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## 4E1 Project Management

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**4E1 Project Management**Financial and Other Evaluation Techniques - 1**Lecture Objectives**At the end of this lecture you should: • be aware of the scope of evaluation • be able to • compute simple and annualised return on investment and payback • discuss the strengths and weaknesses of these methods • explain what is meant by “the time value of money” • compute the discounted payback and net present value for a given cash flow • be aware of some of the problems and subtleties with discount rates**Commercial business objectives vary:**Profit increase revenue decrease costs Customer service Quality improvement Better product safety Public sector objectives may differ: Reduced traffic congestion Lower waiting times Better community health Better educated workforce Reduction in drug usage etc. Introduction to Evaluation**Evaluation & objectives**Important concepts: Capital rationing Return on investment (RoI) Return on equity (RoE) (Economic) value added (EVA) Cost of funds Risk/reward Evaluation in the public sector: Cost/benefit Non-financial techniques Complexities in measurement Importance of clarity about objectives Objectives**Profit and loss-based**Raise complicated accounting issues So we will ignore them! Cash-based Capital budgeting Conceptually simpler Four important cash-based techniques: Payback Discounted payback Net present value Internal rate of return Money has a “time value” Financial Evaluation**Widely used**Assumes: Money invested in project Profits realised in future RoI is profit as % of investment Example: Investment required for a project is €2 million Revenue is €2.5 million after 4 years Annualised: 25% after 4 years is equivalent to 5.5% p.a. Strengths and weaknesses Return on Investment (RoI)**Payback**• Also widely used • The “payback period” is the length of time before cumulative cash flow becomes positive • Simple example: • Option 1 • Investment -€1,000 • Year 1 €200 • Year 2 €500 • Year 3 €400 • Year 4 €0 • Year 5 €500 Here the payback period is three years**Payback - Graphically**We can see this graphically as follows Cumulative Cash Flow +ve Time -ve Payback (≥ Break even point)**Payback (cont.)**• Payback can be used for comparing projects • Simple example: • Doesn’t necessarily give best overall result • Option 1 Option 2 • Year 0 -€1,000 -€1,000 • Year 1 €200 €0 • Year 2 €500€0 • Year 3 €400 €700 • Year 4 €0 €700 • Year 5 €500€500 • Payback 3 years 4 years**The Time Value of Money**• This envelope contains €1,000 cash • It will be put in a bank vault to be opened in 5 years • You can purchase the right to the money in 5 years’ time • How much would you be prepared to pay (today, in cash) for that right? • If the amount were €10k, how much would you pay? • If it were a promise to pay €1,000 in 5 year’s time, would that change what you are prepared to pay?**Why pay less than €1,000?**Loss of value Loss of interest Loss of utility Risk Each of the above involves an element of judgment Questions: What is a rational basis for deciding what to pay today for a future amount? How can I use all of the above factors to calculate what I should pay now? One way is “discounting” Discounting is like inflation in reverse The Time Value of Money**Principle**Money in the future is worth less in the future than money is worth now Consider €1,000 at 10% compound p.a.over 3 years = €1,331 €1,331 is the “Future Value” (FV) of the investment Inverting At 10% discount rate, €1,331 in three years time is worth €1,000 now €1,000 is the “Present Value” (PV) of €1,331 in three years time At a discount rate of 5%, what is €80 worth: a year from today? two years from today? Discounting**Rephrasing:**What amount today is worth €80 in one year? Calling this A, we have: A x (1 + 5/100) = €80 A = €80/1.05 = €76.19 Work out the value in two years’ time Fully generalised, for N years at interest rate R% Where: PV = Present Value FV = Future Value R = Discount rate % per period N = No. discount periods Discounting**Discounted Payback**• We can apply this to calculate discounted payback • The payback period is now the point in time at which cumulative discounted cashflow becomes positive • Using a 10% discount rate: • This is not the same outcome as before • Option 1 Option 2 • Year 0 -€1,000 -€1,000 • Year 1 €182 €0 • Year 2 €413€0 • Year 3 €300 €526 • Year 4 €0 €478 • Year 5 €310€310 • Payback 5 Years 4 years**Present Value**• You are offered an annual payment of €1,000 for three years or a lump sum now. What minimum lump sum should you accept? • To answer this question, we calculate the present value of the future stream of payments • Let’s assume that the first payment is today, the second in a year’s time and the third a year later • Assuming a discount rate of 10%**Present Value (cont.)**• Work out the value of the above offer if: • discount rate is 5% • there are 5 payments of €1,000 over five years • payments will be made a year in arrears**Net Present Value**• Now suppose somebody offers me a series of cash flows from a €1,000 investment: • Is this a good investment? Year 0 -€1,000 (my investment) Year 1 €0 Year 2 €500 Year 3 €500 Year 4 €0 Year 5 €500**Net Present Value (cont.)**• To answer this question, calculate the net present value of all payments • If NPV > 0, the investment is a good one • Assuming: • the investment is today, andall subsequent events happen at one year intervals • 10% discount rate**Net Present Value**• We can use NPV to compare projects • For example, which option is a better investment for an initial outlay of €1,000? • Note that payback would suggest option 1, total profit, option 2 • Option 1 Option 2 • Year 0 -€1,000 -€1,000 • Year 1 €200 €0 • Year 2 €500 €0 • Year 3 €400 €300 • Year 4 €0 €700 • Year 5 €500 €800**Net Present Value**• To answer this question, compare the NPV of both options • At discount rate of 10% and with the same assumptions as before: • So option 1 is better • Would this be true if the discount rate was 5%?**Non-trivial question**Possible answers: Inflation rate Inflation plus a risk premium The Dublin Inter-Bank Offered Rate (DIBOR) Company’s marginal cost of borrowing Government’s cost of borrowing The weighted average cost of capital W.A. cost of capital plus risk premium The after-tax cost of borrowing Inflation-adjusted, after-tax cost of borrowing etc.. What Discount Rate is Appropriate?**Summary: Key Points**• There are many methods of evaluation • Not all evaluation is financial • There are several methods of financial evaluation, which break down into: • Profit and loss-based • Cash flow-based**Summary: Key Points (cont.)**• Money has a time-related value • This is reflected in the concept of discounting • Some methods ignore this • Most evaluation methods use discounting • e.g. discounted payback, net present value • Arriving at the ‘right’ discount rate is not always simple