4- Project Financial Tools - 2

8/3/2019 4- Project Financial Tools - 2

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PROJECT COST MANAGEMENTSession-4


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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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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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Project Financial Tools

The methods used by investors to evaluate investment projects are given below.The methods used by investors to evaluate investment projects are given below.

In this session we will discuss the remaining twos: IRR & B/C RatioIn this session we will discuss the remaining twos: IRR & B/C Ratio


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5

Internal Rate of Return

o IRR is a measure of return on investment.

o Assume, 11% IRR of a project investment over a five year period.

o It tells that for each dollar invested in the project generates 11%of return each year.


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IRR: Example


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IRR Analysis- 1

o The IRR computations for project A and B have same NPV of$99.96, so from the prospective of real profit, the two projects aresame.

o However because project B has cash outflows occurring later than

project A, Project B has a higher IRR.

o IRR figure of 23% is saying: select me, I am spending money laterthen project A, when money is cheaper, so I have better rate ofreturn.

o Project A is spending money at early stage, when money value is

high.


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IRR Calculations


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IRR Calculations

o The three projects shown have identical values ofoutflows, inflows and netflows inside the table

o The NPV is different due to difference in interest rates.

o Project A with interest rate 10% give NPV $99.96 Byincreasing interest rate to 15%, NPV drop to $37.80 forproject B. for project C when interest rate is increased to20%, reflect NPV -$8.17.

o By going from project A to C, we are going from money-making to a money-losing scenario.

o At interest rate of 19%, NPV is zero, a breakeven point.

o This 19% figure is IRR.


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IRR Calculations

o The three projects shown have identical values of outflows, inflowsand netflows inside the table

o The NPV is different due to difference in interest rates.

o Project A with interest rate 10% give NPV $99.96 By increasinginterest rate to 15%, NPV drop to $37.80 for project B. for project Cwhen interest rate is increased to 20%, reflect NPV -$8.17.

o By going from project A to C, we are going from money-making toa money-losing scenario.

o At interest rate of 19%, NPV is zero, a breakeven point.

o This 19% figure is IRR.


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IRR Analysis- 2

o For a project calculate the IRR. Let say IRR for a project A is 9%

o Compare it with other investment opportunities, let say Savingaccount (14.5%), Bonds (8.0%) and also another project with IRR(7.3%).

o Avail the investment opportunity of highest IRR from financialprospective.

o In the above case we will opt for depositing money in savingaccounts.

o If IRR is 15% for project A, we will definitely select it because ofhigher gains it can provide.

o If the prevailing interest rate is same as IRR, neither one offers anadvantage.


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Benefit- Cost Ratio

o Concern with weighing the benefits of a decision against the costs.For a project calculate the IRR. Let say IRR for a project A is 9%

o Its just the measure of benefit divided b a measure of cost.

o The measure of benefit is revenue, cost saving, error reduction andso on.

o The measure of cost is money expended to carry out a project.

o In other words on a project, benefits are revenue and costs isexpenditures.


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B/C ratio possibilities

B/C > 1.0, B/C= $100/50=2.0

Revenue is greater than expenditure. Investment is profitable.For each dollar we are spending on the project, we are

gaining $2.0 revenue.

B/C = 1.0, B/C= $50/50=1.0

Revenue and expenditures offset each other, facing abreakeven situation. For each dollar investment, we aremaking $1.0 in revenue.

B/C < 1.0, B/C= $50/100=0.5


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B/C ratios Comparison

Project A:B/C= $1300/500= 2.6

Project A:B/C= $1400/500= 2.8

Here project B has the higher B/C ratio.


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B/C comparison- NPV


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B/C comparison: NPV

o Carrying the B/C analysis for the above two projects based ondiscounted or present values of cash inflows and outflows.

o Again project B is giving higher benefits.

o When B/C ratio analysis are applied with discounted cash flows, itsis specifically called profitability index.


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Integrating the Financial tools

o Each of the financial tools discussed has its special value as well asits limitation

o No one tools is the best, effective utilization require that they wouldbe employed in parallel.

o If a project is support by most of the tools among all, it is worthy tobe selected.

o In random case when project A is supported by IRR, Project B byB/C, Project C by NPV. You have to decide which financial measureis most important to you in taking any decision.


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Integrating the Financial tools

o Payback periods enables you to determine when you are finallymaking more money than you spent. The earlier the better.

o NPV tells you how profitable a project in today currency value.Project with higher NPV is preferred.

o IRR measures the return on investment for different projects.

o The B/C measures of each dollar spent on project, how much returnyou anticipating against it. Each of the financial tools discussed hasits special value as well as its limitation


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4- Project Financial Tools - 2

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