PROJECT EVALUATION. Introduction Evaluation comparing a proposed project with alternatives and deciding whether to proceed with it Normally carried.

PROJECT PROJECT EVALUATIONEVALUATION

IntroductionIntroduction

Evaluation Evaluation comparing a proposed comparing a proposed project with alternatives and deciding project with alternatives and deciding whether to proceed with itwhether to proceed with it

Normally carried out in step 0 in Step Wise Normally carried out in step 0 in Step Wise (i.e. select project)(i.e. select project)

Strategic AssessmentStrategic Assessment

Program ManagementProgram Management Program: collection of individual projectsProgram: collection of individual projects Organizational structure for program management: program Organizational structure for program management: program

director or program executivedirector or program executive

Portfolio ManagementPortfolio Management Third party developers must also carry out strategic and Third party developers must also carry out strategic and

operational assessment of project proposalsoperational assessment of project proposals The proposed project will form part of the portfolio of ongoing The proposed project will form part of the portfolio of ongoing

and planned projectsand planned projects The selection of projects must take account of the possible The selection of projects must take account of the possible

effects on other projects (eg. Competition of resources) and effects on other projects (eg. Competition of resources) and overall portfolio profile (eg. Specialization vs diversification)overall portfolio profile (eg. Specialization vs diversification)

Technical AssessmentTechnical Assessment

Consists of evaluating the required Consists of evaluating the required functionality against the hardware and functionality against the hardware and software availablesoftware available

Strategic information system plan might Strategic information system plan might influence the nature of solution and its costinfluence the nature of solution and its cost

Cost-benefit AnalysisCost-benefit Analysis

Economic assessment by comparing the Economic assessment by comparing the expected costs of development and expected costs of development and operation of the system with the benefit of operation of the system with the benefit of having it in placehaving it in placeAssessment is based uponAssessment is based upon Whether the estimated costs are exceeded by Whether the estimated costs are exceeded by

the estimated income and other benefitthe estimated income and other benefit Whether or not the project under Whether or not the project under

consideration is the best of a number of consideration is the best of a number of options options

Evaluating the economic benefitEvaluating the economic benefit

The standard way of evaluating the The standard way of evaluating the economic benefits of any project is to carry economic benefits of any project is to carry out a out a cost benefit analysiscost benefit analysis, which consist , which consist of two steps:of two steps: Identifying and estimating all of the costs and Identifying and estimating all of the costs and

benefits of carrying out the projectbenefits of carrying out the projectEg, development cost, operating costs, and the Eg, development cost, operating costs, and the benefitsbenefits

Expressing these costs and benefits in Expressing these costs and benefits in common unitscommon units

Ie, in monetary termsIe, in monetary terms

Cost CategoryCost Category

Development costsDevelopment costs SalariesSalaries

Setup costsSetup costs Cost of putting the new system into placeCost of putting the new system into place

Operational costsOperational costs Cost of operating the systemCost of operating the system

Benefit CategoryBenefit Category

Direct benefitDirect benefit Eg, he reduction in salary billsEg, he reduction in salary bills

Assessable indirect benefitsAssessable indirect benefits Secondary benefitSecondary benefit Eg, increased accuracy, reduction of errors, and Eg, increased accuracy, reduction of errors, and

hence costshence costs

Intangible benefitsIntangible benefits Longer term, very difficult to quantifyLonger term, very difficult to quantify Eg. Reduced staff turnover, and hence, lower Eg. Reduced staff turnover, and hence, lower

recruitment costrecruitment cost

Cash Flow ForecastingCash Flow Forecasting

Typically products generate a negative cash flow during the Typically products generate a negative cash flow during the development followed by a positive cash flow over their operating development followed by a positive cash flow over their operating life. life.

There might be decommissioning cost at the end of product’s lifeThere might be decommissioning cost at the end of product’s life

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me

Exp

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Cost-benefit evaluation techniquesCost-benefit evaluation techniques

Net profitNet profit

Payback periodPayback period

Net Present ValueNet Present Value

Internal rate of ReturnInternal rate of Return

Net profitNet profit

The difference between the total cost and The difference between the total cost and the total income over the life of the projectthe total income over the life of the project

Year Project 1 Project 2 Project 3 Project 4

0 -100,000 -1,000,000 -100,000 -120,000 1 10,000 200,000 30,000 30,0002 10,000 200,000 30,000 30,0003 10,000 200,000 30,000 30,0004 20,000 200,000 30,000 30,0005 100,000 300,000 30,000 75,000

Net Profit 50,000 100,000 50,000 75,000

Net profit (2)Net profit (2)

Project 2 shows the greatest profit but at Project 2 shows the greatest profit but at the expense of a large investmentthe expense of a large investment

