Financial Management

51st All India Course on

“Project Planning, Monitoring and Control Systems”
14th October 2006
INTRODUCTION

2
 Your experience with Finance ?
 Pressure to tighten estimates to the extent that you are
destined to exceed them during project execution
 There is a constant fight for funds for the project ?
 Meddling in finalising terms of contracts for supplies ?
 Delay in payments of suppliers ?
 Purchase proposals coming back with comments on
procedure ?
Have you ever asked yourself:
Why does finance predominate almost every thing you do
in the organisation ?

3
 Business organisations are about money
 Everything that anyone in a business organisation does
reflects in the Profit & Loss Account

If done inefficiently, expenses increase, profits reduce

If projects are delayed, expected revenues are delayed while
expenses accumulate leading to losses

On time installation and commissioning of a machine results in
higher production, more business and greater profits
 Over a period of time this also reflects in the Balance Sheet

Balance sheet is a snapshot of the state of an organisation

It reflects the Assets and Liabilities of a business organisation

As organisations earn profits, they pass on part of it as dividends,
and retain part for expansion through acquisition of assets.

This is how organisations grow, add capacity to take on newer
business opportunities, offer better professional opportunities to
their employees
4
 How does effective project management
relate to financial goals of an organisation
 Low cost project management  lower capital costs

Competitive product cost; Greater market share
Healthier P&L

More projects within given resources Stronger
Balance Sheet
 On time project delivery

Beat rivals by being early to market  Long term
competitive advantage leads to higher profits

 Faster realisation of project benefits, such as expected
revenues Healthier P&L

 More projects in given time  Stronger Balance
Sheet
5
 An eye on finance
 Even though individuals are well intentioned, decision
making within organisations needs to be controlled, so that
resources are expended as per business priorities
 Those aspects of behaviour that affects the financial
condition of the organisation are controlled through
financial control systems
 Instead of being frustrated with these control systems,
Project Managers must understand these and use them for
their projects’ benefit
 Finance is too important to be left to finance managers

6
 Financial Management focus
 Government/ PSU projects can be funded by

Public Finance through budgetary grants or guaranteed debt; OR

Public Private Partnerships (PPP) where financing is raised by a
private concessionaire, who recovers his investment over several
years of operation
 The focus of financial management is different for both
these delivery mechanisms.

Public financed projects: focus is on budgeting and control as well
as financial monitoring of projects, variations control, extension of
time etc.

Private financed projects: focus is on design of optimum project
structure, setting up proper incentives for all players so as to make
project bankable

7
 Financial management activities for
public financed projects
 Planning Stage

Investment decision: assessment of financial viability of project

Due diligence: review and approval of Detailed Project Report, with
focus on robustness of cost and revenue estimates and scope definition
 Budgetary estimating and planning

Construct appropriate project financial life-cycles (S curves)
 Bid process

Financial vetting of contracts : Choice of type of contracts (e.g. fixed
price, cost plus etc.); Ensuring standard escalation clauses, enforceable
responsibilities; adequate competition etc.;
 Contract management

Vetting proposals to make payments against works; grant of Extension
of Time; enforcement of Performance Guarantees and Liquidated
Damages; Control over scope through approval of variations
 Budgetary control and project monitoring
8
INVESTMENT DECISION

9
 Investment decisions
Fruit
Net Goods &
Earnings Services
Operating
Activities

Reinvested Investment
Investing in Producing
Activities Assets

Debt Branches
Payment Trunk &
Debt
Financing Financing
Activities Dividends Equity
Financing Roots

10
 Steps in the investment decision making
 Estimate the project cost
 Estimate the cash flows expected
 Determine the appropriate required rate of return

To use for computing the Net Present Value of the estimated cash flows

To use as the hurdle rate for Internal Rate of Return (IRR) calculations
 Compute the financial parameters of the expected cash flows

NPV/ Project IRR: Public projects

Equity IRR; Debt Service Coverage Ratios (DSCR): Private financed
projects
 Apply decision criteria to ascertain feasibility of the project

NPV > 0 or Project IRR > 12% for public funded projects

Equity IRR > Required rate of return by equity investors and DSCR >
1.5 for private financed projects, under different debt structures
11
 Capital Budgeting Evaluation Techniques

