3- Project Financial Tools- 1

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PROJECT COST MANAGEMENTSession-3


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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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Someone said

Success in life often depends on theSuccess in life often depends on the

choices we make.choices we make.

Take advantage of best practices and available financial tools that can help youmake betterquality decisions

How do you make theright choice?


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Project selection is fundamentally a process of prioritization. When trying to

determine which projects have merit to qualify, a numberof selection criteria

involved and should be considered.

Typical criteria include:

o Technical merit

o Financial merit

o Production merit

o Marketing sales/merit

o Human resource management/merit


Project PrioritizationProject Prioritization


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Optimal Connections, LLC

o These requires us to look at two aspects:

Spending money (cost)

Making money (revenues)

o Use a combination of financial tools to improve yourdecision making.

o AnsweryourQuestions regarding:

o Assessing whether an investment project is worthwhile?

o Do the benefits really justify the cost?

o How long will it take to recover our investment?

o Follow best-practices

o These tools are not new they have been used fordecades by organizations of all

kinds

Project Financial Tools: Why and How


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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

Investors use a numberof methods to evaluate investment projects, rank themInvestors use a numberof methods to evaluate investment projects, rank them

and select the most attractive among them to finance.and select the most attractive among them to finance.


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Payback period: Concept

o How long does it take for an investment to pay for itself?

OR

o How long does it take for incoming returns to cover costs

OR

o How long does it take for the investment to break even?


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Payback period: Project prioritization

o A viable project is one that is able to pay back the original investment as early

as possible.

o Project that take long time to achieve payback are less attractive than those

that achieve quick payback.

o Lengthy project restrict capital utilization fora long time.

o Forlengthy Projects many things can go wrong.

o From investment prospective the pay back indicates that we are finally out of

wood.


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Payback period: Calculations


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Payback period: Calculations

o Payback could occur during a year

o Only possible to give a rough estimate.

o One of the formulae is:

Duration x Investment

Payback = ------------------------------------------

Total Cash Received


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Payback example

Let us Consider

Cost of a machine = 60,000

Income streams from investment = 24,000/yr

Payback = 3 x 60,000/72,000

= 30 months (21/2 yrs)

Duration Income

Year 1 24,000

Year 2 24,000

Year 3 24,000

Amachine costs 50,000. It produces items that generate a profit of 5 eachon a production run of 25,000 units per year.Payback period will be 4 years


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Payback example

o Payback could occurduring a year

o In this case, payback can only be estimated through interpolation.

Investment Cash Flow Year1 Year2 Year3 Year4 Year5

Cash Inflows 300 300 300 300 300

Cash Outflows 800 150 0 0 0Net Cash Flow 500 150 300 300 300

Cumulative Cash Flow 500 350 50 250 550

Using the table above, where the payback year is clearly Year 4, payback period can

be calculated as follows;

Payback Period = Y + ( A / B ) Where,Y = The number of years before final payback year. In the example, Y = 3.0

A = Remaining to be paid at the start yr 3 to bring cumulative cash flow to 0. A = 50.

B = Total paid back in the entire payback year 4. In the example, B = 300.

For the example,

Payback Period = 3+ (50) / (300)

Payback Period = 3 + 1/6 = 3.17 Years


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Payback analysis: Example

o When viewed from a payback

perspective, project A is more

attractive than project B.

o By achieving payback earlier,

Project A has funds that can bereleased after year 2 to exploit

another business opportunity.

Project B not provide this

opportunity before year 4.

o We are in better position to make

prediction and risk analysis forproject A.


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February 3, 2012 15Sana Ullah Khan P E, PMP

o A concept that suggests that a dollar today has different value than a

dollar one year from now.

o A number of factors effect the money value. Inflation is one of the

aspects.

o For a 10% inflation, a job of 10,0000/- promised in July 2011 will cost

you 11,000 if you are going to perform it in Jun 2012.

o In a case of no inflation, if you invested Rs 1000/- to a business at a

10% per annum interest rate.

o You would receive a payment ofRs 1100/- at the end of the year.

o Your initial investment ofRs 1000/- has grown to Rs 1100/- by 10%

over time.

Time value of money


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o When looking at your money that you

control today and take into account

how much it will be worth some time

in future, your are assessing the

future value of money.

o Take the case of money deposit in a

saving account that earn you 10% of

interest income per year over a five

year of time.

February 3, 2012 National Institute of Design andAnalysis 16

Future Value of Money


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Present Value of Money

o Future Value is calculated when you deposit money in saving

accounts. But when you invest in a project, you are doing the

reverse process.

o Suppose you started a new project and you invested Rs

10,000/- in it. After 5year you must have Rs 16,105/- at least to

have no loss.

o When you look at the future cash flow and assess it in terms of

today money, you are conducting a present value analysis.

o It is the reverse process of future cash flow.


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Present Value of Money

Considertwo five yearprojects A and B (UMT2003 series)


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NPV

o Both Projects A & B are making the same overall profit when stretched for5yrs.

o But On the basis present value associated with net flows, Project A is more

attractive because its discounted profit (533.0) is more then that ofProject

B(485.0).

o This Present value associated with net flows is called net present value (NPV).

o NPV is actually the present value of profit of a project future.


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NPV analysis

o ForPositive NPV, the project will be profitable.

o ForVe, it will lose money and should not be supported.

o Can be Computed automatically in most of the financial software.


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