time value of money lecture 2011j se21 w script
DESCRIPTION
NPV, net present value, present value, discounted cash flow, time value of money, project finance, IRR, ROI, internal rate of return, project management, discount rate, cost of capital, capital budgeting, capital allocation, Excel financial functionsTRANSCRIPT
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Time Value of MoneyImportant to Project Finance
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Why Time Value of Money Is Importantin Project Mgmt
• If we can’t fund all the projects, we need a way to compare, rank & choose
• Which is the best project?
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Best Way to Evaluate & Choose I.T. Projects
• How well does this project align with the company’s strategic plan & goals?
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Strategic Planning
• Corp asks:– Where are we? (status)– Where are we going? (goals)– How do we get there (tactical
planning)
• Try to Identify:– Corp strengths– Corp weaknesses– Corp opportunities– Corp threats
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Ways to Compare, Rank & Choose Projects
• Focus on broad organizational needs
• Categorize information technology projects
• Use a weighted scoring model • Implement a balanced
scorecard• Perform net present value or
other financial analyses
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from Schwalbe, IT Project Mgmt, 6th edition
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Focus on Broad Organizational Needs
• Is there a need? • Are funds available? • Is there a strong will (or a
strong mgr) to make the project succeed?
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from Schwalbe, IT Project Mgmt, 6th edition
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Categorize I.T. Projects
• Does the project address • A problem? • An opportunity? • A directive?
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from Schwalbe, IT Project Mgmt, 6th edition
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Use a Weighted Scoring Model
• identify criteria important to project success
• assign weights to each • assign scores to each criterion
for each project• multiply scores by weights to
get total weighted scores• rank projects according to total
weighted scores
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from Schwalbe, IT Project Mgmt, 6th edition
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Implement a Balanced Scorecard
• convert an organization’s value drivers, such as • customer service • innovation • operational efficiency • financial performance, etc.
• to a series of defined metrics • and rank accordingly
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from Schwalbe, IT Project Mgmt, 6th edition
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Perform NPV or other Financial Analyses
• Project costs & benefits often have– Long durations (years)– Very different cost & benefit cash
flow patterns– Irregular patterns, sign switching
• Makes them difficult to compare & rank
• NPV addresses this issue
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Which is the Best Project?
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Year Costs Benefits Net0 12 -121 5 10 52 5 15 103 5 6 14 5 20 15
totals 32 51 19
Year Costs Benefits Net0 50 -501 15 25 102 4 25 213 4 25 214 4 21 17
totals 19
Year Costs Benefits Net0 5 -51 5 12 72 5 10 53 5 12 74 5 10 5
totals 19
All amounts positive for graphing
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What do we need to do to compare these very different cashflow streams?
•We need to measure the costs and benefits with the timing differences removed but altering the value based on how far in the future they occur
•We do that by adjusting the cashflows back to a single value at a point in time, the present time or time zero
•We call this net present value or NPV•We do this by discounting each
cashflow stream by a discount rate (sort of a reverse interest rate)
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Is there a math formula which will do the discounting for us?
• Yes, here it is:NPV=net present value=∑t=0…n
At/(1+r)t
•where:– t=period of the cash flow– n=last period of the cash flow– A=amount of cash flow each period– R=discount rate per period
• Don’t panic – Excel will do the math for us
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Using NPV To Pick the Best Projectoutflows negative for calc of NPV
Year Costs Benefits Net NPV0 -12 -121 -5 10 52 -5 15 103 -5 6 14 -5 20 15
totals -32 51 19 $13.53
Year Costs Benefits Net0 -50 -501 -15 25 102 -4 25 213 -4 25 214 -4 21 17
totals -77 96 19 $8.70
Year Costs Benefits Net0 -5 -51 -5 12 72 -5 10 53 -5 12 74 -5 10 5
totals -25 44 19 $14.99
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Time Value of Money - The Concept
• What would you rather have? – $100 today or– $100 one year from now
• Why?– Because $100 today is worth more than
$100 one year from now• How?