 Payback Period/ Discounted payback period

 Net present value (NPV)

 Internal rate of return (IRR)

12
13
 Payback period
 Payback period is the length of time before the original
cost of an investment is recovered from the expected cash
flows
 Disadvantage of Payback Period: Ignores time value of
money Ignores all cash flows after payback has been
reached
 Unrecovered cost at start 
 Number of years before   
   of full - recovery year 
Payback   full recovery of  
 original investment   Total cash flow during
   

 full - recovery year 

14
Investment decisions based on Payback Period

Example: $350 $350 $350 $350

1 2 3 4
years
-$1,000
Payback Period (Investment) = 3 years

Discounted payback is the length of time it takes for a project’s

discounted cash flows to repay the initial cost of the investment

15
 Net Present Value
 NPV is a method of evaluating capital investment
proposals by finding the present value of future net cash
flows, discounted at the rate of return required by the firm
CF̂1 CF̂2 CF̂n
NPV  CF̂0     
1  k 1 1  k 2 1  k n
n
CF̂t

t  0 1  k 
t

 Decision criteria: If NPV > 0 Accept the project

 Three characteristics of NPV

NPV recognizes the time value of money

NPV reflects the risk involved in the project

NPV depends only on future cash flows and the opportunity cost of
capital

NPV is additive, i.e. NPV(A) + NPV(B) = NPV(A + B)
16
 Discount Factor DF

1 1 ir
DFi ,r  or or e
1  r i  r 
im

1  
 m

PV ECFi   ECFi  DFi ,r

3
 1 
DF3, 0.10     0.75
 1 .1 

17
 Understanding Net Present Value

Example: $350 $350 $350 $350

1 2 3 4
years
-$1,000

NPV12%  1,000( y 0),350( y1),350( y 2),350( y3),350( y 4) 

350 350 350 350
  2
 3
 4
 1,000
1.12 1.12 1.12 1.12
 350  0.89  350  0.80  350  0.71  350  0.64  1,000
 63
Q: What is the meaning of “the NPV (at 12%) of a $1,000 investment that
returns $350 in the years 1,2,3 and 4 is $63”?

18
 Payback Period versus NPV

Example: $350 $350 $350

1 2 3
years
-$1,000
Payback Period (Investment) = 3 years

NPV Investment 
 350  AF3, 0.12  1,000
 350  2.4  1,000
 840  1,000
 160

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 Internal Rate of Return
 IRR is the discount rate that forces the PV of a project’s
expected cash flows to equal its initial cost
CF̂1 CF̂2 CF̂n
CF̂0      0
1  IRR  1  IRR 
1 2
1  IRR n

n
CF̂t

t  0 1  IRR 
t
0

20
21
 NPV profile
 NPV profile is a graph (curve) showing the relationship
between a project’s NPV and various discount rates
(required rates of return)
 IRR is at the point where the NPV profile crosses the X
axis
 Crossover rate: the discount rate at which the NPV profiles
of two projects cross and, thus, at which the project’s
NPVs are equal
 Comparison of two projects based only on IRR may be
misleading

22
 NPV and IRR Methods
 Decision rule: Invest if NPV > 0 or IRR> opportunity cost
of capital (k)
 Independent Projects: NPV & IRR both lead to same
decision

If a project’s NPV is positive, its IRR will exceed k, while if NPV
is negative, k will exceed the IRR
 Mutually Exclusive projects:

If NPV profiles cross, NPV and IRR decisions may conflict
depending on discount rate selected

In such cases, NPV method is preferred
 A project can have two or more IRRs

unconventional cash flow pattern

large outflow during or at the end of its life

NPV profile is required
23
 Internal Rate of Return versus NPV
Example 1:

