Project Management 07

Tathagat Varma

Tathagat Varma
Session 7/12: 22-Jun-2010

  A Project can be viewed as a series of cash flows
  This cash flow can be used to analyze a project’s
viability, ROI, etc.
  Project involves
  Some initial investment (capex, infrastructure costs, etc.)
  Some recurring expenses
o  Salaries to workforce
o  Buy additional raw material
o  Cost of project site (rental, utilities, data communication, etc.)
  Returns over a period of time
o  Interim returns
o  End-project returns
o  Lifetime returns

  Rs. 100 today ≠ Rs. 100 tomorrow
 Your money earns interest
o Simple interest
o Compound interest
 Also,
inflation makes cost of buying
higher (generally speaking)

  Present Value (PV) is the value on a
given date of a future payment or series
of future payments, discounted to
reflect the time value of money and
other factors such as investment risk.
  Present value calculations are widely
used in business and economics to
provide a means to compare cash flows
at different times on a meaningful "like
to like" basis.

  Future value (FV) measures the nominal
future sum of money that a given sum
of money is "worth" at a specified time
in the future assuming a certain interest
rate, or more generally, rate of return; it
is the present value multiplied by the
accumulation function.

  Compound interest (or compounding of earnings) is
simply the ability of interest (or investment return)
earned on a sum of money to earn additional interest
(or investment return), thereby increasing the return
to the owner of the money or investor. (
http://www.buffettsecrets.com/compound-
interest.htm)
  Warren Buffet is said to look at the compounding
factor when deciding on investments, requiring a
stock investment to show a high probability of
compound growth in earnings of at least 10 per cent
before making an investment decision.
  When asked to nominate the most powerful force on
earth, Albert Einstein is reputed to have answered
‘compound interest’. Buffett might well agree.

  Compounding involves moving cash flows from the
present into the future, and is the way we show how
an initial deposit earns interest on interest over time.
  For example, if you put $100 in the bank today and earned 10%
interest on the funds at the end of the year, you would have
earned $10 of interest.
  If you then decided to leave it in the bank for a second year at
10%, you would earn another $10 on your original deposit and
another $1 interest on your interest, for a total interest of $11.
  The process of earning interest on interest results in the balance
growing progressively after each successive year, and continues
until you withdraw money from the account.
  The compounding factor is used to make calculations
that move cash flows forward in time.
  (1+i)n

  The discounting factor is the reciprocal
of the compounding factor; it's the
compounding factor upside-down.
  The discounting factor enables us to
translate the future value of a lump sum
back to the value it has at the present
time.

  An annuity is a series of equal payments made
over a finite number of periods. The equal stream
of cash flows can either be paid out, as in the case
of a mortgage payment, or received, as in the case
of a retirement annuity.
  A perpetuity is a series of equal payments made
at a fixed interval forever (in perpetuity).
  A growing perpetuity is a series of payments that
grow at a constant rate over a fixed interval in
perpetuity. It differs from a simple perpetuity in
that the payments grow at a constant rate, rather
than remaining the same.

  The minimum acceptable rate of return, often
abbreviated MARR, or hurdle rate is the minimum
rate of return on a project a manager or company is
willing to accept before starting a project, given its
risk and the opportunity cost of forgoing other
projects.[1]. A synonym seen in many contexts is
minimum attractive rate of return (MARR)
  The MARR is often decomposed into the sum of
following components (range of typical values
shown)[4]:
  Traditional inflation-free rate of interest for risk-free loans: 3-5%
  Expected rate of inflation: 5%
  The anticipated change in the rate of inflation, if any, over the
life of the investment: Usually taken at 0%
  The risk of defaulting on a loan: 0-5%
  The risk profile of a particular venture: 0-50% and higher

  The opportunity cost of the funds used
to invest in the project is a reflection of
the next-best-alternative use of the
money.
  Remember, the money available for this
project could be invested elsewhere; if
it were possible to get a higher return
given a similar level of risk, that would
be preferable.

  The expected number of years required to
recover a project's initial investment. Payback
period is an appropriate rule to use when
there is a concern for fast capital turnover.
  Forecastthe amount and timing of the cash flows.
  Determine the maximum payback period acceptable
to you.
  Sum the consecutive cash flows to find the year at
which the project is paid back.
  Using this method, accept the project if the
payback period is less than or equal to the
maximum payback period acceptable to you.

  The discounted payback period (DPBP) is the
expected number of years required to equate a
project's discounted future cash flows to its
initial investment. Discounted payback period
differs from payback period (PBP) in that DPBP
takes into account the time value of money.
  Forecast the amount and timing of the project cash flows.
  Determine the maximum payback period acceptable to
you.
  Calculate the discounted value (or present value) of each
of the project's future cash flows using the hurdle rate.
  Sum the consecutive discounted cash flows to find the
year at which the project is paid back.
  A project is accepted if the discounted payback
period is less than or equal to the maximum
payback period acceptable to you.

  The profitability index (PI) is the net present value of future
cash flows divided by the initial investment. The profitability
index approach presents what is known as a constrained
optimization problem, where the constraint is cash (it could be
any limited resource). Modifications of the profitability index
can be useful when any resource is limited. For example, the
resource could be floor space in a manufacturing plant, gates at
an airport, or the hours available from an employee who
performs a specialized task.
  Forecast the amount and timing of the cash flows.
  Using the estimated hurdle rate, find the net present value of the future cash
flows.
  Divide the net present value of the future cash flows by the initial investment.
  If the profitability index is greater than 0, accept the project. For
multiple projects, rank the projects by their profitability indexes
and accept them in order until you've exhausted the funds
available or have run out of projects with a PI greater than 0.

  Net present value (NPV) is one of two widely
used finance rules in practice today. When a
particular project is being considered for
development, decision makers can look to the
NPV for some indication of the strength of the
project plan (evaluated in terms of the wealth
that is going to be created by the project).
  The NPV is found by calculating the present
value of its cash flows, discounting that amount
by the hurdle rate, and subtracting the initial
investment to get the final result. If the final
result is positive, the NPV rule says the project
can go forward. If the result is negative, the
project should not go forward.

  The internal rate of return (IRR) is the discount rate at
which the NPV will be 0; that is, the rate that equates
the present value of a project's cash outflows to the
present value of its cash inflows. If the IRR is greater
than the hurdle rate, the investors will earn more than
they require. Thus, when the IRR is greater than the
hurdle rate, accept the project.
  Forecast the amount and timing of the cash flows.
  Using the formula for net present value, set the net present
value to 0 and solve for the discount rate (the sole unknown).
This is usually done using a financial calculator or spreadsheet
program.
  Compare the calculated IRR to the hurdle rate. If the
IRR is greater than the hurdle rate, the IRR rule
recommends that you go ahead with the project.

  As a PM, you will take capital investment
decisions
  Never decide on a single metric
  Identify what is more critical to a project:
whether it is
  Profitability?
  NPV?
  IRR?
  PBP?
  or something else ?

  The risk shared between the buyer and the seller
is determined by the contract type
  All legal contractual relathipships generally fall
between one of the two broad families:
  Fixed price
o  Firm fixed price contracts (FFP)
o  Fixed price incentive fee contract (FPIF)
o  Ficed price with economic price adjustment control (FP-EPA)
  Cost reimbursable
o  Cost Plus Fixed Fee Contracts (CPFF)
o  Cost Plus Incentive Fee Contracts (CPIF)
o  Cost Plus Award Fee Contracts (CPAF)
  Time and Material Contracts (T&M)

Project Management 07

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