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**Agenda Cost Management Capital Budgeting Payback Period**

Time Value of Money Present Value Future Value Discounted Cash Flow concepts Net present value Profitability 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 Budget At Completion (BAC) = 4000**

Days Day-1 Day-2 Day-3 Day4 Amount Spent 1000 1200 600 Nil Work Completed 100% 50% Budget At Completion (BAC) = 4000 Earned Value (EV) = 2500 Actual Cost (AC) = 2800 Planned Value (PV) = 3000

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**Earned Value Concepts CV < 0 - Over budget CV > 0 - Under budget**

Cost Variance (CV) = EV – AC = 2500 – 2800 = - 300 Schedule 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 = 0.89 Schedule Performance Index (SPI) = EV / PV = 2500 / 3000 = 0.83 CV < 0 - Over budget CV > 0 - Under budget SV < 0 - Behind Schedule SV > 0 - Ahead of Schedule CPI < 1 - Over budget CPI > 1 - Under budget SPI < 1 - Behind Schedule SPI > 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 Period Time Value of money Present Value Future Value Discounted Cash flow techniques Net Present Value Profitability Index Internal Rate of Return (IRR)

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Payback Period 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

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Payback Period 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 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)

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Payback Period 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. Year Expected Cash Flow Cumulative Cash Flow 150, 000 150,000 1 30,000 120,000 2 50,000 70,000 3 55,000 15,000 4 60,000 45,000 5 105,000 6 165,000 7 65,000 205,000

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**Compare the cash inflows for two projects ABC and XYZ.**

Payback Period 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 Project ABC Project XYZ Year Expected Cash Flow Cumulative Cash Flow 14000 1 3000 11000 2 4000 7000 3 4 1500 5 Year Expected Cash Flow Cumulative Cash Flow 14000 1 6000 8000 2 5000 3000 3 4 2000 5 1000

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**Present Value and Future Value**

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 in one year (Rs multiplied by 1.10). Conversely, Rs received one year from now is only worth Rs. 909 today (Rs 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 interest N = number of periods

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**Annuity Table Present Value of 1 Years 0.9804 0.9615 0.9524 0.9434**

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

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**Net Present Value (NPV)**

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 Year Expected Annual net cash Flow 12% Discount Factor Present Value 1 50000 0.8929 44645 2 0.7972 39860 3 0.7118 35590 4 0.6355 31775 5 0.5674 28370 6 0.5066 25330 7 0.4523 22615 Totals 350000 228185

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**Net Present Value (NPV)**

When the cash flows are all the same NPV is calculated as below Investment (1) = Cash inflow every year = Operational Cost every year = Net cash inflow = – = (each year) Sum of the Present values of the cash after discounting at a discount rate of 12% (2) = Present value of salvage (3) = 2262 Sum of (2) and (3) = NPV = – (Investment) = 80446

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**Net Present Value (NPV)**

When the net cash flows are different, a separate present value calculation is made for each periods cash flow 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 0.6355 38130 5 50000 0.5674 28370 6 35000 0.5066 17731 7 0.4523 20353 Totals 350000 231319

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**Net Present Value (NPV)**

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 * = 226 Total 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.

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**Internal Rate of Return (IRR)**

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 acceptable Determining IRR Divide the proposed capital investment amount by the net annual cash inflow. This gives the IRR factor Find out the closest value along the line of the number of years the project lasts. The rate for this value would be the IRR

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**Present Value of an annuity of 1**

Annuity Table Present Value of an annuity of 1 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

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**Internal Rate of Return (IRR)**

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 which corresponds to the column 12% in the table.

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**Profitability Index Present Value of cash flows 231545**

Required Investment 230447 Profitability Index = = (Equal Cash flows) 150000 231545 Profitability Index = = (Unequal Cash flows)

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Cost Benefit Analysis 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

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**Cost Benefit Analysis Calculation of all costs and all benefits**

Tangible 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 returns Comparing the net rate of returns from a particular project in question with other projects

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Chapter 8 Long-Term (Capital Investment) Decisions.

Chapter 8 Long-Term (Capital Investment) Decisions.

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