Project A $20,000 Project B $35,000

1 1 year
year
-$10,000 -$20,000

20,000 35,000
NPV A r    10,000 NPVB r    20,000
1  r  1  r 

24
 Internal Rate of Return versus NPV
Example1:
Cash flows ($)
NPV at
Project IRR
t=0 t=1 10%

A -10,000 +20,000 100 +8,182

B -20,000 +35,000 75 +11,818

NPV(A) and NPV(B) as function of the discount rate

20000
NPV at 10%
15000
IRR
10000
Project A
Project B
5000

0
0 20 40 60 80 100
-5000

25
 Internal Rate of Return versus NPV
Example 2:

Project C
Project D
$6,000
$5,000 $4,000

$3,500 $3,500 $3,500 $3,500 $3,500

1 2 3 4 5 year

-$9,000
NPVC r   3,500  AF5,r  9,000
-$9,000

6,000 5,000 4,000

NPVD r      9,000
1  r  1  r  1  r 
2 3

26
Example 2:

Cash flows ($)

NPV at
Project IRR
t=0 t=1 t=2 t=3 t=4 t=5 10%

C -9,000 +6,000 +5,000 +4,000 0 0 33 +3,592

D -9,000 +3,500 +3,500 +3,500 +3,500 +3,500 27 +4,268

NPV(C) and NPV(D) as function of the discount rate

10000
8000
NPV at 10% IRR
6000
4000 Project C
2000 Project D

0
-2000 0 10 20 30 40 50

-4000

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 Examples of calculation

 Consider a firm with the following projects:

Project Initial Outlay NCF/yr Life
A 1000 350 4
B 500 150 6
C 750 200 5
D 800 200 5
E 200 50 10

28
 Examples of calculation (cont.)

 Firm cost of capital is 10%

 (1) Payback Period PP = time to recover initial outlay

PPA = 2 + 300/350 = 2 6/7 yrs

PPB = 500/150 = 3 1/3 yrs

PPC = 3 ¾

PPD = 4

PPE = 4
 Net Present Value

NPVA = 109.5

NPVB = 153.3 NPVC = 8.2

NPVD = -41.8 NPVE = 107.2

RANK: B-A-E-C-D

Reject D only
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 Capital Budgeting (cont.)

 IRR for projects in general cannot be found

analytically, but can only be found numerically
(e.g. use function in Excel)
 For our project A: want NPV =0 or 350 A4,r –
1000 = 0

r = .15 or 15%

30
 Capital Budgeting (cont.)
IRRs
Project IRR
A .15
B .20
C .1025
D .08
E .21

If k = .10 then accept all projects except D

Note: NPV and IRR rankings are different

31
 Capital Budgeting (cont.): Rankings

 NPV IRR
B E
A B
E A
C C
D D
Rankings are different, but accept/reject same

32
 Capital Budgeting

 NPV is superior to IRR Method for the following

reasons:

(1) Reinvestment rate assumption

(2) Multiple Internal Rates of Return

(3) Scale Differences

33
 Capital Budgeting (cont.): Multiple IRRs

 Assume your company can borrow at 10% and has a

following cash flow
 Year CF
0 -1600
1 10000
2 -10000
NPV = -1600 + 10000/1.1 – 10000/1.21
= -773.55
IRR = .25 and 4 or 25% and 400%

34
 Capital Budgeting (cont.): Scale Differences
 Consider 2 projects with CFs as follows:
Year 0 1 2
A I0 CF1 CF2
B I0/M CF1/M CF2/M
Where M is some large # (e.g. 1 Million)
NPVA = NPVB x M
Project A is much better than B
But IRRs are the same!

35
 Discount rate
 Opportunity cost of capital, Weighted average cost of capital
 This is the rate of return that investors expect from the
company (or project if it is stand alone project)
 Public funded projects = 12% (by policy)
 Private funded projects = WACC

WACC = % of equity in capital * required rate of return by equity
investors + % of debt in capital*cost of debt

Return required by equity investors is determined by the risk
associated with the project

36
Incorporating Risk in Capital Budgeting
Analysis
 Scenario analysis

a risk analysis technique in which “good” and “bad” sets of
financial circumstances are compared with a most likely, or best-
case situation

Worst-case scenario: an analysis in which all of the input variables
are set at their worst reasonably forecasted values

Best-case scenario: all input variables are set at their best forecasts

Base case: all of the input variables are set at their most likely
values
 Risk-adjusted discount rate

required rate of return for a particularly risky stream of income

equal to the risk-free rate of interest plus a risk premium
appropriate for the level of risk attached to a particular project’s
income stream

