Download Capital Budgeting in Projects

Capital Budgeting in Projects
Types of Project Feasibility
• Economic feasibility – cost benefit analysis. The bottom line in many projects
• Operational feasibility – Does it fit within the culture of the organization? Will it be
accepted by end-users?
• Schedule feasibility – potential time frame and completion date schedules can be met
and that meeting these dates will be sufficient for dealing with the needs of the organization
• Technical feasibility - what is practical and reasonable. It addresses three major issues:
• (1) Is the proposed technology or solution practical?
• (2) Do we currently possess the necessary technology?
• (3) Do we possess the necessary technical expertise?
Estimates of IT Investment
• IT investment difficult to cost
• Information technology capital investment, defined as hardware, software, and
communications equipment, grew from 32 percent to over 52 percent of all invested
capital between 1980 and 2015.
• Tendency to underestimate costs by 30%-50%
• If cost estimate doubtful, estimate of benefits will be doubtful
Opportunity Cost: the cost of being able to invest money in other
projects, including the possibility of investing in the stock market
or other financial instruments
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Examples of Tangible Costs for IT Projects
Development (Direct)
Operational (Indirect)
Project team salaries
Operational team salaries
Consultant fees
Software upgrades & licensing fees
Development team training
User training
Hardware purchase
Hardware repairs or upgrades
Office space and equipment
Communication charges
Data conversion costs
General and administrative
Direct project costs can be clearly chargeable
to a specific work package. These costs
represent real cash outflows as the project
progresses; therefore they are usually
separated from overhead costs. They include
labor, materials and equipment costs.
Project overhead costs
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Examples of Intangible Costs for IT Projects
Intangible costs are difficult to estimate and even more difficult to
quantify:
o
Cost of losing competitive edge
o
Losing reputation for good service
o
Losing reputation for being the leader in the
field
o
Customer dissatisfaction resulting in declining
company image
o
Ineffective decision making due to
inaccessible or untimely information
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Fixed vs. Variable Costs
• Fixed costs occur at regular intervals but at relatively fixed rates, for
example:
• lease payments,
• software license payments,
• prorated salaries of personnel.
• Variable costs occur in proportion to some usage factor, for example:
• computer usage,
• supplies,
• overhead costs
Estimating Costs: An Example
Assume the following:
• The case subject is a proposed computer system upgrade
• Business objectives:
•
•
•
•
Increase transaction capacity
Decrease system response time
Improve the quality of information available to the users
The resource (IT administrative labor) is dedicated 100% to meeting
processing needs, maintaining system performance, and ensuring
that users have access to information
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Estimating Costs: An Example
Three questions that must be asked:
• What resources does this cost item use?
• IT staff labor and overhead
• What drives the resource?
• Number of users
• Transaction volume
• What else must we know in order to assign value?
• Current costs for IT administrative labor
• Expected changes in labor
• Expected changes in number of users and transaction volume
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Estimating Costs: An Example
• What is the estimate for next year?
• We make the following assumptions:
•
•
•
•
Current years’ costs are $290,100 (salaries and overhead).
Year 1 salaries will average 3% higher than this year.
The user base will remain constant through year 1.
Transaction volume will increase by 10% in year 1 under the proposal
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Estimating Costs: An Example
Proposal scenario:
Year 1 = Current Cost * Salary Growth rate * Transaction growth rate
= $290,100 * 1.03 * 1.10 = $328,683
Business as usual scenario: Scenario:
Entered into cash
flow statement as
with parentheses
($----)
Year 1 = Current Cost * Salary Growth rate * Transaction growth rate
= $290,100 * 1.03 * 1.00 = $298,803
Incremental cash flow:
Year 1 = Proposal cash flow - Business as usual cash flow growth rate
= ($328,683) – ($298,803) = ($29,880)
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Case Should Include Critical Success Factors
• Case may predict net cash flow of $20 M if marketing program
implemented
• Assumes many things must happen
• Some of these assumptions can be managed or controlled
• These are the critical success factors
• Staff may need new training, partnerships
agreements may need to be in place etc.
