COMM02

Project Evaluation

Unit 3

University of
Sunderland CIFM02 Unit 3
 Project Evaluation
• Introduction
– Why evaluate?
• To decide a project feasibility
• To assess the level of risk
– What is evaluated
• Strategic issues
• technical issues
• economic issues

University of
Sunderland CIFM02 Unit 3
 Strategic Issues
Some typical strategic issues
– some or all of which may apply to a IT project

• Objectives
– What will the project contribute to the
organisations objectives
• for example - may it contribute to increasing market
share

University of
Sunderland CIFM02 Unit 3
 Strategic Issues
• IS plan
– Does the proposed project fit into the
organisations IS plan
• if yes then in which way
– How and will the proposed project fit with
existing systems
• will it replace any
– How dose it fit with proposed future
developments

University of
Sunderland CIFM02 Unit 3
 Strategic Issues
• Organisation structure
– Will the project affect the current organisation
structure
• Management information system (MIS)
– Will it complement or enhance existing MIS
• Personnel
– Skill base, manning, availability, development

University of
Sunderland CIFM02 Unit 3
 Technical Issues

• Is it really understood what is required

technically
– If “no” can this be resolved before the start of the
project.
– Will any lack of understanding cause changes to
the project as it progress

University of
Sunderland CIFM02 Unit 3
 Technical Issues

• What functionality is require

– Can hardware accommodate this
– Is it within the bounds of current available
software and/or programming languages

University of
Sunderland CIFM02 Unit 3
 Technical Issues

• Do strategic issues place limitations on

technical solutions

• Cost constraints on technical solutions

University of
Sunderland CIFM02 Unit 3
 Economic Issues

• Cost-benefit analysis
• Cash flow forecasting
• Cost-benefit evaluation techniques
• Risk analysis

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Analysis
• The comparison of estimated costs and
benefits

• The general question is

– will income and other benefits exceed costs
– how do the various project options compare

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Analysis
• Analysis is in two stages
– Identify and estimate all costs and benefits
– Convert costs and benefits into common units
• normally monetary units
• Costs to be estimated
– Development costs
– Set-up costs
– Operational costs

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Analysis
• Benefits to be estimated
– direct benefits
• e.g. reduction in staffing levels
– Assessable indirect benefits
• e.g. reduction in operator errors
– Intangible benefits
• e.g. improved working conditions

University of
Sunderland CIFM02 Unit 3
 Cash Flow Forecasting
• Provides an estimate of the expenditure
incurred and the income generated
throughout the life of the product.
• It is time related
• It will provide an indication of when positive
and negative cash flow will occur

University of
Sunderland CIFM02 Unit 3
 Cash Flow Forecasting
• It is not easy to get things right due to the
number of uncertainties
• The longer the whole life of the product the
more uncertain is the forecast
• The increase in aliancing contracts and PPFI
have increase the need for improving the
accuracy of cash flow forecasting

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

Five techniques will be explored, they are:

• Net profit
• Payback period
• Return on investment (ROI)
• Net present value
• Internal rate of return

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Net Profit

• NP = total income - total cost

– A very simple technique

– Does not consider time element
– Of limited use when used in isolation

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Net Profit

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 30,000
2 10,000 200.000 30,000 30,000
3 10,000 200.000 30,000 30,000
4 20,000 200.000 30,000 30,000
5 100,000 300.000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Payback period
– Time taken to break even
• i.e. payback initial investment
– Projects with short payback periods are
preferred nowadays
– Does not consider income or expenditure after
break even point is reached

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
Net profit + payback period

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 30,000
2 10,000 200.000 30,000 30,000
3 10,000 200.000 30,000 30,000
4 20,000 200.000 30,000 30,000
5 100,000 300.000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Return on investment (ROI)
– or Accounting rate of return (ARR)

– Compares investment required with net

profitability

• ROI= average annual profit / total investment x 100

•
• ROI for project 1 = 10,000 / 100,000 x 100 = 10%

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
Net profit + payback period + ROI

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 30,000
2 10,000 200.000 30,000 30,000
3 10,000 200.000 30,000 30,000
4 20,000 200.000 30,000 30,000
5 100,000 300.000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
Net profit + payback period + ROI
ROI is Project 1 = 10% Project 2 = 2%
Project 3 = 10% Project 4 = 12.5%
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 30,000
2 10,000 200.000 30,000 30,000
3 10,000 200.000 30,000 30,000
4 20,000 200.000 30,000 30,000
5 100,000 300.000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

