Time Value of MoneyImportant to Project Finance

Why Time Value of Money Is Importantin Project Mgmt

• If we can’t fund all the projects, we need a way to compare, rank & choose

• Which is the best project?

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Best Way to Evaluate & Choose I.T. Projects

• How well does this project align with the company’s strategic plan & goals?

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Strategic Planning

• Corp asks:– Where are we? (status)– Where are we going? (goals)– How do we get there (tactical

planning)

• Try to Identify:– Corp strengths– Corp weaknesses– Corp opportunities– Corp threats

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Ways to Compare, Rank & Choose Projects

• Focus on broad organizational needs

• Categorize information technology projects

• Use a weighted scoring model • Implement a balanced

scorecard• Perform net present value or

other financial analyses

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from Schwalbe, IT Project Mgmt, 6th edition

Focus on Broad Organizational Needs

• Is there a need? • Are funds available? • Is there a strong will (or a

strong mgr) to make the project succeed?

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from Schwalbe, IT Project Mgmt, 6th edition

Categorize I.T. Projects

• Does the project address • A problem? • An opportunity? • A directive?

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from Schwalbe, IT Project Mgmt, 6th edition

Use a Weighted Scoring Model

• identify criteria important to project success

• assign weights to each • assign scores to each criterion

for each project• multiply scores by weights to

get total weighted scores• rank projects according to total

weighted scores

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from Schwalbe, IT Project Mgmt, 6th edition

Implement a Balanced Scorecard

• convert an organization’s value drivers, such as • customer service • innovation • operational efficiency • financial performance, etc.

• to a series of defined metrics • and rank accordingly

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from Schwalbe, IT Project Mgmt, 6th edition

Perform NPV or other Financial Analyses

• Project costs & benefits often have– Long durations (years)– Very different cost & benefit cash

flow patterns– Irregular patterns, sign switching

• Makes them difficult to compare & rank

• NPV addresses this issue

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Which is the Best Project?

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Year Costs Benefits Net0 12 -121 5 10 52 5 15 103 5 6 14 5 20 15

totals 32 51 19

Year Costs Benefits Net0 50 -501 15 25 102 4 25 213 4 25 214 4 21 17

totals 19

Year Costs Benefits Net0 5 -51 5 12 72 5 10 53 5 12 74 5 10 5

totals 19

All amounts positive for graphing

What do we need to do to compare these very different cashflow streams?

•We need to measure the costs and benefits with the timing differences removed but altering the value based on how far in the future they occur

•We do that by adjusting the cashflows back to a single value at a point in time, the present time or time zero

•We call this net present value or NPV•We do this by discounting each

cashflow stream by a discount rate (sort of a reverse interest rate)

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Is there a math formula which will do the discounting for us?

• Yes, here it is:NPV=net present value=∑t=0…n

At/(1+r)t

•where:– t=period of the cash flow– n=last period of the cash flow– A=amount of cash flow each period– R=discount rate per period

• Don’t panic – Excel will do the math for us

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Using NPV To Pick the Best Projectoutflows negative for calc of NPV

Year Costs Benefits Net NPV0 -12 -121 -5 10 52 -5 15 103 -5 6 14 -5 20 15

totals -32 51 19 $13.53

Year Costs Benefits Net0 -50 -501 -15 25 102 -4 25 213 -4 25 214 -4 21 17

totals -77 96 19 $8.70

Year Costs Benefits Net0 -5 -51 -5 12 72 -5 10 53 -5 12 74 -5 10 5

totals -25 44 19 $14.99

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Time Value of Money - The Concept

• What would you rather have? – $100 today or– $100 one year from now

• Why?– Because $100 today is worth more than

$100 one year from now• How?