• Case must describe who needs to do what, by when, in order
for the predicted results to occur
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Case Should Identify and Measure Risk
• Example: a case predicts net cash flow of $20 M if marketing program implemented
• Depends on assumptions that cannot be managed or controlled.
• Will overall results be close to predicted value?
• Sensitivity and risk analysis produce information about uncertainties.
• Sensitivity analysis - which assumptions are most important in controlling overall
results?
• If predicted results depend heavily on market size then readers should be warned
to pay close attention to this factor during project life
• Risk analysis – the likeliness of other outcomes besides the most likely result
• If management says any investment must return results at least 100% greater than
program costs, then use risk analysis to estimate probability that returns will be
that high
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Sensitivity Analysis
• What happens to predicted results if the assumptions
change?
• Which assumptions have a strong influence on the
results?
• The easy approach: hold all assumptions constant except
one, change that assumption to its lowest reasonable
value, see what happens to the predicted results.
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Sensitivity Analysis (cont’d)
In the real world assumptions are often correlated. As a
result many business cases require a more rigorous,
statistically oriented sensitivity analysis which uses
correlation coefficients. Inexpensive software is available to
do this with a dynamic model.
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Risk Analysis
• Asks the question – How likely are other results?
• What are the chances that we realize only 50% of
what is predicted?
• Relies on understanding the individual assumptions and
how each contribute to overall results
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Monte Carlo Simulation
• Works with a dynamic financial model
• Cash flow depends on underlying assumptions
• Using sensitivity analysis, identify the most important assumptions.
• The ones that have the most control over results
• Describe the range of possible values for the assumption (a probability density
function for each input assumption)
• The Monte Carlo software “runs the future” (tries out combinations of
assumptions thousands of times)
• The Monte Carlo output is a probability curve based upon these thousands of tries
• We can then make statements such as:
• “We have an 80% chance of realizing a net gain of at least $1 M,
• We have a 50% chance of gaining $5 M
• We have a 30% chance of gaining at least $8 M”
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Using Tree Plan
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Cost Terms
• Total Cost of Ownership (TCO): The total cost of acquiring, installing,
maintaining, changing, and getting rid of something across an
extended period of time
• TCO is a life cycle estimate
• TCO supports decision making when it is likely that all options come
with the same benefits and the only differences are on the cost side.
• TCO analysis shows what an acquisition implies for future spending or
budgetary planning
• Five year TCO for computing equipment can be 3 – 10 times the
original purchase price
• The Gartner Group reports that nearly 80% of total IT costs occur
after purchase and nearly half of these costs are outside the IT
budget
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Cost Terms (cont’d)
• Cost Item: A spending category for something the company spends money on,
including assets, goods, services, and resources of all kinds
• Examples: Staff salaries, security service fees, the purchase of computer
hardware or software
• Cost items are line items in budgets and spending plans
• Most business cases have many cost items and just a few benefit items
• Typically 80% or more of business case development goes into finding cost items,
identifying cost impacts, and measuring and valuing them
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Total Cost of Ownership Cost Components
Hardware acquisition Purchase price of hardware including computers,
terminals, storage and printers
Software acquisition
Purchase or license of software for each user
Installation
Cost to install hardware and software
Training
Cost to train IT staff and end-users
Support
Cost to provide ongoing technical support; help
desks, documentation etc
Infrastructure
Cost to acquire, maintain and support related
infrastructure such as networks and specialized
equipment (including storage and backup units)
Downtime
Lost productivity if hardware or software failures
cause the system to unavailable for processing
user tasks
Space and energy
Real estate and utility costs for hosing and
providing power for the technology
The Cost Model
• The cost model identifies the cost items that belong in
the business case
• The cost impacts are summarized in cash flow statement.
• We may compare costs from different scenarios and find
that an item has a lower cost in one scenario than in
another
• First determine which costs go in the case
• Later determine how they behave over the analysis
period
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The Cost Model
Personnel
costs comprise
one of the
highest sources
of project
expense.
