You are on page 1of 48

Riphah International University

Engineering Project
Management
Lecture 3

Project Appraisal
The

fundamental question is to whether if the


Business Case/Project Feasibility is convincing
to invest in a project?

The

details of the Project Feasibility must


indicate how the proposed investment might
contribute to the overall objectives of the
organisation and to do this, it must establish the
predicted costs and benefits for the whole life of
the project

There

must be a formal and transparent process


for selecting from a number of competing
investment opportunities

Why Project Appraisal

A number of investment opportunities (in the form of potential project) may exist and these
must be examined and compared in terms of the deliverables and viability SELECTION

Project Managers are responsible for making the most effective use of finite RESOURCES and
this will often necessitate deciding where to allocate resources, when to allocate resources
and how much resource to allocate.

This fact emphasises the need to minimise the RISKS


associated with decisions made, through the use of a
structured investment appraisal process.

To establish that the Business Opportunity is:


Profitable
Reliable
Achievable/Do-able
Sustainable
Needed (Defines a relevant solution to a business
problem or justifies its role as a key opportunity,
aligned with organizational objectives)

Process of Analysis/Appraisal
Identify a Problem or Opportunity
Conduct Feasibility Study / (Business
Case)
Define Scope and Objectives
Evaluate Alternatives

Project
Initiation
Phase

Capital Investment Decision


Develop a Project Charter (PID)
Plan the Project in Detail

Project
Planning
Phase

Objectives of Project
Appraisal/Feasibility
The

Key Objectives of Project Feasibility are:

To ensure you are not embarking on a


Titanic The Risks and Returns should
coincide

To ensure that you are not missing your


train- To establish successfully that the
project is the need of the time and exceeds
the opportunity costs of doing or not doing
anything else, in a sensible manner.

Project Environments
Macro Spheres/
General
Environment

Competitive/
Meso Environment

Internal/
Micro Environment

Tools and Techniques for Appraisal

For Micro level/Internal environmental


analysis, tools like SWOT and TOWS
analysis are used.

For Competitive Environment analysis,


tools like BCG Matrix, Porters 5 Forces
Model, McKinsey 7s Model are used.

For Macro level/General Environment,


tools like PEST, PESTLE and STEEPLE are
used.

SWOT Analysis

PEST Analysis

PESTLE Analysis

Porters 5 Forces Model


Potential/Threats of new
entrants

Power of suppliers

Intensity of rivalry

Power of Customers/
Buyers

Potential/Threats of
substitutes

BCG Matrix

Dogs: Projects with a low share of


a low growth. Do not generate cash
for the company

Cash Cows: Projects with a high


share of a slow growth market.
Generate more than is invested in
them.

Question
Marks:
These
are
projects with a low share of high
growth market. They consume
resources and generate little in
return

Stars: Projects that are in high


growth markets with a relatively
high share of that market. Stars
tend to generate high amounts of
income

McKinseys 7-S Model


Structure: e.g., Functional, Project, Matrix,
Network, JV, Holding, Centralised, Decentralised

Systems: Procedures, Processes, e.g., financial


systems, Information systems

Style: Cultural, e.g., management style,


working

pattern

Staff: Numbers/Types of personnel within the


organisation

Skills: Distinctive capabilities of personnel and


organisation, e.g., Core competencies

Strategy: Allocation of the organisations


resources over time, environment, competition,
customers

Shared Values: Central belief and attitudes,


aspirations, common aim

Parts of Feasibility Study


A Project Feasibility must define a BUSINESS PROBLEM or
OPPORTUNITY
Must suggest a SOLUTION, addressing parts like:
Justification of the Project (Technical/commercial and or Procedural
Feasibility)
Project Objectives, Scope, Deliverables and Milestones
Its cost and benefit analysis (Monetary and non monetary costs)
Resource Requirements (Human, Technical, Economic, Assets)
Legal Requirements (Contracts and Approvals etc.)
Timeline of implementation
Method of implementation (Project implementation plan)
Project Constraints, Limitations and Risks

Process of Analysis/Appraisal
Identify a Problem or Opportunity
Conduct Feasibility Study / (Business
Case)
Define Scope and Objectives
Evaluate Alternatives

Project
Initiation
Phase

Capital Investment Decision


Develop a Project Charter (PID)
Plan the Project in Detail

Project
Planning
Phase

Scope of The project

Using XML in Excel

Defining Scope

PMBoK (2008) defines project scope as:


"Project scope is the work that must be done to deliver a product with the specified features and
functions"

Using XML in Excel

Scope Statement

What the project must deliver and sets the parameters of the project

Describes the requirements which the product or service has to perform

Basis for all future decisions and plans

Clarifies Objectives and deliverables: the project must deliver to be successful

Using XML in Excel

Scope statement

Buying a car, what would the scope look like?

