Question

Course: Project Management.

Textbook

Project Management: A Systems Approach to Planning, Scheduling, and Controlling – 12th Ed.

Publisher: John Wiley & Sons; ISBN: 9781119165354.

2) As a project manager, you have the responsibility of selecting a viable project for the company out of many suggestions from multiple sources. Financially, what tools are available to you to select a specific project? (Discussion should include payback and rate-of-return calculations, at a minimum)

Answer 1

The Project manager has the overall responsibilty for selecting, implementing a project. He evaluates different alternatives and choose the viable one.

To determine whether a project is viable or not, the project manager need to evaluate the following tools and understand each one of them :

1. Economic Value Added

This metric is a performance metric that calculates the creation of wealth to the company while also defining the return of the capital, ie net profit after deduction of capital expenditure and taxes. This implies that the project with the highest EVA should be selected.

2. Opportunity Cost

Opportunity Cost is basically the cost that is forgone while selecting a alternative project. Project manager should choose the project with the lowest opportunity cost.

3. Discounted Cash Flow

Basically, this comes from the concept of Time Value of Money which means that $1 received 10 years of now is not equivalent to $1 received today. Hence while calculating the viability of the project we should discount all the cashflows (inflows & outflows) at the appropriate rate of interest to bring the cashflows to the present date.

4. Net Present Value

NPV is basically the second step of discounted cash flows. NPV is calcuated as the difference between discounted cash inflows and discounted cash outflows.

Net Present Value should always be positive to make a project viable. The project with the higher NPV should be choosen among multiple projects.

5. Payback Period

The use of payback period is to calculate the total time required to recover the cost of investment. In simple words, it is the payback period of the investment. The project that has the shortest payback period is preferred because it means that the entity can recover the initial cost of investment in a shoter period of time.

Payback period is calculated by dividing initial cost of investment by average annual cash inflows.

6. Rate of Return

Rate of return is basically an interest rate which makes discounted cash inflows equal to discounted cash outflows, NPV = 0.

It is basically an annualized effective compund interest rate that makes the net present value of all the cashflows from a particular project equal to zero.

Explanation with an example (Hypothetical)

A project of battery costs $ 100

Returns $ 25 per year for 5 years

Discount rate of 5%

Therefore NPV

Present Value = Cash Inflow or Future Value x (1 + rate)^-(time)

NPV = sum of all PV – Cash Outflow

If NPV > 0 accept

= 25*(1.05)^-1 + 25*(1.05)^-2 + 25*(1.05)^-3 + 25/(1.05)^-4 + 25/(1.05)^-5 – 100

= $ 8.236

And therefore, for IRR for 5 years

Set NPV to zero

0 = [Cash Inflow x (1 + IRR)^-(time)] – Cash Outflow

When IRR > rate accept

0 = 25*(1/(1+IRR)) + 25*(1/(1+IRR)^2) + 25*(1/(1+IRR)^3) + 25*(1/(1+IRR)^4) + 25*(1/(1+IRR)^5) – 100

IRR = 7.9%

And Payback Period

Initial Investment/ Annual cash inflows

= $100/$25

= 4 Years