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Line Items for the
IT Cost Model
Use this model as a
guide and for
a“brainstorming”
workshop with the
project team
The same cost
model should be
applied to all
scenarios in the
case
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Validating Purchased Software and Vendors
• Send prospective vendors a questionnaire asking specific
questions about their packages
• Use the software yourself and run it through a series of tests
based on the criteria for selecting software
• Review software documentation and technical marketing
literature
• Visit sites of companies similar to your company who are using
the software
One-time vs. Recurring Costs
• One-time costs: A cost associated with project start-up and
development or system start-up
• Recurring costs: Application software maintenance, new software
and hardware leases, and incremental communications are examples
of recurring costs.
• Operating costs tend to recur throughout the lifetime of the system
Capital Budgeting in Projects
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Formal Cost/Benefit Analysis Metrics
Used to determine economic feasibility of a project and
to compare and rank projects and alternative project
solutions
Each Financial metric measures something different
about the cash flow stream:
•
•
•
•
•
Net Cash Flow
Payback Analysis
Return on Investment (ROI)
Net Present Value Analysis
Internal Rate of Return
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Net Cash Flow
• Measures the total flow result in non-discounted dollars.
• It is simply the difference between money coming in and money going out over a time
period:
• Net Cash Flow = Cash Inflows – Cash Outflows
• This is the case’s bottom line.
• “What does the proposed action mean to us in real money?”
• When two or more proposal scenarios compete for support, the one with the higher net
cash flow is considered the better decision (all other things being equal).
• It is the starting point for subsequent analyses.
• Cumulative cash flow
• Net present value (discounted cash flow)
• Return on investment
• Payback period
• Internal rate of return
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Net Cash Flow (cont’d)
Note: Use negative
numbers for all outflows
and positive numbers for
all inflows.
If the cumulative net cash flow
is negative, the total outflows
exceed the total inflows at the
end of that period
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Net Cash Flow Graphs
Graphs provide easy to follow
feedback on the effects of
changing assumptions in a
dynamic spreadsheet.
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Payback Period
• Determines the amount of time that passes before the
accumulated benefits of a system equal the accumulated costs
of developing and operating the system
• Answers the question “How long does it take for the
investment to pay for itself?
• It is sometimes used as a way of comparing alternative
investments with respect to risk:
• Other things being equal, the investment with the shorter
payback period is considered less risky
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Payback Period
Determines how long it takes for a project
to reach a breakeven point
Investment
Payback Period 
Annual Cash Savings
Lower numbers are better (faster payback)
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Payback Period Example
A project requires an initial investment of $200,000 and will
generate cash savings of $75,000 each year for the next five
years. What is the payback period?
Year
Cash Flow
Cumulative
0
($200,000)
($200,000)
1
$75,000
($125,000)
2
$75,000
($50,000)
3
$75,000
$25,000
25, 000
3
 2.67 years
75, 000
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Divide the
cumulative amount
by the cash flow
amount in the third
year and subtract
from 3 to find out
the moment the
project breaks even.
Two Payback Tables
Year
Costs
Cumm. Costs
Benefits
Cumm. Benefits
0
60,000
60,000
3,000
-
1
17,000
77,000
28,000
31,000
2
18,500
95,500
31,000
62,000
3
19,200
114,700
34,000
96,000
4
21,000
135,700
36,000
132,000
5
22,000
157,700
39,000
171,000
6
23,300
181,000
42,000
213,000
Year
Costs
Cumm. Costs
Benefits
Project A
Payback
is approx.
4.2 years
Cumm. Benefits
0
80,000
80,000
-
-
1
40,000
120,000
6,000
6,000
2
25,000
145,000
26,000
32,000
3
22,000
167,000
54,000
86,000
4
24,000
191,000
70,000
156,000
5
26,500
217,500
82,000
238,000
6
30,000
247,500
92,000
330,000
Project B
Payback
is approx.
