Financial Project Metrics in Feasibility Study

Cost Estimation - Factors Hardware and Software costs including maintenance Travel and Training costs Effort costs (costs of paying SW engineers) Heating lighting and office space Support staff (accountants, cleaners etc) Infrastructure (network + communications) Facilities (library, refreshments, recreation) Social security, employee benefits, pensions etc

Cost Benefit Analysis Compare the costs of carrying out a project with the estimated benefits Identify all costs Development Costs Running Costs – annual costs

Cost Benefit Analysis Include all direct benefits of the project Will normally accrue on completion – but not always May be annual benefits/savings Express costs and benefits in a common unit £, €, $ etc What about intangible benefits?

Cost Benefit Analysis Example layout

Project Costs Direct Costs – Costs that can be directly attributed to a project task (labour, materials etc.) Indirect Costs – Overheads that do not directly contribute to the project (rent, heating, lighting, admin)

Pricing vs. Costing Price to charge for software = Cost + Profit Other factors may effect the pricing e.g. competitive environment, loss leader project Pricing therefore involves: project managers for costing senior management for pricing strategies

Costs vs. Budget Cost = how much it will cost to produce system Budget = how much you will be allowed to spend on producing system

Top Down Budget High level management set budget against high level tasks This is then divided amongst lower level tasks – by lower levels of management Generally results in: Inaccurate low level budgets Competition for available funds

Bottom up Budget Estimates are made on resource costs etc. for low level tasks (WBS) These are aggregated to provide direct costs for the project PM adds indirect costs – admin, etc. and reserve (and profit figures) Senior management then cut the budget!

Evaluating a Project Which of these projects is the best?

Net Profit

Net Profit The most obvious criteria for comparison Does not give the full picture regarding the viability of the project

Cash Flow Can the organisation afford the –ve cash flow required for the development of the project e.g. Project BBB requires an initial outlay of £1000,000

Cash Flow We need to spend money during the development of a product We hope to get it back once the product is finished Therefore projects will have a –ve cash flow during their development This should become +ve once the project is complete

Cash Flow Diagram b Income Time a c Cotterell and Hughes page 43

Cash Flow

Evaluating a Project

Payback Period The period of time it takes to recoup your initial investment A shorter payback period is preferred as it minimises the amount of time a project is in debt

Payback Period

Payback Period

Payback Period Find the payback period for projects BBB and DDD

Payback Period

Return on Investment Is it really worth investing all that time, money and effort into the project? To help make that decision we use the return on investment The investment will be the initial development costs of the project

Return on Investment Used to discover the percentage of return on the original project investment ROI = average annual profit x 100 total investment

Return on Investment For Project AAA ROI = £10,000 x 100 £100,000 Average annual profit = £50,000/5 (years) Initial investment = £100,000 ROI = £10,000 x 100 £100,000 ROI = 10%

Return on Investment Calculate the ROI for the remaining projects and show which one provides the best return

Return on Investment Project BBB Project CCC Project DDD Project BBB ROI = (100,000/5)/1000000x100 = 2% ROI = (50,000/5)/100000 x100 = 10% ROI = (75,000/5)/120000 x100 = 12.5%

Net Present Value Takes into account the profitability of a project and the timing of cash flows Receiving £1000 today is better then receiving £1000 next year Inflation – things will cost more Investment – we lose a year’s interest

Net Present Value - Examples If we invested £100 this year it would be worth £110 next year (assuming 10% interest rate – not likely) Therefore if we were given £100 next year it would have been the same as investing £90(ish) this year. This 10% is called the discount rate

Net Present Value The present value of any future cash flow can be calculated using the following formula: Present Value = value in year t (1 + r)t

PV Exercise If I gave you £100 in one year’s time, what would be its present value? Assume a percentage rate of 20% 100/(1.20)1 = £83.33 How about in three years? 100/(1.20)3 = £57.87

Net Present Value An alternative approach is to break down the problem into cash flow and discount factor: Discount factor = 1 (1+r)t Therefore: Present Value = Cash Flow x Discount Factor

Discount factor table

Net Present Value Net Present Value is the sum of the present values (aka discounted cash flows) As can be seen on the next slide, the profit figures can differ significantly using Net PV instead of Net Profit The payback period may also be effected

Net Present Value

Net Present Value

Have a look Again: Simple ROI vs Discounted ROI  The simple ROI calculation is commonly used for short-term (e..g., less than one year) investments and benefits. For example, say $1,000 is invested and it earns $1,250. This is a gain of $250. Divide the $250 by $1,000 (the amount invested) gives an ROI of 25%. However, the simple ROI calculation is less accurate when the investments and/or benefits involve future years because future dollars are worth less than current dollars. The general rule for greater accuracy is to use the discounted ROI calculation method when the investments and/or the benefits involve future years.

This table can be used to determine the present value of $1000 spent or received in up to 7 future years. The table is in thousands

Year 1 PV of Benefits: $1,000,000 received at end of year 1 = $943,400 PV of Investment: $1,000,000 paid at the end of year 1 = $943,400 (PV benefits less PV cost) divided by PV cost = ($943,400 less $943,400) divided by $943,400 = 0% This is same as for the Simple ROI calculation because both all of the investment and all of the savings occurred at the same time in the first year.

Year 2 PV of Benefits: $1,000,000 received at the end of year 1 ($943,400) and PV of another $3,000,000 received at the end of year 2 ($2,670,000) = $3,613,400 PV of Investments: $1,000,000 made at the end of year 1 = $943,400 (PV benefits less PV cost) divided by PV cost = ($3,613,400 minus $943,400) divided by $943,400 = 2.830, or a cumulative ROI at the end of year 2 of 283% Notice that the calculation for the Simple ROI shows 300%, which overstates the true (discounted) cumulative ROI by 17 percentage points.