Having defined the scope, cost and time can be calculated

Using XML in Excel

What the client


asked for

What the client got.

Using XML in Excel

Scope Management

It is the rigorous monitoring and control of the work necessary to complete the project

It defines what work is required and ensures that the project only includes that work.

Involves managing both product scope and project scope.

Using XML in Excel

Scope Management Process

Collect
Requireme
nt

Defin
e
Scope

Using XML in Excel

Verif
y
Scop
e

Contro
l
Scope

Scope Creep

PMI defines scope creep as adding features and functionality (project scope) without addressing
the effects on time, costs, and resources, with or without customer approval.

Using XML in Excel

Scope Creep ..

Scope creep accumulates so slowly and subtly


that you don't realize it's happening until it's
too late,

like when you've already promised it or,


worse, when you're already building it.

Scope creep is like slowly loading up your


plate with little portions of everything on the
buffet until you realize man, this plate is
getting heavy and I can't eat all of this, what
was I thinking!

Using XML in Excel

How is Scope Creep Introduced

Poor Requirements Analysis

Not Involving the Users Early Enough

Underestimating the Complexity of the Project

Lack of Change Control

Not giving sufficient time for requirement definition.

Change in business or technical landscape.

Aiming to please the customer (beyond what has been paid for)

Using XML in Excel

Can Scope Creep be Good?

When its producing what the client actually wants


When you can take advantage of new technology

When it takes advantage of an opportunity scope change can be advantageous it


might depend on your contract

Using XML in Excel

Objectives

The project objective is a clear statement describing what the project is trying to achieve.
A well-worded objective will be Specific, Measurable, Achievable, Realistic and Time-bound
(SMART).

Using XML in Excel

Objectives Vs Deliverables

Project objectives: These objectives describe the purpose of the project and what the
project will achieve from a business perspective. Generally, the project is considered to be
successful if the project objectives are met successfully.
Project deliverables. Deliverables describe the tangible products that are being built by
the project. All projects produce deliverables
Using XML in Excel

When you have completed creating your objectives and deliverables, go back and make
sure that theyre all in alignment.

Using XML in Excel

Project Appraisal Scenarios

SCALE CAN
WE AFFORD
THIS?

WILL THE
PROJECT MAKE A
PROFIT

COULD WE
MAKE BETTER
MONEY
ELSEWHERE

WHAT ARE THE


RISKS OF
DOING (OR NOT
DOING)?

HOW SOON
WILL I SEE A
RETURN?

DO WE NEED
ADDITIONAL
RESOURCE?

HOW LONG IS
THIS PROJECT?

WHAT ARE THE KEY


MILESTONES AND
DECISION POINTS

Capital Investment Appraisal

It is a formal Process of evaluation in order to aide/facilitate decision making process

It includes a cost benefit analysis and takes into account all the relevant factors such as:

Capital Costs, Operating Costs and Fixed Costs


Support and Maintenance Costs
Disposal Costs
Expected gains (monetary and non monetary)

It compares different projects by using tools like:

ROI
IRR
Pay Back Period
NPV

Return on Investment

Return on investment (ROI)

The simplest way to ascertain whether the investment in a project is viable is to calculate the return on
investment (ROI).

Return on investment % = Expected return 100


Investment

This calculation does not, however, take into account the cash flow of the

investment which in a real situation may vary year by year.

