PROJECT EVALUATION

Introduction Evaluation  comparing a proposed project with alternatives and deciding whether to proceed with it Normally carried out in step 0 in Step Wise (i.e. select project)

Strategic Assessment Program Management Program: collection of individual projects Program: collection of individual projects Organizational structure for program management: program director or program executive Organizational structure for program management: program director or program executive Portfolio Management Third party developers must also carry out strategic and operational assessment of project proposals Third party developers must also carry out strategic and operational assessment of project proposals The proposed project will form part of the portfolio of ongoing and planned projects The proposed project will form part of the portfolio of ongoing and planned projects The selection of projects must take account of the possible effects on other projects (eg. Competition of resources) and overall portfolio profile (eg. Specialization vs diversification) The selection of projects must take account of the possible effects on other projects (eg. Competition of resources) and overall portfolio profile (eg. Specialization vs diversification)

Technical Assessment Consists of evaluating the required functionality against the hardware and software available Strategic information system plan might influence the nature of solution and its cost

Cost-benefit Analysis Economic assessment by comparing the expected costs of development and operation of the system with the benefit of having it in place Assessment is based upon Whether the estimated costs are exceeded by the estimated income and other benefit Whether the estimated costs are exceeded by the estimated income and other benefit Whether or not the project under consideration is the best of a number of options Whether or not the project under consideration is the best of a number of options

Evaluating the economic benefit The standard way of evaluating the economic benefits of any project is to carry out a cost benefit analysis, which consist of two steps: Identifying and estimating all of the costs and benefits of carrying out the project Identifying and estimating all of the costs and benefits of carrying out the project Eg, development cost, operating costs, and the benefits Expressing these costs and benefits in common units Expressing these costs and benefits in common units Ie, in monetary terms

Cost Category Development costs Salaries Salaries Setup costs Cost of putting the new system into place Cost of putting the new system into place Operational costs Cost of operating the system Cost of operating the system

Benefit Category Direct benefit Eg, he reduction in salary bills Eg, he reduction in salary bills Assessable indirect benefits Secondary benefit Secondary benefit Eg, increased accuracy, reduction of errors, and hence costs Eg, increased accuracy, reduction of errors, and hence costs Intangible benefits Longer term, very difficult to quantify Longer term, very difficult to quantify Eg. Reduced staff turnover, and hence, lower recruitment cost Eg. Reduced staff turnover, and hence, lower recruitment cost

Cash Flow Forecasting Typically products generate a negative cash flow during the development followed by a positive cash flow over their operating life. There might be decommissioning cost at the end of product’s life Income Expenditure

Cost-benefit evaluation techniques Net profit Payback period Net Present Value Internal rate of Return

Net profit The difference between the total cost and the total income over the life of the project

Net profit (2) Project 2 shows the greatest profit but at the expense of a large investment Takes no account of the timing of cash flows According to this criterion, project 1 & 3 would be equally preferable According to this criterion, project 1 & 3 would be equally preferable

Payback Period The time taken to break even or pay back the initial investment Normally, the project with the shortest payback period is chosen Advantage: Simple to calculate Simple to calculate Not particularly sensitive to small forecasting errors Not particularly sensitive to small forecasting errorsDisadvantages: It ignores the overall profitability of the project It ignores the overall profitability of the project Eg, the fact that project 2 & 4 are, overall, more profitable than project 3 is ignored

Return on Investment Also known as: Accounting Rate of Return (ARR) Provides a way of comparing the net profitability to the investment required

ROI (2) Advantage: Simple, easy to calculate Simple, easy to calculate Not particularly sensitive to small forecasting errors Not particularly sensitive to small forecasting errorsDisadvantages: It takes no account of the timing of the cash flows It takes no account of the timing of the cash flows It is tempting to compare the rate of return with current interest rate It is tempting to compare the rate of return with current interest rate

Net Present Value A project technique that takes into account the profitability of a project and the timing of the cash flows that are produced By discounting future cash flows by a percentage known as the discount rate By discounting future cash flows by a percentage known as the discount rate

NPV (2) Table of NPV discount factors

NPV (3) Applying the discount factors to project 1

Internal Rate of Return (IRR) Disadvantage of NPV The projects may not directly comparable with earnings from other investments or the costs of borrowing capital The projects may not directly comparable with earnings from other investments or the costs of borrowing capital IRR attempts to provide a profitability measure as a percentage return that is directly comparable with interest rates Eg., a project that showed an estimated of IRR of 10% would be worthwhile Eg., a project that showed an estimated of IRR of 10% would be worthwhile if the capital could be borrowed for less than 10% or if the capital could be invested elsewhere for a return greater than 10%

IRR (2) IRR is calculated as that percentage discount rate that would produce an NPV of zero Manually it must be calculated by trial-and- error or estimated using two values and using the resulting NPVs to estimate the correct value

IRR (3) For a particular project A discount rate of 8% gives NPV of $7,898 A discount rate of 8% gives NPV of $7,898 A discount rate of 12% gives NPV of -$5,829 A discount rate of 12% gives NPV of -$5,829  IRR is about 10.25%  IRR is about 10.25%

IRR (4) A project cash flow treated as an investment at 10% Investing in a project that has an IRR of 10% can produce exactly the same cash flow as lending the money to a bank with 10% interest rate A project with an IRR greater than current interest rates will provide a better rate of return than lending the investment to a bank

Note on IRR & NPV One deficiency of IRR is that it does not indicate the absolute size of the return Example: Example: a project with an NPV of $100,000 and IRR of 15% can be more attractive than one with an NPV of $10,000 and IRR of 18%  the return of capital is lower but the net benefits greater

Risk Evaluation Risk Identification and Ranking Construct a project risk matrix utilizing a checklist of possible risks and to classify each risk according to its relative importance and likelihood Construct a project risk matrix utilizing a checklist of possible risks and to classify each risk according to its relative importance and likelihood RiskImportanceLikelihood Software never completed or delivered H___ Project cancelled after design stage H___ Software delivered late MM Development budget exceeded <= 20% LM Development budget exceeded > 20% ML Maintenance costs higher than estimated LL Response time targets not met LH H = High, M = Medium, L = Low, __ = unlikely

Risk Evaluation (2) Risk and Net Present Value Where a project is relatively risky, it is common practice to use a higher discount rate to calculate net present value Where a project is relatively risky, it is common practice to use a higher discount rate to calculate net present value The addition is usually called risk premium The addition is usually called risk premium

Risk Evaluation (3) Cost Benefit Analysis Consider each possible outcome and estimate the probability of its occurring and the corresponding value of the outcome Consider each possible outcome and estimate the probability of its occurring and the corresponding value of the outcome

Risk Evaluation (3) Risk Profile Analysis Use sensitivity analysis Use sensitivity analysis Project A is less risky than project B i.e unlikely to depart form its expected value Project C unlikely more profitable than expected

Risk Evaluation (4) Using decision trees extend replace expansion No expansion NPV -100,000 75, , ,000 (0.8* *( )) (0.8*(-50000)+0.2*(250000))