Takes no account of the timing of cash Takes no account of the timing of cash flowsflows According to this criterion, project 1 & 3 would According to this criterion, project 1 & 3 would

be equally preferablebe equally preferable

Payback PeriodPayback Period

The time taken to break even or pay back the The time taken to break even or pay back the initial investmentinitial investmentNormally, the project with the shortest payback Normally, the project with the shortest payback period is chosenperiod is chosenAdvantage:Advantage: Simple to calculateSimple to calculate Not particularly sensitive to small forecasting errorsNot particularly sensitive to small forecasting errors

Disadvantages:Disadvantages: It ignores the overall profitability of the projectIt ignores the overall profitability of the project

Eg, the fact that project 2 & 4 are, overall, more profitable Eg, the fact that project 2 & 4 are, overall, more profitable than project 3 is ignoredthan project 3 is ignored

Return on InvestmentReturn on Investment

Also known as: Accounting Rate of Return Also known as: Accounting Rate of Return (ARR)(ARR)

Provides a way of comparing the net Provides a way of comparing the net profitability to the investment requiredprofitability to the investment required

100investment total

profit anual averageROI

ROI (2)ROI (2)

Advantage:Advantage: Simple, easy to calculateSimple, easy to calculate Not particularly sensitive to small forecasting Not particularly sensitive to small forecasting

errorserrors

Disadvantages:Disadvantages: It takes no account of the timing of the cash It takes no account of the timing of the cash

flowsflows It is tempting to compare the rate of return It is tempting to compare the rate of return

with current interest ratewith current interest rate

Net Present ValueNet Present Value

A project technique that takes into account A project technique that takes into account the profitability of a project and the timing the profitability of a project and the timing of the cash flows that are producedof the cash flows that are produced By discounting future cash flows by a By discounting future cash flows by a

percentage known as the discount ratepercentage known as the discount rate

NPV (2)NPV (2)

Table of NPV discount factorsTable of NPV discount factors

Year 5 6 8 10 12 15

1 0.9524 0.9434 0.9259 0.9091 0.8929 0.86962 0.9070 0.8900 0.8573 0.8264 0.7972 0.75613 0.8638 0.8396 0.7938 0.7513 0.7118 0.65754 0.8227 0.7921 0.7350 0.6830 0.6355 0.57185 0.7835 0.7473 0.6806 0.6209 0.5674 0.49726 0.7462 0.7050 0.6302 0.5645 0.5066 0.43237 0.7107 0.6651 0.5835 0.5132 0.4523 0.37598 0.6768 0.6274 0.5403 0.4665 0.4039 0.32699 0.6446 0.5919 0.5002 0.4241 0.3606 0.284310 0.6139 0.5584 0.4632 0.3855 0.3220 0.247215 0.4810 0.4173 0.3152 0.2394 0.1827 0.122920 0.3769 0.3118 0.2145 0.1486 0.1037 0.061125 0.2953 0.2330 0.1460 0.0923 0.0588 0.0304

Discount Rate (%)

Year 5 6 8 10 12 15

1 0.9524 0.9434 0.9259 0.9091 0.8929 0.86962 0.9070 0.8900 0.8573 0.8264 0.7972 0.75613 0.8638 0.8396 0.7938 0.7513 0.7118 0.65754 0.8227 0.7921 0.7350 0.6830 0.6355 0.57185 0.7835 0.7473 0.6806 0.6209 0.5674 0.49726 0.7462 0.7050 0.6302 0.5645 0.5066 0.43237 0.7107 0.6651 0.5835 0.5132 0.4523 0.37598 0.6768 0.6274 0.5403 0.4665 0.4039 0.32699 0.6446 0.5919 0.5002 0.4241 0.3606 0.284310 0.6139 0.5584 0.4632 0.3855 0.3220 0.247215 0.4810 0.4173 0.3152 0.2394 0.1827 0.122920 0.3769 0.3118 0.2145 0.1486 0.1037 0.061125 0.2953 0.2330 0.1460 0.0923 0.0588 0.0304

Discount Rate (%)

NPV (3)NPV (3)

Applying the discount factors to project 1Applying the discount factors to project 1

YearProject 1

Cash FlowDiscount Factor

10%Discounted

cash flow

0 -100,000 1.0000 -100,000 1 10,000 0.9091 9,0912 10,000 0.8264 8,2643 10,000 0.7513 7,5134 20,000 0.6830 13,6605 100,000 0.6209 62,092

Net Profit 50,000 621

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

Disadvantage of NPVDisadvantage of NPV The projects may not directly comparable with The projects may not directly comparable with

earnings from other investments or the costs of earnings from other investments or the costs of borrowing capitalborrowing capital

IRR attempts to provide a profitability measure IRR attempts to provide a profitability measure as a percentage return that is directly as a percentage return that is directly comparable with interest ratescomparable with interest rates Eg., a project that showed an estimated of IRR of Eg., a project that showed an estimated of IRR of

