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