A project manager should be aware of the various techniques and approaches to determine the financial value of a project. Usually during the concept and initiation stage of a project, best efforts are undertaken to estimate the costs of a project along with an estimate of future financial benefit or value. Best attempts should be made to provide a complete financial perspective of the project’s impact on the organization’s finances.
In order to perform a cost benefit analysis or to calculate a Return on Investment (ROI), the following should be estimated:
- Project investment (total cost estimates of resources required to complete the project
- Total life cycle cost of the product, service or result of the project (i.e. maintenance costs of a software program).
- Economic benefits (one time and ongoing) – these can include not only additional revenue but also cost reduction or savings.
While Return on Investment can be used to determine the financial viability of a project and prioritization of the project, it may not be the only consideration for funding and prioritization. Projects with a poor ROI may still be given a green light because of other considerations or strategic reasons including political or social factors.
Common techniques used to determine a Return on Investment (ROI) include determining a payback period, calculating a net present value (NPV) and calculating an internal rate of return (IRR). Analyzing long term benefits and/or costs requires an understanding of the value of money over time and should also consider economic factors such as inflation.
The payback method can be used to compare the financial value of a project. Payback is calculated by determining the length of time required to recover the initial investment in the project. The payback period for a project requiring a $100,000 investment and estimated to return $10,000 a month in benefits after project completion is 10 months ($100,000 / 10).
The advantage of this method is that the calculation is simple and fast. The disadvantage is that this method does not take into account the value of money.
Net Present Value
The net present value method uses the value of money to calculate financial value of a project. The resulting value (the “net present value”) can be used to compare projects. A negative or low value would indicate that the project might not have financial viability.
To understand Net Present Value, the concepts of Future Value (FV) and Present Value (PV) should also be understood. The future value of a financial investment can be calculated through the following formula:
FV = PV * (1 + i)n
Where “FV” is the calculated future value, “PV” is the Present Value (“today’s money”), “i” is the interest rate (or cost of capital) and “n” is the number of time periods. As an example, the future value of an investment of $1,000 one year from today assuming an annual interest rate of 5% would be $1,050. The value of that same investment two years from today would be $1,102.50 [$1,000 * (1.05 * 1.05)].
The present value of an expected future financial value can be calculated as follows:
PV = FV / (1 + i)n
Where “PV” is the calculated present value, “FV” is the future sum of money, “i” is the interest rate or cost of capital, and “n” is the number of time periods. Using the values and data from the previous example, the PV of an expected sum of money of $1,050 one year from now is $1,000 assuming a 5% interest rate. The present value of an expected sum of money of $1,102.50 two years from now is $1,000 [$1,102.50 / (1.05 * 1.05)].
The net present value of a project is calculated by subtracting the initial investment (project cost) from the sum of the present values of future cash flows over a fixed period of time
(to allow fair comparisons among multiple projects). A project with a negative or low net present value most likely not be financially viable. The net present value of a project can be calculated as follows:
NPV = ∑ [ FV/(1+i)n ] – I
Where “NPV” is the net present value, “FV” is the Future Value of the cash flow (or monetary benefit), “i” is the interest rate or cost of capital, “n” is the number of the respective time period for the future cash flow, and “I” is the initial investment or project cost. This formula could also be shorted as follows: ∑ PV – I (or sum of the present values less the initial investment).
Let’s try an example: Project A costs $100,000 and is expected to produce $40,000 in benefits annually. Assuming the cost of funds is 6%, the net present value of Project A over 5 years is calculated as follows:
PV of year 1 cash flow = $40,000 / 1.06 = $37,736
PV of year 2 cash flow = $40,000 / 1.12 = $35,714
PV of year 3 cash flow = $40,000 / 1.19 = $33,613
PV of year 4 cash flow = $40,000 / 1.26 = $31,746
PV of year 5 cash flow = $40,000 / 1.34 = $29,851
Sum of PV’s = $168,660
Less Investment: $100,000
NPV = $68,660
Internal Rate of Return
Another way to value a project financially is to determine the rate of return that the project will produce. The Internal Rate of Return (IRR) is the rate that will cause the project’s net present value to be zero. Using the following formula, you can solve for the IRR that nets zero:
∑ [ FV/(1+IRR)n ] – I = 0
Where “FV” is the future cash flow, “IRR” is the Internal Rate of Return, “n” is the year of the cash flow and “I” is the initial project investment. Solving for the IRR can be accomplished through a trial and error approach or more exactly using an excel function. (Note: the test will not test you on the IRR math but you will be expected to know the concept). A calculated IRR for a project can then be compared against the company’s cost of capital. For example, if a company’s cost of capital is 7%, then an IRR lower than 7% would be considered a bad investment while an IRR greater than 7% would be viewed as a favorable IRR.
Tips for the exam:
- Understand the different methods of calculating a return on investment and the differences between the methods.
- Remember that the payback method does not take the cost of money into consideration.
- Understand that ROI is used to determine if a project is financially viable.
- Understand that NPV can be used to rank projects and could also be used to screen projects which produce a negative or low value.
- Understand that an IRR greater than the company’s cost of capital is desired while an IRR lower than the cost of capital is not desired.