1
Agenda
Cost Management Capital Budgeting Payback PeriodTime Value of MoneyPresent ValueFuture ValueDiscounted Cash Flow conceptsNet present valueProfitability index
Cost Benefit Analysis
2
Cost Management
• Cost management on a project includes the processes necessary to ensure that the project is completed within the approved budget
• Includes cost trade-offs, risks, make Vs buy, Buy Vs Lease, sharing of resources etc.
• Accuracy of Estimates• During initiation can have ROM of: +/- 50%• Later Stages can narrow down to : +/- 10%
• Estimates include, but are not limited to : labor, material, equipment, services & facilities as well as inflation allowance, contingency costs
3
Cost management
• Direct Cost – Cost of resources that is directly traced and utilized completely for the project purposes
• Indirect Cost – Cost that is shared across multiple projects or programs
• Fixed Cost – A periodic cost that does not vary with the business volume.
• Variable Cost – Cost that varies depending upon the business volume
4
Earned Value Concepts
Days Day-1 Day-2 Day-3 Day4
Amount Spent 1000 1200 600 Nil
Work Completed 100% 100% 50% Nil
Budget At Completion (BAC) = 4000Earned Value (EV) = 2500Actual Cost (AC) = 2800Planned Value (PV) = 3000
5
Earned Value Concepts
Cost Variance (CV) = EV – AC = 2500 – 2800 = - 300Schedule Variance (SV) = EV – PV = 2500 – 3000 = - 500 (Remember SV is also calculated in terms of money only)Cost Performance Index (CPI) = EV / AC = 2500 /2800 = 0.89Schedule Performance Index (SPI) = EV / PV = 2500 / 3000 = 0.83
CV < 0 - Over budgetCV > 0 - Under budgetSV < 0 - Behind ScheduleSV > 0 - Ahead of Schedule
CPI < 1 - Over budgetCPI > 1 - Under budgetSPI < 1 - Behind ScheduleSPI > 1 - Ahead of Schedule
6
Capital Budgeting
Capital budgeting is the process of authorizing capital spending on
Large projects and Long term projects.
Capital budgeting focuses on cash inflows and cash outflows over
the period of the project rather than net income calculated on
accrual basis
Cash inflows may include estimated cash inflows from customers,
proceeds from sale of assets, reduced costs and salvage value
Cash outflows may include capital investment, cost of investment,
operating costs and maintenance costs
7
Capital Budgeting - Techniques
Capital budgeting Concepts
Cash Payback PeriodTime Value of moneyPresent ValueFuture Value
Discounted Cash flow techniquesNet Present ValueProfitability IndexInternal Rate of Return (IRR)
8
Payback period is the time required to recover the cost of the Project
(the investment)
Payback period is calculated by dividing the capital investment by
the net annual cash flow. If the net annual cash flow is not expected
to be the same, the average of the net annual cash flows will be used
Cost of the project (Investment)
Payback Period = -----------------------------------------------
Average net annual cash inflow
Payback Period
9
An organization ABC is considering the purchase of an equipment for Rs. 150,000. The equipment is expected to work for 7 years and have a salvage value of Rs. 5000 at the end of its life. The annual cash inflows are expected to be Rs. 250,000 and the annual cash outflows are estimated to be Rs. 200,000.
Case I – Payback Period when the net annual cash inflows are same
150,000
Payback Period = -------------------------------------- = 3.0 Years
50,000 (250,000 – 200,000)
Payback Period
10
Case II – When the net annual cash inflows are different. The payback
period is the point in time where the cumulative ne cash flows become
zero. In the following case the payback period is 3.25 years.
Payback Period
Year Expected Cash Flow Cumulative Cash Flow
0 150, 000 150,000
1 30,000 120,000
2 50,000 70,000
3 55,000 15,000
4 60,000 45,000
5 60,000 105,000
6 60,000 165,000
7 65,000 205,000
11
Compare the cash inflows for two projects ABC and XYZ.Both projects have the same payback period (3 years) but
their cash flows are different. Similarly two projects may have the same
payback Period. But one project may last for 5 years and other may
last only one year after the payback period
Payback Period
Year Expected Cash Flow
Cumulative Cash Flow
0 14000 14000
1 3000 11000
2 4000 7000
3 7000 0
4 1500 1500
5 1500 3000
Year Expected Cash Flow
Cumulative Cash Flow
0 14000 14000
1 6000 8000
2 5000 3000
3 3000 0
4 2000 2000
5 1000 3000
Project ABC Project XYZ
12
Value of money available at the present time (PV) has more value
than the value of same amount of money in the future (FV)
For example, assuming a 10% interest rate, Rs 1000 invested today
will be worth Rs. 1100 in one year (Rs. 1000 multiplied by 1.10).