– You could invest the $100 now and have more in a year due to a return (interest)
• How much more?– The amount you could earn in one year
on the money received today
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Terminology• Present value
– The value of a future cash flow discounted to present value
• Discount (rate)– Adjusting future values to the
present by a % called a discount rate (reverse interest)
• Future value– The value of a present sum in the
future as a result of compounding interest
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Cash Flow
• Cash in & cash out of business• Net of in & out is net cash flow
in same period• Not accounting income
– Accounting income must be adjusted by:•Adding back (dropping) non-cash
expenses like depreciation & amortization
•Adding amortized cash outflows like capital expenditures in period in which they occurred
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More terms• Annuity
– A series of equal payments over some future time period
• Discounted cash flow– A series of future amounts discounted
to their present value
• Non-cash expense– An income statement expense that is a
non-cash item (paid at an earlier time), e.g., depreciation
• IRR– Internal rate of return (interest or
discount rate)
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More terms• Payback period
– How long it takes to get your initial investment back
• ROI– Return on investment
• Cost of capital– The cost of financing, e.g., via
bonds, loans, stock• Opportunity cost
– What return you lose by not investing the money
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Applications• Compound interest
– Bonds– Mortgages & loans
• Lease vs. buy decisions• Annuities• Life insurance• Project costs• Capital budgeting/allocation• Investment returns• Lease comparisons
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You Won the Lottery•Payout Options
–Lump Sum of $1,000,000 now–$75,000/yr for 20 yrs ($1.5 million)
Which is the better deal?
Lottery Payout Choices
-
200
400
600
800
1,000
1,200
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year
$000
Lump Sum of $1 million $75,000/yr for 20 yrs
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Excel Functions• NPV – Net present value
– Use for regular periods– All flows occur at end of period
• PV– Use for annuities (same amount each
regular period)– Can specify flows occur at beg or end of
period• IRR - Internal rate of return
– can estimate rate (needed if only 2 periods)
– Has to have at least 1 minus & 1 plus #– Assumes flows occur at end of period
• XNPV (Excel 2007 only)– Use for irregular periods
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Excel Tips
• Remember to state disc rate in same period as cashflows– e.g., if cashflows in months, state
rate per month (annual rate/12)
• Remember that outflows are negative, inflows are positive -10,000 is an outflow +10,000 is an inflow
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More Excel Tips• Think about whether the initial cash
outflow should be discounted or not– without evidence that it is spread over
time, assume it is all spent up front and, therefore, does not need to be discounted;
– but don't forget to include it in the net present value at full value and as a negative (cash outflow).
• If you are not discounting the initial cash outflow, – place it in a period called Time Zero (Yr
0 or Month 0), so it is evident you are treating it as an upfront outlay & not discounting it;
– this will also help to remind you not to discount it
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Evaluating Excel NPV Results
-100
-50
0
50
100
PositiveGood Investment
ZeroNeutral
NegativeBad Investment
Evaluating NPV Results
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Evaluating Excel IRR Results
-30%
-20%
-10%
0%
10%
20%
30%
IRR=>CCGood Investment
IRR=CCNeutral
IRR=<CCBad Investment
IRR=negWorse Investment
Evaluating IRR Results Assume Cost of Capital (CC) = 10%
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Payback Period
•set up net cash flow stream, including initial outlay•net outflows as negatives, net inflows as positives•set up cumulative value for each period, starting with initial outlay•when cumulative net cash flow goes positive, that is the payback period
Yr 0 Yr 1 Yr 2 Yr 3
Discounted benefits - costs (100,000) 51,150 47,300 43,450
Cumulative benefits - costs (100,000) (48,850) (1,550) 41,900
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Return on Investment (ROI)
• (Total Benefits – Total Costs)/Total Costs
• Discounted or not discounted, can compute either way, but don’t mix the two
• Label whether you computed it on discounted or undiscounted net cashflows
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Endnotes• Date: Sep 21, 2011• Title: Time Value of Money – Important to
Project Finance• File name: Time Value of Money Lecture
2011jSE21.ppt• Author: Ron Gottardi• © 2010, 2011 Ron Gottardi