Project required rate of return is the risk adjusted required rate of
return for an individual project, kproj = kRF + (kM - kRF)Betaproj

37
Points to remember about cash flow estimation
 Cash is different from accounting profits: add back
depreciation as it is a non-cash expense
 Count cash flows after taxes
 Only incremental cash flows are relevant to the accept/
reject decision i.e. the change in a firm’s net cash flow
attributable to an investment project
 Inflation: cash flow projections should exclude inflation.
Discount rates to be used should be real rates
 Identifying costs for investment decision

Exclude sunk costs as they have already been incurred by your
organization and cannot be recovered (e.g. cement)

Consider opportunity costs i.e. return on the best alternative use
of a resource or an asset

Take into account positive and negative externalities: the effect a
project will have on the cash flows in other areas of the firm

38
Identifying Incremental (Relevant) Cash Flows
 Initial investment outlay

includes the incremental cash flows associated with a project that
occur only at the start of a project’s life, CF0
 Incremental operating cash flow

changes in day-to-day cash flows that result from the purchase of
a capital project and continue until the firm disposes of the asset
 Revenue - Cash Expenses - Taxes
 NI t  Deprt

 Terminal cash flow


the net cash flow that occurs at the end of the life of a project,
including the cash flows associated with final disposal of the
project returning the firm’s operations to where they were before
the project was accepted
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 Conclusions on the Capital Budgeting
Decision Methods
 Investment decision criteria

Public financed projects: Project IRR >= 12% (hurdle rate)

Public Private Partnership projects: Mix of criteria – Project IRR,
Equity IRR, Debt Service Coverage Ratio (DSCR), government
policy on Viability Gap Grant.
 Payback and discounted payback indicate risk and liquidity
of a project
 NPV gives a direct measure of the Rupee benefit to the
shareholders
 IRR provides information about a project’s “safety margin”
 IRR reinvestment assumption may be unrealistic
 Watch out for multiple IRRs
40
BUDGETING & ACCOUNTING

41
 Project Accounting
 Most small projects

Work through procurement and accounting section of host department
or the organisation’s main financial function
 Larger projects

Need their own finance capability

Large, complex or joint-venture projects need a professional
accountant and team to deal with the volume of work

Some joint ventures are run as entirely separate businesses requiring
their own legal, financial and organisational structure
 May use accounting software to manage the project's finances
independently of the organisation's overall accounting, with
proper consolidation of accounts

42
 Formulating the budget: start of project
 Project's budget will evolve from the project definition
 Budgets are usually set and managed for the duration of the
project. In some cases you might prefer to work with a
budget per stage or phase
 Issue:

The project needs to manage its budget over its full duration but the
organization needs to manage budgets on annual basis - so you
might need to manage and reconcile two sets of figures based over
different time periods
 A typical project budget shows the various types of
expenditure and the time period they are planned to fall
into. This subsequently allows you to track costs against the
plan.
43
 Budget Sheet
 categories of cost,

 specific types of cost,

 which month elements of each cost type fall into,

 total costs per category and type,

 total spend per month,

 overall project cost.

44
45
 Cost of participant’s time
 No charge: employees time is a sunk cost
 Fee rate per hour; agreed for different resource types

Pay costs: How much the individual is paid for the given time
period.

Cost of service: fully loaded cost including pension, office space,
apportioned HR costs

Opportunity cost: How much would a person like this be able to
contribute to the business if he was not diverted onto the project

Cost to external customer: How much would be charged to an
external customer if they were to hire this employee from us
 These rates are to be decided between the project manager
and the financial management of the organisation.

46
 Budgetary control during execution: costs
 For each cost, review whether it is appropriate, justified,
authorised, and in line with budget expectations
 These costs can be of following types

Charges for time spent by project participants taken from the
project's timesheet and time control system (based on agreed rates)

Charges for time reported by other business units and participants

Actual payroll costs of project participants

Purchases, rentals and other direct expenditure of the project

Purchases, travel, subsistence, accommodation and other
expenditure incurred by individuals and re-charged to the project

Internal cross-charges, e.g. use of facilities, telephone calls,
printing etc

Depreciation charges for capital assets such as equipment and
facilities.

