest (or investment return) earned on a sum of money to earn additional interest (or investment return), thereby increasing the return to the owner of the money or investor. (http://www.buffettsecrets.com/compound-interest.htm)

  Warren Buffet is said to look at the compounding factor when deciding on investments, requiring a stock investment to show a high probability of compound growth in earnings of at least 10 per cent before making an investment decision.

  When asked to nominate the most powerful force on earth, Albert Einstein is reputed to have answered ‘compound interest’. Buffett might well agree.

  Compounding involves moving cash flows from the present into the future, and is the way we show how an initial deposit earns interest on interest over time.   For example, if you put $100 in the bank today and earned 10%

interest on the funds at the end of the year, you would have earned $10 of interest.

  If you then decided to leave it in the bank for a second year at 10%, you would earn another $10 on your original deposit and another $1 interest on your interest, for a total interest of $11.

  The process of earning interest on interest results in the balance growing progressively after each successive year, and continues until you withdraw money from the account.

  The compounding factor is used to make calculations that move cash flows forward in time.

  (1+i)n

  The discounting factor is the reciprocal of the compounding factor; it's the compounding factor upside-down.

  The discounting factor enables us to translate the future value of a lump sum back to the value it has at the present time.

  An annuity is a series of equal payments made over a finite number of periods. The equal stream of cash flows can either be paid out, as in the case of a mortgage payment, or received, as in the case of a retirement annuity.

  A perpetuity is a series of equal payments made at a fixed interval forever (in perpetuity).

  A growing perpetuity is a series of payments that grow at a constant rate over a fixed interval in perpetuity. It differs from a simple perpetuity in that the payments grow at a constant rate, rather than remaining the same.

  The minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects.[1]. A synonym seen in many contexts is minimum attractive rate of return (MARR)

  The MARR is often decomposed into the sum of following components (range of typical values shown)[4]:   Traditional inflation-free rate of interest for risk-free loans: 3-5%   Expected rate of inflation: 5%   The anticipated change in the rate of inflation, if any, over the

life of the investment: Usually taken at 0%   The risk of defaulting on a loan: 0-5%   The risk profile of a particular venture: 0-50% and higher

  The opportunity cost of the funds used to invest in the project is a reflection of the next-best-alternative use of the money.

  Remember, the money available for this project could be invested elsewhere; if it were possible to get a higher return given a similar level of risk, that would be preferable.

  The expected number of years required to recover a project's initial investment. Payback period is an appropriate rule to use when there is a concern for fast capital turnover.   Forecast the amount and timing of the cash flows.  Determine the maximum payback period acceptable

to you.   Sum the consecutive cash flows to find the year at

which the project is paid back.

  Using this method, accept the project if the payback period is less than or equal to the maximum payback period acceptable to you.

  The discounted payback period (DPBP) is the expected number of years required to equate a project's discounted future cash flows to its initial investment. Discounted payback period differs from payback period (PBP) in that DPBP takes into account the time value of money.   Forecast the amount and timing of the project cash flows.   Determine the maximum payback period acceptable to

you.   Calculate the discounted value (or present value) of each

of the project's future cash flows using the hurdle rate.   Sum the consecutive discounted cash flows to find the

year at which the project is paid back.   A project is accepted if the discounted payback

period is less than or equal to the maximum payback period acceptable to you.

  The profitability index (PI) is the net present value of future cash flows divided by the initial investment. The profitability index approach presents what is known as a constrained optimization problem, where the constraint is cash (it could be any limited resource). Modifications of the profitability index can be useful when any resource is limited. For example, the resource could be floor space in a manufacturing plant, gates at an airport, or the hours available from an employee who performs a specialized task.   Forecast the amount and timing of the cash flows.   Using the estimated hurdle rate, find the net present value of the future cash

flows.   Divide the net present value of the future cash flows by the initial investment.

  If the profitability index is greater than 0, accept the project. For multiple projects, rank the projects by their profitability indexes and accept them in order until you've exhausted the funds available or have run out of projects with a PI greater than 0.

  Net present value (NPV) is one of two widely used finance rules in practice today. When a particular project is being considered for development, decision makers can look to the NPV for some indication of the strength of the project plan (evaluated in terms of the wealth that is going to be created by the project).

  The NPV is found by calculating the present value of its cash flows, discounting that amount by the hurdle rate, and subtracting the initial investment to get the final result. If the final result is positive, the NPV rule says the project can go forward. If the result is negative, the project should not go forward.

  The internal rate of return (IRR) is the discount rate at which the NPV will be 0; that is, the rate that equates the present value of a project's cash outflows to the present value of its cash inflows. If the IRR is greater than the hurdle rate, the investors will earn more than they require. Thus, when the IRR is greater than the hurdle rate, accept the project.   Forecast the amount and timing of the cash flows.   Using the formula for net present value, set the net present

value to 0 and solve for the discount rate (the sole unknown). This is usually done using a financial calculator or spreadsheet program.

  Compare the calculated IRR to the hurdle rate. If the IRR is greater than the hurdle rate, the IRR rule recommends that you go ahead with the project.

  As a PM, you will take capital investment decisions

  Never decide on a single metric   Identify what is more critical to a project:

whether it is   Profitability?  NPV?   IRR?   PBP?   or something else ?

  The risk shared between the buyer and the seller is determined by the contract type

  All legal contractual relathipships generally fall between one of the two broad families:   Fixed price

o  Firm fixed price contracts (FFP) o  Fixed price incentive fee contract (FPIF) o  Ficed price with economic price adjustment control (FP-EPA)

  Cost reimbursable o Cost Plus Fixed Fee Contracts (CPFF) o Cost Plus Incentive Fee Contracts (CPIF) o Cost Plus Award Fee Contracts (CPAF)

  Time and Material Contracts (T&M)