Slide 5.1

4E1 Project Management

Financial and Other Evaluation

Techniques - 1

Slide 5.2

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

Slide 5.3

Introduction to Evaluation

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.

Slide 5.4

Objectives

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

Slide 5.5

Financial Evaluation

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”

Slide 5.6

Return on Investment (RoI)

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

€2.0M

€2.0M - €2.5M100RoI

Slide 5.7

Here the payback period is three years

Payback

Also widely used• The “payback period” is the length of time before cumulative cash flow becomes positive

Simple example:

Option 1Investment -€1,000Year 1 €200Year 2 €500Year 3 €400Year 4 €0Year 5 €500

Slide 5.8

Payback - Graphically

We can see this graphically as follows

Time

CumulativeCash Flow

Payback (≥ Break even point)

+ve

-ve

Slide 5.9

Option 1 Option 2Year 0 -€1,000 -€1,000Year 1 €200 €0Year 2 €500 €0Year 3 €400 €700Year 4 €0 €700Year 5 €500 €500Payback 3 years 4 years

Payback (cont.)

Payback can be used for comparing projects

Simple example:

Doesn’t necessarily give best overall result

Slide 5.10

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?

Slide 5.11

The Time Value of Money

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

Slide 5.12

Discounting

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?

Slide 5.13

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

N)100R

(1

FV PV

Slide 5.14

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 2Year 0 -€1,000 -€1,000Year 1 €182 €0Year 2 €413 €0Year 3 €300 €526Year 4 €0 €478Year 5 €310 €310Payback 5 Years 4 years

Discounted Payback

Slide 5.15

735,2€)1.1(

000,1€

1.1

000,1€000,1€

2PV

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%

Slide 5.16

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

Slide 5.17

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 €0Year 2 €500Year 3 €500Year 4 €0Year 5 €500

Slide 5.18

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, and all subsequent events happen at one year intervals

• 10% discount rate

99.34€)1.1(

500€

)1.1(

0€

)1.1(

500€

)1.1(

500€

1.1

0€000,1€

5432NPV

Slide 5.19

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 2Year 0 -€1,000 -€1,000Year 1 €200 €0Year 2 €500 €0Year 3 €400 €300Year 4 €0 €700Year 5 €500 €800

Net Present Value

Slide 5.20

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%?

03.206€(1.1)

500

(1.1)

0

(1.1)

400

(1.1)

500

1.1

200-1,0001 OptionNPV

5432

24.200€(1.1)

800

(1.1)

700

(1.1)

300

(1.1)

0

1.1

0-1,0002 OptionNPV

5432

Slide 5.21

What Discount Rate is Appropriate?

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..

Slide 5.22

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

Slide 5.23

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