10% would be worthwhile 10% would be worthwhile if the capital could be borrowed for less than 10% or if the capital could be borrowed for less than 10% or if the capital could be invested elsewhere for a return greater if the capital could be invested elsewhere for a return greater than 10%than 10%

IRR (2)IRR (2)

IRR is calculated as that percentage IRR is calculated as that percentage discount rate that would produce an NPV discount rate that would produce an NPV of zeroof zero

Manually it must be calculated by trial-and-Manually it must be calculated by trial-and-error or estimated using two values and error or estimated using two values and using the resulting NPVs to estimate the using the resulting NPVs to estimate the correct valuecorrect value

IRR (3)IRR (3)

For a particular projectFor a particular project A discount rate of 8% gives NPV of $7,898A discount rate of 8% gives NPV of $7,898 A discount rate of 12% gives NPV of -$5,829A discount rate of 12% gives NPV of -$5,829 IRR is about 10.25%IRR is about 10.25%

8 12

7898

-5829

-8000

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

1 2

Discount Rate

NPV

IRR (4)IRR (4)A project cash flow treated as an investment at 10%A project cash flow treated as an investment at 10%

Year(a)

Project cash flow forecast

(b)Capital at

start of year

(c)Interest

during year

(d)Capital at

end of year

(e)End of year withdrawal

0 -100,000 1 10,000 100,000 10,000 110,000 10,0002 10,000 100,000 10,000 110,000 10,0003 10,000 100,000 10,000 110,000 10,0004 20,000 100,000 10,000 110,000 20,0005 99,000 90,000 9,000 99,000 99,0006 0 0 0 0

Equivalent Investment at 10%

Investing in a project that has an IRR of 10% can produce exactly Investing in a project that has an IRR of 10% can produce exactly the same cash flow as lending the money to a bank with 10% the same cash flow as lending the money to a bank with 10% interest rateinterest rate

A project with an IRR greater than current interest rates will provide a A project with an IRR greater than current interest rates will provide a better rate of return than lending the investment to a bankbetter rate of return than lending the investment to a bank

Note on IRR & NPVNote on IRR & NPV

One deficiency of IRR is that it does not One deficiency of IRR is that it does not indicate the absolute size of the returnindicate the absolute size of the return Example:Example:

a project with an NPV of $100,000 and IRR of 15% a project with an NPV of $100,000 and IRR of 15% can be more attractive than can be more attractive than

one with an NPV of $10,000 and IRR of 18% one with an NPV of $10,000 and IRR of 18%

the return of capital is lower but the net benefits the return of capital is lower but the net benefits greater greater

Risk EvaluationRisk Evaluation

Risk Identification and RankingRisk Identification and Ranking Construct a project risk matrix utilizing a checklist of possible Construct a project risk matrix utilizing a checklist of possible

risks and to classify each risk according to its relative importance risks and to classify each risk according to its relative importance and likelihoodand likelihood

RiskRisk ImportanceImportance LikelihoodLikelihood

Software never completed or deliveredSoftware never completed or delivered HH ______

Project cancelled after design stageProject cancelled after design stage HH ______

Software delivered lateSoftware delivered late MM MM

Development budget exceeded <= 20%Development budget exceeded <= 20% LL MM

Development budget exceeded > 20%Development budget exceeded > 20% MM LL

Maintenance costs higher than estimatedMaintenance costs higher than estimated LL LL

Response time targets not metResponse time targets not met LL HH

H = High, M = Medium, L = Low, __ = unlikely

Risk Evaluation (2)Risk Evaluation (2)

Risk and Net Present ValueRisk and Net Present Value Where a project is relatively risky, it is Where a project is relatively risky, it is

common practice to use a higher discount common practice to use a higher discount rate to calculate net present valuerate to calculate net present value

The addition is usually called risk premiumThe addition is usually called risk premium

Risk Evaluation (3)Risk Evaluation (3)

Cost Benefit AnalysisCost Benefit Analysis Consider each possible outcome and estimate Consider each possible outcome and estimate

the probability of its occurring and the the probability of its occurring and the corresponding value of the outcomecorresponding value of the outcome

Risk Evaluation (3)Risk Evaluation (3)

Risk Profile AnalysisRisk Profile Analysis Use sensitivity analysisUse sensitivity analysis

• Project A is less risky than project B

i.e unlikely to depart form its expected value

• Project C unlikely more profitable than expected

Risk Evaluation (4)Risk Evaluation (4)

Using decision treesUsing decision trees

extend

replace

expansion

expansion

No expansion

No expansion

0.2

0.8

0.2

0.8

NPV

-100,000

75,000

250,000

-50,000

(0.8*75000+0.2*(-100000))

(0.8*(-50000)+0.2*(250000))