Payback Period
Payback is the period of time it takes to recover the capital
outlay of the project, having taken into account all the
operating and overhead costs during this period.
Usually this is based on the undiscounted cash flow so does
not take into account the time value of money
Payback is particularly important when the capital must be
recouped as quickly as possible as would be the case in shortterm projects
Pay Back Period = Investment/average per year return
e.g. a project investment is Rs 100 and average return is Rs
10 per year, so payback period would be = 100/10 = 10 years

Net Present Value


It measures the actual cash flow to obtain a realistic measure of
the profitability of the investment with respect to time value of
money
Can be calculated forward and backwards as well
Forward Analysis of NPV
Find the Future Value (FV) of investment compared with
time value of money
Backward Analysis
Find the Present value (PV) of the future returns to
todays value

Net Present Value

Example

Project Investment = Rs 100

Project Return after 3 years = Rs 115

Future value of Rs 100 if kept at bank at interest rate of 5%/annum

= Present Value (1+r)n

Where n = number of years

r= % return/100

= 100 (1+0.05)3

= Rs115.76

So if the Bank pays more than the Project returns, the Project is not feasible

Forward analysis

Backward Analysis = Future Value x 1/(1+r) n

115 x 1/(1+ 0.15)3 = Rs 97.75

So, if the Project does not meet or exceed its present value of the Money, it is not feasible

Internal Rate of Return


Internal rate of return is the discount rate that makes the
NPV of the project = 0
IRR tells us how high the discount rate would need to be
before a project is unacceptable
IRR = (FV/PV)1/n 1
= (121/100)1/2 -1
= (1.21)0.5 -1
= 1.1 -1 = 0.1 or 10%

NPV vs IRR

NPV directly measures the increase in value to the firm

Whenever there is a conflict between NPV and another decision rule, you shouldalwaysuse NPV

IRR is unreliable in the following situations

Non-conventional cash flows


Mutually exclusive projects
N.B: Mutually exclusive projects are projects amongst which only one can be selected. E.g.
Replacing a machine or repairing it are two mutually exclusive projects, you may choose only one
at a time and disqualify other

NPV vs IRR

Year

e.g. If the Required Rate of Return is 10%

Project
For project
A, theA
investment isProject
Rs 100

-100For B, it is Rs130 -130

The cash flows are given here as

70

90

50

70

NPV

99.17

132.23

IRR

9.54%

10.94 %

Definitely, here the Project B is more feasible and IRR compliments NPV

NPV Vs IRR
Year

Project A

Project B

-100

-250

105

130

49

254

NPV (@10%)

128.92

317.35

IRR

24.9 %

23.9 %

Notice the difference in IRR and NPV

See another Example

Capital Investment Process

Capital Rationing
In this situation, the decision maker is faced
with a limited capital budget. As a result, it
may not be possible to take all positive net
present value projects. Under this scenario,
the problem is to find that combination of
projects (within the capital budgeting
constraint) that leads to the highest Net
Present Value.
The problem here is that the number of
possibilities become very large with a
relatively small number of projects. Thus,
in order to make the problem
"manageable", we can systematize the
search.

Capital Rationing
We would want to choose that set of projects within the capital
budgeting constraint that gives the highest:
Net Present Value
INVESTMENT
This ratio is called the profitability Index

Capital Rationing
Suppose we have a Capital Budget of Rs 100 and 5
viable options
Project

Investment

NPV

45

50

15

16

80

82

10

20

24

What will be your right mix ?

Qualitative Aspects of Project Appraisal


A Qualitative Assessment must also be
performed to consider the non-financial
elements. This may Include areas such
as:
-

Strategic Fit

Risk Assessment

Competitive Position

Technical/Operational/Marketing
drivers
Track record

Contribution to current or future


activities

HSE/Legal/HR/Commercial issues or
challenges

Management
considerations etc.,

of

change

Facilitation of Capital Investment


By the use of capital
investment appraisal
techniques, more clarity
is gained to make an
informed decision
Qualitative inputs
should not be ignored
Cost + Risk > Benefits
= Reject
Benefits > Cost + Risks
= Approve

Limitations of Capital Budgeting

Discount Rate:
Organizations sometimes seriously lack the understanding that the Discount Rate is:

Minimum Return required (Adjusted for Time Value) + Adjustment For Risk

An Organization might classify projects as A, B or C with C being the riskiest project.


Project classified A might have nothing added to the discount rate while B projects
would have a certain amount added with an even larger amount added for the C
projects.

Companies generally assume they are actually earning the discount rate if they achieve a
NPV of Zero or greater.

These limitations can be used to manipulate the results of an otherwise unfavorable


project and make it appear to have a larger return than it actually has. Therefore, a
Project Manager should:
Evaluate the cash outflows after the payback data and how long does it take to recoup
those cash flows?
See how will cash inflows be reinvested throughout the life of the project and will those
reinvestments earn the same or greater amount than the discount rate on the project?