4.7 years
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More About Payback
• Criticized because it places emphasis on earlier costs and
benefits, ignoring all benefits after the payback period
• Rarely used to compare and rank projects because later benefits
are ignored
• Many companies establish a minimum payback period for
prospective projects
• Payback cannot be calculated if the positive cash inflows do not
eventually outweigh the cash outflows.
• That is why payback (like IRR) is of little use when used with
a pure “costs only” business
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Payback and Risk
• Other things being equal, the investment with the shortest
payback period is the better investment because it is less
risky.
• It is usually assumed that the longer the payback period, the
more uncertain are the positive returns.
• For this reason, payback period is often used as a measure of
risk, or a risk-related criterion that must be met before funds
are spent.
• A company might decide to undertake no major investments or
expenditures that have a payback period over 3 years.
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Return on Investment (ROI)
ROI is a percentage that measures profitability by relating the estimated
total benefits (return) to the estimated total costs (investment) of a project
Simple ROI = (total benefits – total investment costs) / total investment costs
•
ROI considers costs and benefits for a longer time span than payback
analysis
•
Typically 5 to 7 years are used, thus using only the more certain future
cost and benefit estimates
•
ROI has several meanings – be sure that everyone with the case has
the same meaning in mind.
• The most frequently used and simplest ROI metric is the one
above
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Other ROI Calculations
• A more complex ROI calculation is:
• The Accounting ROI, computed as:
• (Benefits – cost – depreciation)
Useful system life
• When ROI is requested, ask specifically how it is to be calculated.
• Understand clearly how both the “return” and the “investment” are
derived and what time period is covered.
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Return on Investment (cont’d)
Using the payback tables in the previous slide, ROI has
been calculated for 6 years of operation for each project.
Project A: ROI = 17.7%
total benefits – total costs
ROI =
total costs
213,000 – 181,000
= 17.7%
181,000
Project B: ROI = 33.3%
total benefits – total costs
ROI =
total costs
330,000 – 247,500
= 33.3%
247,500
ROI can be used to
rank projects or
solutions for a
single project
Project B is the
better project
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More on ROI
• Many organizations have a minimum ROI
• This minimum is an estimate of the return the organization
would receive from investing in external opportunities such
as stocks and treasury bills
• Criticism of ROI:
• ROI is an average rate of return for the total period,
annual rates can vary considerably
Two projects with the same ROI may not be the same if
the benefits in one occur much earlier than the other
Thus, ROI ignores the timing of costs and benefits
• ROI (like payback analysis) ignores the time value of
money
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Present Value Analysis
• A dollar today is worth more than a dollar one year from now
• You could invest the dollar and receive discount on it, and thus
have more a year from now.
• Invested at 8% discount, a dollar today is worth $1.08 a year
from now
• Conversely, $1 a year from now is worth less than 93 cents today,
because the 93 cents could be invested at 8% and grow to $1 in a
year. Thus , money one year from now is worth less than the
same amount today
• Known as the time value of money and forms the basis of
present value analysis
• Future money is expected to be worth less for two
reasons: 1) the impact of inflation, and 2) the
inability to invest the money.
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More on Present Value Analysis
• Criticisms applied to payback analysis and ROI analysis are
answered by PV analysis
• PV analysis considers all the costs and benefits, not just the
earlier values
• The timing of costs and benefits is taken into account by the
PV factors: the factors are larger for the early years,
therefore giving more weight to earlier costs and benefits
• The earlier estimates, about which there is more certainty,
weigh more heavily than do the later, less certain estimates
• PV analysis is based on the time value of money
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Present Value continued
• What future money is worth today is called its Present Value, and what
it will be worth when it finally arrives in the future is called, not
surprisingly its Future Value.
• Just how much present value should be discounted from future value is
determined by two things:
• the amount of time between now and the future payment,
• and an discount rate. (For rough estimates, think of the discount
rate as the return rate we would expect if we had the money now
and invested it).
