Building Economics and Value Management

Building Economics and Value Management

Dr. Sarbesh MishraFinance Area, NICMARHyderabad – 500 084.

04/11/23 Dr Sarbesh Mishra 2

About Myself

Name : Dr Sarbesh Mishra

Qualifications 1. B.Com (Hons) 2. Post-graduate in Commerce 3. M.Phil in Commerce 4. Ph.D. (Commerce)

Experience : Joined University of Delhi, as a Lecturer in Commerce in 2001 and continued till 2005 and then joined Army Institute of Management, NOIDA as Senior Faculty, Finance prior to current appointment at NICMAR.


Related to Cost (Thoughts) The most successful man in the life is the

man who has the best information.Benjamin Disraeli, 19th. Century PM of

England

Even if you’re on right track, you’ll get run over if you just sit there.

Will Rogers, Certified Cost Analyst

He who controls the past controls future.George Orwell, Certified Public Accountant


Contd…. You can’t get caught up in things that

you can’t control…….we can’t control our selling price. We can control our cost of manufacturing. We can control our efficiencies. We can control our waste.

Steven Appleton, CEO of Micro Technology

If you don’t know where you’re going, it doesn’t matter how you get there.

Prof. Sarbesh Mishra, NICMAR, Hyderabad


Capital Expenditure (CAPEX)

Expenditure expended for the purpose of obtaining long term advantage for the business.

Examples Expenditure incurred in increasing the

quality fixed assets e.g. Purchase of additional furniture, Plant, Building for permanent use in Business.


Revenue Expenditure“An expenditure that arises out of and in the course of regular business of a concern is termed as revenue expenditure”.

ExampleExpenditure incurred in the normal course of running the business e.g. expenses of administration, maintaining of facilities viz. Electricity, Telephone etc. cost incurred in manufacturing & selling the products, repairs, Depreciation, Interest on loan.


Importance of Investment Decision

Influence the firm’s growth in long-term

They affect the risk of the firm They involve commitment of large

volume of funds They are irreversible, or reversible at

substantial loss They are among most difficult

decisions to make.


Investment Evaluation Criteria

Estimation of Cash flows.

Estimation of required rate of return (Opportunity cost of capital)

Application of decision rule for making the choice


Cash Flows Cash inflows or outflows occur at three

stages of capital investment project1. Project Initiation (For beginning operations,

Working Capital needs, Replacement of asset)

2. Project Operation (Operating Expenditure, Addl. Working capital need, inflow of cash generated by the investment)

3. Final Project Disposal (Cash inflows or outflows related to investment’s disposal, Cash inflows from the release of working capital no longer committed to the investment)


Investment appraisal Techniques

Traditional Techniques Payback Period Method Accounting Rate of return MethodDiscounted Cash flow Technique1. Net Present Value method (NPV)2. Internal Rate of Return Method (IRR)3. Profitability Index Method (PI)


Traditional TechniquesPayback Period Method Payback is the number of years required to

recover the original cash outlay invested in a project.

Payback = Initial Investment

Annual Average Cash Flows

Project would be accepted if its payback period is less than the maximum or standard payback period set by management.


Accounting Rate of Return (ARR)

This measures the profitability of an investment.

ARR = Average Income

Average Investment

Projects with higher ARR over the minimum rate established by the management will be accepted.


DCF Techniques It explicitly recognizes the time value of

money.

Cash flows arising at different time periods differ in their value and are comparable when their present values are found out.

The compound interest rate is used for discounting cash flows is also called as the discount rate.


Net Present Value Method (NPV) Cash flows of the invested projects should

be forecasted based on realistic assumptions.

Appropriate discount rate should identified to discount the forecasted cash flows.

Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

Net Present Value is found out by subtracting present value of cash inflows.


NPV Formula

C1, C2 ….. Represent cash inflow in year 1,2 …., k is the opportunity cost of capital C0 is the initial cost of investment n is the expected life of the investment * k is assumed to be known and is constant

n

Ʃt=1

Ct

(1+k)t

- C0 NPV =


Acceptance Rule

1. Accept the project when NPV is positive

2. Reject the project when NPV is negative

3. May accept the project when NPV is zero.

Higher the NPV, the better it is.


Risk Analysis as a measure of cost control

Uncertainty arises from the lack of previous experience and knowledge. Attached factors are:

1. Date of Completion2. Level of capital outlay required3. Level of selling price4. Level of sales volume5. Level of revenue6. Level of Operating Costs7. Taxation Rules


Probability and Expected Values The probability of a particular outcome

of an event is simply the proportion of times this outcome would occur if the events were repeated a great number of times.

Expected Values – It results from the multiplication of each possible outcome of an event by the probability of that outcome occurring.


Risk Adjusted Discounted Rate The capital asset pricing model (CAPM) has

provided an approach to determine project required rate of return with risk consideration.

A measure of risk developed in the portfolio theory is beta (β).

RADR = Rf + Ri (K0 – Rf)

Rf = Risk free rate

K0 = Cost of Capital

Ri = Risk index of the project


Value Management / Earned Value Analysis

Today’s Situation:

Need for accurate and consistent status information

Numerous complex (and interrelated) projects Projects with many WBS activities Virtual offices Diverse technology platforms


Room For Improvement70% of projects are:

Over budget Behind schedule

52% of all projects finish at 189% of their initial budget

And some, after huge investments of time and money, are simply never complete

Source:The Standish Group


Enter Earned Value Analysis (EVA)

“Earned Value Analysis” is: an industry standard way to:

measure a project’s progress, forecast its completion date and final cost, and provide schedule and budget variances along the

way.

By integrating three measurements, it provides consistent, numerical indicators with which you can evaluate and compare projects.


Value Management technique…

VM technique involves 3 main steps:An awareness of value for the organization/

department, 1- Setting up measures/an estimate of value.2- Monitoring methods, and3- Controlling methods. A strong focus on the objectives and targets .A strong focus on deliverables “ maximizing

innovativeand practical outcomes”. WHAT- WHY- WHAT-

WHY…


The Formula…

Satisfaction of Needs

Value = -------------------------------------------- Use of resources( Staff , $,time , etc.)

As long as the level of satisfaction of needs is higher than the used resources ( staff, $, time, etc ), then the value is in the positive side.


Implementation of EVA EVA works best when work is

‘compartmentalized’.

Compartmentalization is best achieved with a well-planned Work Breakdown Structure.

So, how do I create a WBS for a really complex project?


How am I gonna eat this elephant?

Obviously in small bites.


Proper WBS Design One WBS per program

Deliverable-oriented Work not in the WBS is out-of-scope Each descending level represents more

detail Full (and accurate) definition is key

Defined deliverable(s) Timeframe for delivery of product Total cost (direct and indirect) to deliver

product


THANK YOU

Building Economics and Value Management

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