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Agenda

Cost Management Capital Budgeting Payback PeriodTime Value of MoneyPresent ValueFuture ValueDiscounted Cash Flow conceptsNet present valueProfitability index

Cost Benefit Analysis

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Cost Management

• Cost management on a project includes the processes necessary to ensure that the project is completed within the approved budget

• Includes cost trade-offs, risks, make Vs buy, Buy Vs Lease, sharing of resources etc.

• Accuracy of Estimates• During initiation can have ROM of: +/- 50%• Later Stages can narrow down to : +/- 10%

• Estimates include, but are not limited to : labor, material, equipment, services & facilities as well as inflation allowance, contingency costs

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Cost management

• Direct Cost – Cost of resources that is directly traced and utilized completely for the project purposes

• Indirect Cost – Cost that is shared across multiple projects or programs

• Fixed Cost – A periodic cost that does not vary with the business volume.

• Variable Cost – Cost that varies depending upon the business volume

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Earned Value Concepts

Days Day-1 Day-2 Day-3 Day4

Amount Spent 1000 1200 600 Nil

Work Completed 100% 100% 50% Nil

Budget At Completion (BAC) = 4000Earned Value (EV) = 2500Actual Cost (AC) = 2800Planned Value (PV) = 3000

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Earned Value Concepts

Cost Variance (CV) = EV – AC = 2500 – 2800 = - 300Schedule Variance (SV) = EV – PV = 2500 – 3000 = - 500 (Remember SV is also calculated in terms of money only)Cost Performance Index (CPI) = EV / AC = 2500 /2800 = 0.89Schedule Performance Index (SPI) = EV / PV = 2500 / 3000 = 0.83

CV < 0 - Over budgetCV > 0 - Under budgetSV < 0 - Behind ScheduleSV > 0 - Ahead of Schedule

CPI < 1 - Over budgetCPI > 1 - Under budgetSPI < 1 - Behind ScheduleSPI > 1 - Ahead of Schedule

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Capital Budgeting

Capital budgeting is the process of authorizing capital spending on

Large projects and Long term projects.

Capital budgeting focuses on cash inflows and cash outflows over

the period of the project rather than net income calculated on

accrual basis

Cash inflows may include estimated cash inflows from customers,

proceeds from sale of assets, reduced costs and salvage value

Cash outflows may include capital investment, cost of investment,

operating costs and maintenance costs

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Capital Budgeting - Techniques

Capital budgeting Concepts

Cash Payback PeriodTime Value of moneyPresent ValueFuture Value

Discounted Cash flow techniquesNet Present ValueProfitability IndexInternal Rate of Return (IRR)

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Payback period is the time required to recover the cost of the Project

(the investment)

Payback period is calculated by dividing the capital investment by

the net annual cash flow. If the net annual cash flow is not expected

to be the same, the average of the net annual cash flows will be used

Cost of the project (Investment)

Payback Period = -----------------------------------------------

Average net annual cash inflow

Payback Period

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An organization ABC is considering the purchase of an equipment for Rs. 150,000. The equipment is expected to work for 7 years and have a salvage value of Rs. 5000 at the end of its life. The annual cash inflows are expected to be Rs. 250,000 and the annual cash outflows are estimated to be Rs. 200,000.

Case I – Payback Period when the net annual cash inflows are same

150,000

Payback Period = -------------------------------------- = 3.0 Years

50,000 (250,000 – 200,000)

Payback Period

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Case II – When the net annual cash inflows are different. The payback

period is the point in time where the cumulative ne cash flows become

zero. In the following case the payback period is 3.25 years.

Payback Period

Year Expected Cash Flow Cumulative Cash Flow

0 150, 000 150,000

1 30,000 120,000

2 50,000 70,000

3 55,000 15,000

4 60,000 45,000

5 60,000 105,000

6 60,000 165,000

7 65,000 205,000

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Compare the cash inflows for two projects ABC and XYZ.Both projects have the same payback period (3 years) but

their cash flows are different. Similarly two projects may have the same

payback Period. But one project may last for 5 years and other may

last only one year after the payback period

Payback Period

Year Expected Cash Flow

Cumulative Cash Flow

0 14000 14000

1 3000 11000

2 4000 7000

3 7000 0

4 1500 1500

5 1500 3000

Year Expected Cash Flow

Cumulative Cash Flow

0 14000 14000

1 6000 8000

2 5000 3000

3 3000 0

4 2000 2000

5 1000 3000

Project ABC Project XYZ

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Value of money available at the present time (PV) has more value

than the value of same amount of money in the future (FV)

For example, assuming a 10% interest rate, Rs 1000 invested today

will be worth Rs. 1100 in one year (Rs. 1000 multiplied by 1.10).  