• For a future payment coming in one year:
• Present Value = (Future Value) / (1.0 + discount Rate)
The discount rate for a business is the opportunity cost of being able to invest money in other projects,
including the possibility of investing in the stock market or other financial instruments.
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Present Value continued
• What is the present value of $100 we will not have for a full year? If we use an annual
discount rate of10%,
• Present Value = ($100)/(1.0 +0.10) = $90.91
• What is the present value if the payment were not coming for 3 years?
• For multiple periods, the present value calculation becomes:
• Present Value = (Future Value) / (1.0 + discount rate)n
• The exponent “n” is simply the number of periods, or years, in this case 3.
• The present value of $100 to be received in 3 years, using a 10% discount rate is thus:
• Present Value = $100 / (1.0 +0.10)3 = $100 / (1.1) 3 = $75.13
• “Periods” for these calculations can actually be years, months, or any other time.
• Be sure that the discount rate represents discount for that period.
• When calculating DCF on a monthly basis, for instance, use the annual discount
rate divided by 12).
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Net Present Value (NPV) Example
• Consider two competing investments in computer equipment.
• Each calls for an initial cash outlay of $100, and each returns a
total of $200 over the next 5 years making a net gain of $100.
• But the timing of the returns is different, as shown in the table
on the next slide.
• Therefore the present value of each year’s return is different.
• The sum of each investment’s present values is called the
Discounted Cash flow, or DCF.
• Using a 10% discount rate again, we find:
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NPV
Example
As the payment gets further into the future, its present value drops. As
you can see, increasing the discount rate would further reduce the present
value. Only where discount rates were assumed to be 0 (an economy with
no investment possibility and no inflation) would present value always
equal future value.
Timing
Case A Net Cash Flow
Case A Present Value
Case B Net Cash Flow
Case B Present
Value
Now
-$100
-$100
-$100
-$100
Year 1
+$60
+$54.54
+$20
+$18.18
Year 2
+$60
+$49.59
+$20
+$16.52
Year 3
+$40
+$30.05
+$40
+$30.05
Year 4
+$20
+$13.70
+$60
+$41.10
Year 5
+$20
+$12.42
+$60
+$37.27
Total
+$100
NPV = $60.30
+$100
NPV = $43.12
•Comparing the two investments, you can see that the early large returns
in Case A lead to a better total net present value (NPV) than the later
large returns in Case B.
•Note especially the Total line for each present value column in the table.
•This total is the net present value (NPV) of each “cash flow stream.”
•When choosing alternative investments or actions, other things being
equal, the one with the higher NPV is the better investment.
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Internal Rate of Return (IRR)
• Often used in capital budgeting, it's the discount rate that
makes net present value of all cash flow equal zero
• Essentially, this is the return that a company would earn if it
invested funds, rather than spending that money
• Some companies use IRR as a “hurdle rate” – proposals must
project an IRR above the hurdle to receive funding
• IRR can be very misleading if there is no large initial cash
outflow
• It is not a good metric for making “lease vs. buy” decisions – the
relatively small initial expenditure for the “lease” option leads to a huge
IRR compared to the “buy” option
• The IRR cash flow stream must have positive inflows somewhere
in order for it to have meaning
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IRR
To grasp IRR quickly lets look at the graph below.
For the Case A cash flow, the
prevailing discount rate would
have to rise all the way to
38% to make this investment
worthless.
The Case B investment would
become worthless if discount
rates rose to 22%.
•We have used nine different discount rates, including 0 and 0.10, on through 0.80.
•As the discount rate used for calculating Net Present Value of the cash flow stream
increases, the resulting NPV decreases.
•For Case A, an discount rate of 38% produces NPV or DCF = 0,
whereas Case B hits 0 with an discount rate of 22%.
•Case A therefore has an IRR of 38%, Case B an IRR of 22%.
•Which is the better Investment? Other things being equal, the one with the higher
IRR.
•Would an investment with an IRR of, say 75% be a better investment? YES.
•Another way to think of IRR is this: IRR tells you just how high discount rates would
have to go in order to “wipe out” the value of the investment.
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