47
Budgetary control during execution: purchase
 Must be a valid thing to buy
 Requester must be authorised to make such a request
(possibly subject to spending limits, restrictions on the
type or method of expenditure, dual authorisation
requirements etc)
 Budget must be available (a running total of commitments
is kept to identify the remaining budget available)
 Delivery of the product or service is validated
 Payment is only made if there is a three-way match
between what was ordered, what was delivered, and what
was billed.

48
Financial Aspects of Project Monitoring:
Earned Value analysis

49
 Tracking and reporting financial progress
 Financial data should be part of the routine project
tracking and control reporting information
 The basic requirement is to track and report spend against
budget. Expenditure to date is compared with the project
budget, typically showing:

This period: expenditure; budget; and variance

To Date: expenditure; budget; and variance

Forecasted variance against overall project budget
 Not useful to report financial data without an explanation
 Exception-reporting i.e. only report things significantly
different to the budget or plan
 Graphical reports are more informative than tables

50
 Tracking and reporting financial progress..
 Level 1: Develop a project budget and track spending
against it: Alarm if % of financial spend is more than %
completion
 Level 2: Budget spend plan tracking

Develop a monthly cumulative budget spend plan (S-curve). The
slope of the plan indicates the expenditure rate (“burn rate”)

Track actual costs against the plan by plotting actual costs against
the budget spend plan.

Useful for executive briefings, especially where you want to match
expenditures to a funding stream

For behind schedule projects, the spend plan method does not
provide adequate budget status information. The budget picture
would be worse than it looks, but it would be impossible to quantify

Large or complex project require a more rigorous approach to cost
and schedule tracking 51
Tracking and reporting financial progress..
Budget Spend Plan

52
 Tracking and reporting financial progress..
Earned Value Analysis
 "Earned Value" is a concept used to express the progress
of a task or of the overall project in terms of financial
value. It can give a more accurate view of the project.
 Collection of management practices and a structured
method to:

Establish a Performance Measurement Baseline

Measure and analyze performance
 Links cost and schedule performance together and presents
them in a form that facilitates management analysis and
presentation
 Relies on three key data points: Planned Value, Actual
Cost, Earned Value

53
 Key data required
 Planned Value

Budget at Completion (BAC): How much do you expect
to have done at completion ?

Planned Value or Budgeted Cost of Work Scheduled
(BCWS): How much should you have done at point X ?
 Actual Cost

Actual Cost of Work Performed (ACWP): The Rupee
amount actually spent to date

Has no relationship to work accomplished
 Earned Value

Budgeted Cost of Work Performed (BCWP): How much
work is done as of Today ? i.e. Work done, not money
spent
54
55
 Calculations

Cost Variance: CV = EV - AC
Cost Performance Index: CPI = EV / AC
Schedule Variance: SV = EV - PV
Schedule Performance Index: SPI = EV / PV
Estimate to Complete: ETC = BAC - EV
BAC - EV
Estimate at Completion: EAC = AC + CPI

56
 Tracking and reporting financial progress..
Earned Value
 Work done is calculated using

The percentage complete information for each task

50-50 rule OR 20-80 rule OR 0-100 rule.
 Calculations are done at task levels and aggregated for the
project

Budgeted Cost of Work Performed = Actual % complete * budget

Budgeted Cost of Work Scheduled = Planned % * budget

Actual Cost of Work Performed = Costs from transaction data

57
Work involved in Earned Value Management
 Organization (of the project)

Define the authorized work elements.

Provide for integration of WBS and organizational structure
 Planning, Scheduling, and Budgeting

Identify sequencing and interdependencies of tasks

Describe work in discrete work packages (WBS)

Budget; Schedule; Deliverables

Ensure work packages flow up to over-all budget
 Accounting Consideration

Recognized costing techniques: Obligation; Accrual; Invoice

Regular cost performance measurement (at a suitable time)

Rational identification and accountability of all costs

58
Work involved in Earned Value Management
 Analysis & Management Reports

Generate reports at least monthly
• Schedule Variance
• Cost Variance

Implement managerial actions as appropriate

Develop revised estimates
 Revisions and Data Maintenance

Reconcile budget changes to authorized scope changes

Incorporate authorized changes in a timely fashion

Control retroactive changes

59
Thank You

60