Project Evaluation and Programme Management

A Business Case Introduction and Background to the proposal The proposed project The Market Organizational and operational Infrastructure The Benefits Outline Implementation Plan Costs The financial Case Risks Management Plan

Project Portfolio Management Project Portfolio Definition Project Portfolio Management Project Portfolio Optimization

Project Evaluation Evaluation of individual projects How the feasibility of an individual project can be evaluated. Technical assessment Whether the required functionality can be achieved with current affordable technologies. Organizational policies H/W S/W infrastructure limitations Cost of technology adapted

Project Evaluation Cost-benefit analysis Cost-benefit analysis comprises two steps- Identify costs and benefits of Developing costs Operating costs Benefit expected from the new system Expressing above costs in common units Express cost and benefit in terms of a common unit

Cash Flow Forecasting (Cont’d) Expenditure Income Need to spend money at first (e.g. staff salary, employment cost, hardware and software costs) no matter where the money comes from e.g. resources from company, or money from the bank If the money is from bank, you need to calculate the interest as well. Software Project Management

Cost-benefit evaluation techniques Net Profit Difference b/w total cost and total income Payback Period Time taken to pay back the initial investment Return on Investment Compare the net profitability to the investment required Net Present value Used in capital budgeting to analyze the profitability of an investment or project. NPV measures the total amount by which an investment is expected to increase based on the present value of its potential cash flows and initial cost. Internal Rate of return

Cost-benefit Evaluation Techniques Example Year Project 1 Project 2 Project 3 Project 4 -100,000 -1,000,000 -120,000 1 10,000 200,000 30,000 2 3 20,000 4 25,000 5 100,000 350,000 50,000 Net Profit 60,000 150,000 45,000 Payback ROI 12% 3% Simple example: (where negative values represent net expenses, positive values represent net incomes) Assumptions: 1. Cash flow take place at the end of each year. 2. The year 0 figure represents the initial investment made at the start of the project.

Cost-benefit Evaluation Techniques Net profit = Total income – Total costs Payback period Time taken to pay back the initial investment Payback Period = Initial Investment Cost/ Annual Operating Savings Return on Investment (ROI) Net profit Advantage: simple to use Disadvantage: ignores the timing of the cash flow Payback period Advantage: simple to calculate, not particular sensitive to small forecasting errors Disadvantage: ignores any income (or expenditure) after the payback period Return on Investment (ROI) Advantage: simple and easy to calculate, quite popular Disadvantage: 1. ignores the timing of the cash flow 2. Potentially very misleading because it is very tempting to compare the rate of return with the current interest rates

Payback period Let’s assume that a company invests $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is 4 years ($400,000 divided by $100,000 per year). A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. The payback period is 3.4 years ($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000 occurring in Year 4)

Cost-benefit Evaluation Techniques – NPV Net present value (NPV) Present value is the value which a future amount is worth at present It takes into account the profitability of a project and the timing of the cash flows NPV Advantage: takes into account the profitability of a project and the timing of the cash flows that are produced. Disadvantage: 1. hard to select an appropriate discount rate 2. NPV might not be directly comparable with earnings from other investments or the costs of borrowing capital.

Cost-benefit Evaluation Techniques – NPV (cont’d) Discount rate is the annual rate by which we discount future earning e.g. If discount rate is 10% and the return of an investment in a year is $110, the present value of the investment is $100.

Cost-benefit Evaluation Techniques – NPV (cont’d) Let n be the number of year and r be the discount rate, the present value (PV) is given by

Net present value Would you rather I gave you £100 today or in 12 months time? If I gave you £100 now you could put it in savings account and get interest on it. If the interest rate was 10% how much would I have to invest now to get £100 in a year’s time? This figure is the net present value of £100 in one year’s time If you invested £91 now you would get £9.10 in interest which would give you £100.10 in 12 months

Net present value NPV is a project evolution technique that takes into account the profitability and timing of the cash flows.

Discount factor Discount factor = 1/(1+r)t r is the interest rate (e.g. 10% is 0.10) t is the number of years In the case of 10% rate and one year Discount factor = 1/(1+0.10) = 0.9091 In the case of 10% rate and two years Discount factor = 1/(1.10 x 1.10) =0.8294

Applying discount factors Year Cash-flow Discount factor Discounted cash flow -100,000 1.0000 1 10,000 0.9091 9,091 2 0.8264 8,264 3 0.7513 7,513 4 20,000 0.6830 13,660 5 100,000 0.6209 62,090 50,000 NPV 618 NPV is the sum of the discounted cash flows for all the years of the ‘project’ (note that in NPV terms the lifetime of the completed application is included in the ‘project’) The figure of £618 means that £618 more would be made than if the money were simply invested at 10%. An NPV of £0 would be the same amount of profit would be generated as investing at 10%.

Cost-benefit Evaluation Techniques – NPV (cont’d) Disadvantage May not be directly comparable with earnings from other investments or the costs of borrowing capital

Cost-benefit Evaluation Techniques – IRR Internal Rate of Return (IRR) IRR can be used to rank several prospective projects a firm is considering. the project with the highest IRR would probably be considered the best and undertaken first. Use Excel to demonstrate the calculation of NPV and IRR. See file ‘lect03-npv.xls’. The IRR being a relative measure does not indicate the absolute size of the return.

Cost-benefit Evaluation Techniques – IRR (cont’d) Useful Dismiss a project due to its small IRR value Indicate further precise evaluation of a project Supported by MS Excel and Lotus 1-2-3 It is convenient in the sense that further calculation are not required. It is useful in the sense that, in many cases, it is sufficient to dismiss a project or indicate further investigation of a project even though it is an approximation.

Net profit ‘Year 0’ represents all the costs before system is operation ‘Cash-flow’ is value of income outgoing Net profit value of all the cash-flows for the lifetime of the application Year Cash-flow -100,000 1 10,000 2 40,000 3 4 60,000 5 100,000 Net profit See Section 3.12 for further details. Exercise 3.2 is applicable here