Conversely, Rs. 1000 received one year from now is only worth
Rs. 909 today (Rs. 1000 divided by 1.10), assuming a 10% interest
rate. FV
FV = PV * (1 + r)n PV = -------------
(1+r)n
PV = Present Value; FV = Future Value; r = Rate of interestN = number of periods
Present Value and Future Value
13
Annuity Table
Years 2% 4% 5% 6% 8% 10% 12%
1 0.9804 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929
2 0.9612 0.9246 0.9070 0.8900 0.8573 0.8264 0.7972
3 0.9423 0.8890 0.8638 0.8396 0.7938 0.7513 0.7118
4 0.9238 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355
5 0.9057 0.8219 0.7835 0.7473 0.6806 0.6209 0.5674
6 0.8880 0.7903 0.7462 0.7050 0.6302 0.5645 0.5066
7 0.8706 0.7599 0.7107 0.6651 0.5835 0.5132 0.4523
Present Value of 1
14
The sum of the present values of the cash inflows minus the sum of
the present values of the cash outflows gives the Net Present Value
When the Cash inflows are same
Net Present Value (NPV)
Year Expected Annual net cash Flow
12% Discount Factor
Present Value
1 50000 0.8929 446452 50000 0.7972 398603 50000 0.7118 355904 50000 0.6355 317755 50000 0.5674 283706 50000 0.5066 253307 50000 0.4523 22615
Totals 350000 228185
15
When the cash flows are all the same NPV is calculated as below
Investment (1) = 150000Cash inflow every year = 250000Operational Cost every year = 200000Net cash inflow = 250000 – 200000 = 50000 (each year)Sum of the Present values of the cash after discounting at a
discount rate of 12% (2) = 228185Present value of salvage (3) = 2262Sum of (2) and (3) = 230447NPV = 230447 – 150000 (Investment) = 80446
Net Present Value (NPV)
16
When the net cash flows are different, a separate present value
calculation is made for each periods cash flow
Net Present Value (NPV)
Year Expected Annual net cash Flow
12% Discount Factor
Present Value
1 45000 0.8929 40181
2 55000 0.7972 43846
3 60000 0.7118 42708
4 60000 0.6355 38130
5 50000 0.5674 28370
6 35000 0.5066 17731
7 45000 0.4523 20353
Totals 350000 231319
17
Calculation of Net Present Value
Investment Cost (1) = 150,000
Present value of Cash inflows (from Previous slide) = 231,319 Present value of Salvage = 5000 * 0.4523 = 226Total Present value of cash inflows (2) = 231,545
Net Present Value (2) – (1) = 81,545
NPV with equal cash flows is 80,446 and with unequal cash flows is
81,545.
Net Present Value (NPV)
18
The Internal Rate of Return determines the interest rate of the capital
that makes the NPV zero. In other words it is the return rate at which
the sum of the present values of the cash inflows equals the sum of
the present values of the cash outflows
The higher the IRR the project is acceptableDetermining IRRDivide the proposed capital investment amount by the net
annual cash inflow. This gives the IRR factorFind out the closest value along the line of the number of
years the project lasts. The rate for this value would be the IRR
Internal Rate of Return (IRR)
19
Annuity Table
Years 2% 4% 5% 6% 8% 10% 12%
1 0.9804 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929
2 1.9416 1.8861 1.8594 1.8334 1.7833 1.7355 1.6901
3 2.8839 2.7751 2.7232 2.6730 2.5771 2.4869 2.4018
4 3.8077 3.6299 3.5460 3.4651 3.3121 3.1699 3.0373
5 4.7135 4.4518 4.3295 4.2124 3.9927 3.7908 3.6048
6 5.6014 5.2421 5.0757 4.9173 4.6229 4.3553 4.1114
7 6.4720 6.0021 5.7864 5.5824 5.2064 4.8684 4.5638
Present Value of an annuity of 1
20
Ex: Let the project cost of a project LMN be 250,000 and equal cash
inflows of 55,000 per year are determined with a project life of 5
years.
The IRR factor would be (250,000 / 55,000) = 4.545
Going back to the annuity table and going along with the 5 year row,
this value would be nearest to 4.5638 which corresponds to the
column 12% in the table.
Internal Rate of Return (IRR)
21
Present Value of cash flowsProfitability Index = ---------------------------------- Required Investment
230447Profitability Index = -------------------- = 1.536 (Equal Cash
flows) 150000
231545Profitability Index = --------------------- = 1.543 (Unequal Cash
flows) 150000
Profitability Index
22
Cost Benefit Analysis some times referred to as Benefit Cost Analysis is
a technique for assessing the costs and benefits of a capital investment
over a period of time. Basically applicable to large projects or projects
that extend over a longer period of time
Balancing Trade offs between competing constraints like Schedule,
Cost, Quality, Scope, Risks, is the major challenge in managing projects.
Cost Benefit Analysis provides a way of setting priorities and selecting
Options in the allocation of resources
CBA uses time value of money and discounted cash flows to arrive at
correct results
Cost Benefit Analysis
23
Calculation of all costs and all benefitsTangible Benefits and Costs (Direct costs and benefits)Intangible Benefits and Costs (Indirect costs and benefits)
Checking the uncertainties involved in the expected outcome which is
referred to as the “Sensitivity Analysis”Calculating the present values of the benefits that are
expected to be in Future.Comparing the costs and benefits to get the net rate of returnsComparing the net rate of returns from a particular project in
question with other projects
Cost Benefit Analysis
24
THANK YOU