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

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

Slide 5.8 Payback - Graphically We can see this graphically as follows Time Cumulative Cash Flow Payback (≥ Break even point) +ve -ve

Slide 5.9 Option 1 Option 2 Year 0 -€1,000 -€1,000 Year 1 €200 €0 Year 2 €500 €0 Year 3 €400 €700 Year 4 €0 €700 Year 5 €500 €500 Payback 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

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

Slide 5.15 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 €0 Year 2 €500 Year 3 €500 Year 4 €0 Year 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

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 2 Year 0-€1,000-€1,000 Year 1 €200 €0 Year 2 €500 €0 Year 3 €400 €300 Year 4 €0 €700 Year 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%?

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