– You could invest the $100 now and have more in a year due to a return (interest)

• How much more?– The amount you could earn in one year

on the money received today

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Terminology• Present value

– The value of a future cash flow discounted to present value

• Discount (rate)– Adjusting future values to the

present by a % called a discount rate (reverse interest)

• Future value– The value of a present sum in the

future as a result of compounding interest

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Cash Flow

• Cash in & cash out of business• Net of in & out is net cash flow

in same period• Not accounting income

– Accounting income must be adjusted by:•Adding back (dropping) non-cash

expenses like depreciation & amortization

•Adding amortized cash outflows like capital expenditures in period in which they occurred

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More terms• Annuity

– A series of equal payments over some future time period

• Discounted cash flow– A series of future amounts discounted

to their present value

• Non-cash expense– An income statement expense that is a

non-cash item (paid at an earlier time), e.g., depreciation

• IRR– Internal rate of return (interest or

discount rate)

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More terms• Payback period

– How long it takes to get your initial investment back

• ROI– Return on investment

• Cost of capital– The cost of financing, e.g., via

bonds, loans, stock• Opportunity cost

– What return you lose by not investing the money

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Applications• Compound interest

– Bonds– Mortgages & loans

• Lease vs. buy decisions• Annuities• Life insurance• Project costs• Capital budgeting/allocation• Investment returns• Lease comparisons

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You Won the Lottery•Payout Options

–Lump Sum of $1,000,000 now–$75,000/yr for 20 yrs ($1.5 million)

Which is the better deal?

Lottery Payout Choices

-

200

400

600

800

1,000

1,200

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Year

$000

Lump Sum of $1 million $75,000/yr for 20 yrs

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Excel Functions• NPV – Net present value

– Use for regular periods– All flows occur at end of period

• PV– Use for annuities (same amount each

regular period)– Can specify flows occur at beg or end of

period• IRR - Internal rate of return

– can estimate rate (needed if only 2 periods)

– Has to have at least 1 minus & 1 plus #– Assumes flows occur at end of period

• XNPV (Excel 2007 only)– Use for irregular periods

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Excel Tips

• Remember to state disc rate in same period as cashflows– e.g., if cashflows in months, state

rate per month (annual rate/12)

• Remember that outflows are negative, inflows are positive -10,000 is an outflow +10,000 is an inflow

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More Excel Tips• Think about whether the initial cash

outflow should be discounted or not– without evidence that it is spread over

time, assume it is all spent up front and, therefore, does not need to be discounted;

– but don't forget to include it in the net present value at full value and as a negative (cash outflow).

• If you are not discounting the initial cash outflow, – place it in a period called Time Zero (Yr

0 or Month 0), so it is evident you are treating it as an upfront outlay & not discounting it;

– this will also help to remind you not to discount it

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Evaluating Excel NPV Results

-100

-50

0

50

100

PositiveGood Investment

ZeroNeutral

NegativeBad Investment

Evaluating NPV Results

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Evaluating Excel IRR Results

-30%

-20%

-10%

0%

10%

20%

30%

IRR=>CCGood Investment

IRR=CCNeutral

IRR=<CCBad Investment

IRR=negWorse Investment

Evaluating IRR Results Assume Cost of Capital (CC) = 10%

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Payback Period

•set up net cash flow stream, including initial outlay•net outflows as negatives, net inflows as positives•set up cumulative value for each period, starting with initial outlay•when cumulative net cash flow goes positive, that is the payback period

Yr 0 Yr 1 Yr 2 Yr 3

Discounted benefits - costs (100,000) 51,150 47,300 43,450

Cumulative benefits - costs (100,000) (48,850) (1,550) 41,900

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Return on Investment (ROI)

• (Total Benefits – Total Costs)/Total Costs

• Discounted or not discounted, can compute either way, but don’t mix the two

• Label whether you computed it on discounted or undiscounted net cashflows

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Endnotes• Date: Sep 21, 2011• Title: Time Value of Money – Important to

Project Finance• File name: Time Value of Money Lecture

2011jSE21.ppt• Author: Ron Gottardi• © 2010, 2011 Ron Gottardi