Conversely, Rs. 1000 received one year from now is only worth

Rs. 909 today (Rs. 1000 divided by 1.10), assuming a 10% interest

rate. FV

FV = PV * (1 + r)n PV = -------------

(1+r)n

PV = Present Value; FV = Future Value; r = Rate of interestN = number of periods

Present Value and Future Value

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Annuity Table

Years 2% 4% 5% 6% 8% 10% 12%

1 0.9804 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929

2 0.9612 0.9246 0.9070 0.8900 0.8573 0.8264 0.7972

3 0.9423 0.8890 0.8638 0.8396 0.7938 0.7513 0.7118

4 0.9238 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355

5 0.9057 0.8219 0.7835 0.7473 0.6806 0.6209 0.5674

6 0.8880 0.7903 0.7462 0.7050 0.6302 0.5645 0.5066

7 0.8706 0.7599 0.7107 0.6651 0.5835 0.5132 0.4523

Present Value of 1

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The sum of the present values of the cash inflows minus the sum of

the present values of the cash outflows gives the Net Present Value

When the Cash inflows are same

Net Present Value (NPV)

Year Expected Annual net cash Flow

12% Discount Factor

Present Value

1 50000 0.8929 446452 50000 0.7972 398603 50000 0.7118 355904 50000 0.6355 317755 50000 0.5674 283706 50000 0.5066 253307 50000 0.4523 22615

Totals 350000 228185

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When the cash flows are all the same NPV is calculated as below

Investment (1) = 150000Cash inflow every year = 250000Operational Cost every year = 200000Net cash inflow = 250000 – 200000 = 50000 (each year)Sum of the Present values of the cash after discounting at a

discount rate of 12% (2) = 228185Present value of salvage (3) = 2262Sum of (2) and (3) = 230447NPV = 230447 – 150000 (Investment) = 80446

Net Present Value (NPV)

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When the net cash flows are different, a separate present value

calculation is made for each periods cash flow

Net Present Value (NPV)

Year Expected Annual net cash Flow

12% Discount Factor

Present Value

1 45000 0.8929 40181

2 55000 0.7972 43846

3 60000 0.7118 42708

4 60000 0.6355 38130

5 50000 0.5674 28370

6 35000 0.5066 17731

7 45000 0.4523 20353

Totals 350000 231319

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Calculation of Net Present Value

Investment Cost (1) = 150,000

Present value of Cash inflows (from Previous slide) = 231,319 Present value of Salvage = 5000 * 0.4523 = 226Total Present value of cash inflows (2) = 231,545

Net Present Value (2) – (1) = 81,545

NPV with equal cash flows is 80,446 and with unequal cash flows is

81,545.

Net Present Value (NPV)

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The Internal Rate of Return determines the interest rate of the capital

that makes the NPV zero. In other words it is the return rate at which

the sum of the present values of the cash inflows equals the sum of

the present values of the cash outflows

The higher the IRR the project is acceptableDetermining IRRDivide the proposed capital investment amount by the net

annual cash inflow. This gives the IRR factorFind out the closest value along the line of the number of

years the project lasts. The rate for this value would be the IRR

Internal Rate of Return (IRR)

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Annuity Table

Years 2% 4% 5% 6% 8% 10% 12%

1 0.9804 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929

2 1.9416 1.8861 1.8594 1.8334 1.7833 1.7355 1.6901

3 2.8839 2.7751 2.7232 2.6730 2.5771 2.4869 2.4018

4 3.8077 3.6299 3.5460 3.4651 3.3121 3.1699 3.0373

5 4.7135 4.4518 4.3295 4.2124 3.9927 3.7908 3.6048

6 5.6014 5.2421 5.0757 4.9173 4.6229 4.3553 4.1114

7 6.4720 6.0021 5.7864 5.5824 5.2064 4.8684 4.5638

Present Value of an annuity of 1

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Ex: Let the project cost of a project LMN be 250,000 and equal cash

inflows of 55,000 per year are determined with a project life of 5

years.

The IRR factor would be (250,000 / 55,000) = 4.545

Going back to the annuity table and going along with the 5 year row,

this value would be nearest to 4.5638 which corresponds to the

column 12% in the table.

Internal Rate of Return (IRR)

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Present Value of cash flowsProfitability Index = ---------------------------------- Required Investment

230447Profitability Index = -------------------- = 1.536 (Equal Cash

flows) 150000

231545Profitability Index = --------------------- = 1.543 (Unequal Cash

flows) 150000

Profitability Index

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Cost Benefit Analysis some times referred to as Benefit Cost Analysis is

a technique for assessing the costs and benefits of a capital investment

over a period of time. Basically applicable to large projects or projects

that extend over a longer period of time

Balancing Trade offs between competing constraints like Schedule,

Cost, Quality, Scope, Risks, is the major challenge in managing projects.

Cost Benefit Analysis provides a way of setting priorities and selecting

Options in the allocation of resources

CBA uses time value of money and discounted cash flows to arrive at

correct results

Cost Benefit Analysis

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Calculation of all costs and all benefitsTangible Benefits and Costs (Direct costs and benefits)Intangible Benefits and Costs (Indirect costs and benefits)

Checking the uncertainties involved in the expected outcome which is

referred to as the “Sensitivity Analysis”Calculating the present values of the benefits that are

expected to be in Future.Comparing the costs and benefits to get the net rate of returnsComparing the net rate of returns from a particular project in

question with other projects

Cost Benefit Analysis

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