• ROI is simple to calculate

– this makes it a popular method
• But, it has two major problems
– It does not consider the time element
– The ROI gets compared to bank interest rates
• this is not a valid measure as timing and compounding
of interest are no considered
• This can lead to very misleading conclusions

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

• Net present value (NPV)

– considers profitability
– takes account of the time element
– NPV discounts future cash flows
• to current money values
• it does this using a percentage rate called the discount
rate

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• NPV a simple example using inflation

• £100 today = £100

• £100 today will be worth less in a 12 months time if
inflation is 5%
• with 5% inflation £100 today = £95 in a years time
• today’s present value of £100 gained in 12 months
time would be worth only £95 if inflation is 5%
• £100 gained in 5 years = £78 today if 5% inflation

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• NPV a simple example (cont.)
• Another way of considering NPV is that it is the
reverse of looking at the value of money from the past.

• i.e. with 5% inflation to have the same purchase value

of £100 5 years ago you would need to spend £128
today

• NPV considers the value of money in the future with

today as the baseline

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• The formula for net present values of future
cash flows is
• present value = value in year t / (1+r)t
• where r is the discount expressed as a decimal value
• and t is the number of years in the future
• A simpler method is to use discount tables
• present value = value in year t x discount factor

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Now calculate the NPV for each of the four
projects.

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 30,000
2 10,000 200.000 30,000 30,000
3 10,000 200.000 30,000 30,000
4 20,000 200.000 30,000 30,000
5 100,000 300.000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
Assuming a 10% discount rate, below is the NPV for
project 1. Calculate the NPV for projects 2, 3 & 4.

Year Project 1 Discount Discounted

cash flow factor @ cash flow
(£) 10% (£)
0 -100,000 1.0000 -100,000
1 10,000 0.9091 9,091
2 10,000 0.8264 8,264
3 10,000 0.7513 7,513
4 20,000 0.6830 13,660
5 100,000 0.6209 62,090
Net Profit 50,000 NPV: £618
University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• The NPV for all four projects.
Year Discount Discounted Cash flo w (£)
factor @
10% Project 1 Project 2 Project 3 Project 4
0 1.0000 -100,000 -1,000,000 -100,000 -120,000
1 0.9091 9,091 181,820 27,273 27,273
2 0.8264 8,264 165,280 24,792 24,792
3 0.7513 7,513 150,260 22,539 22,539
4 0.6830 13,660 136,600 20,490 20,490
5 0.6209 62,090 186,270 18,627 46,568

NPV 618 -179,770 13,721 21,662

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

• Net present value disadvantages

– may not be comparable to
• other investments
• cost of borrowing capital

– a solution to this is to utilise Internal Rate of

Return

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

• Internal rate of return (IRR)

– provides a profitability measure as a percentage
return
– this directly comparable to interest rate
– IRR is used in conjunction with NPV

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• IRR is the discount rate when the NPV is 0
– e.g. in project 1 the IRR is just over 10%

• Calculation of IRR is trail and error when

done by hand
• IRR can also be estimated using a graphical
method
• Spreadsheet can often calculate IRR

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques
• Using the graphical method

25000
20000
Net Present Value (NPV)

15000
10000
5000
0
-5000 5 15
-10000
-15000
-20000
Discount rate (%)

University of
Sunderland CIFM02 Unit 3
 Cost-Benefit Evaluation
Techniques

• NPV and IRR are not the complete answer

– funding, future earning prediction, organisation
context must all be taken into consideration

University of
Sunderland CIFM02 Unit 3
 Risk Analysis

• All projects involve some form of risk

• Project evaluation has risks associated with it
• Risk Identification
– potential risks are identified, evaluated and
ranked
• Various analysis techniques available
– e.g. Monte Carlo simulation

University of
Sunderland CIFM02 Unit 3
 Risk Analysis
• Monte Carlo simulation (MCS)
– Simulation … an analytical method meant to
model real life scenarios
– MCS utilises random numbers for deciding the
input variables
– Numerous simulations (often several 1000) are
then performed utilising randomly generates
inputs
– The result is a simulated model of the real life
system of interest.

University of
Sunderland CIFM02 Unit 3
 Concluding remarks
• Project Evaluation

– Strategic

– Technical

– Economic

– Risk considerations
University of
Sunderland CIFM02 Unit 3