Project Financial Evaluation
All organisations have limited resources, which means that a decision to proceed with a project may sometimes preclude another project from proceeding and/or temporarily impact business-as-usual productivity. So project priorities need to be determined. Among other things a financial evaluation of prospective projects is needed. Some projects promise a better financial return than other projects.
Project Business Case
Historically, us project managers have not been too concerned about the reason for a project, but have focused on producing the required deliverables (outputs) as per specifications, on time and within budget. This focus is understandable, since achieving these objectives is usually how our project management performance has been assessed. And while these objectives are important, ultimate project success occurs when the project outputs achieve anticipated benefits and sometimes other unanticipated benefits.
Contemporary thinking is that us project managers now need to be conversant with the project business case even though we may not have been involved in its preparation. The business case that identifies project costs and benefits is often prepared by a business analyst or the project sponsor. External changes (political, economic, social, technological, legislative, environmental and competitors’ activities) and internal changes to our project’s objectives of scope, time, cost and quality may affect our project’s resultant benefits. Our project benefits could be nullified, jeopardized or enhanced by factors both within and beyond our control. Additional benefits and disbenefits might be identified as our project proceeds. Also, the need for our project might evaporate.
Project managers now need to understand their project business case, which is the rationale for their project, and appreciate that project changes (variation) may impact benefits for better or for worse. Although benefit realisation remains the overall responsibility of the project sponsor, we project managers need to understand the reasons for our projects and recognise the impact of internal and external changes on our project’s viability. It’s about taking some responsibility for benefit risk management – at least considering the likely impact of changed project objectives on anticipated benefits. In fact, risks to benefits should be recorded, analysed and responded to as we would for risks to project objectives.
Insufficient financial rigor during project evaluation is often identified as a contributing factor to project failure. At the heart of project evaluation and the project business case or justification is usually a Cost-Benefit Analysis (CBA), sometimes called a Benefit-Cost Analysis (BCA), undertaken during project conception and updated periodically during project development and execution phases, where:
Project Value (Net Benefits) = Benefits – Costs
Cost-Benefit Ratio (CBR) = Benefits/Costs
CBA is a widely-used financial assessment tool first introduced by a French engineer, Jules Dupuit, in the 1930s. Unless a prospective project promises to add value or resultant benefits sufficiently exceed costs we would not normally proceed with a project.
The results of a CBA are often expressed as a payback period – how long before positive cash flows equal the investment. The earlier this breakeven point is achieved the better in most instances. Some CEOs prefer to see benefits realised during their term of office. And projects with a more attractive cost to benefit ratio would usually be given higher priority. An exception may be compliance projects necessary to meet new legislative requirements, although the financial consequences or penalties of not doing such projects may well exceed the project cost.
The main limitation of the CBA is that some relevant benefits and costs may defy quantification. It is not usually possible to assign every benefit and cost a monetary value. For example, how might we assess the financial value of a project that improves one’s health?
Project evaluation typically involves the identification of various options to achieve the project’s purpose, the gathering of relevant data about the options, analysis of the options, and the selection of the preferred option. The extent or depth of this analysis is usually tailored to the size and risk of the proposed project, since the analysis itself also needs to be cost-effective.
Before we can identify plausible options we need to be very clear about the purpose of the project or the desired “outcome” to be achieved once the project deliverable or “output” is in use. Realistic ways of achieving this required outcome should then be identified, including the “do nothing” or “do without” (maintaining the status quo) option. For example, options for storage might include:
- Refurbish or upgrade existing storage facilities.
- Hire, build or purchase new storage facilities.
- Contract out the storage function.
- Hold no stock and apply JIT principles.
- Have our supplier hold stock for us.
- Keep the current storage solution.
Following the identification and preliminary assessment of options, the most suitable options are then assessed in greater detail against our organisation’s project selection criteria. Weighted criteria recognise that some selection attributes are more important than others. See The Framework pages 135 – 137. One key selection attribute will be estimated costs and benefits.
The estimation of costs should identify whole-of-life costs (ie, both capital and maintenance costs for the expected useful life of the product or service) and we need to be sure that a benefit is a benefit. The following are not benefits:
- Our new computer will have an integrated database. This is a feature not a benefit.
- Our reorganisation will free up space. This isn’t a benefit unless the free is used.
- Our working environment will be better, which will improve staff morale, motivation and retention. Such benefit are certainly possible, but are usually too vague, too difficult to measure, and too difficult to relate to productivity improvements.
Watch too for “benefit contamination” where a benefit claimed by a project is affected by something outside the project. For example, improved staff retention may not be due to the improved working environment project, but due to a worsening national economic climate when employees have no option but to remain with their current employer. Also, on occasions different projects might claim the same benefits.
Costs and benefits are best expressed in monetary terms to enable their comparison on a consistent basis. Here’s an example. Graphic Works’ sales are exceeding targets. Two designers are working over-time, and the owners are considering increasing capacity to meet demand. This would involve leasing more space and hiring two more designers. They decide to complete a Cost-Benefit Analysis.
Currently, the owners of the company have more work than they can cope with, and they are outsourcing to other design firms at a cost of $50 an hour. The company outsources an average of 100 hours of work each month. They estimate that revenue will increase by 50 percent with increased capacity. Per-person production will increase by 10 percent with more working space. The analysis horizon is one year – they expect benefits to exceed costs within the year.
Description of Costs
Costs in First Year
|Lease||75 square metres available next door at $180 per square metre||
|Leasehold improvements||Knock out walls and reconfigure office space||
|Hire two more designers||Salary, including benefits||
|Two additional workstations||Furniture and hardware||
|Construction downtime||Two weeks at approximately $7,500 revenue per week||
Benefits in First Year
|50 percent revenue increase||
|Paying in-house designers $15 an hour, versus $50 an hour outsourcing (100 hours per month, on average: savings equals $3,500 a month)||
|10 percent improved productivity per designer ($7,500 + $3,750 = $11,250 revenue per week with a 10 percent increase = $1,125/week)||
|Improved customer service and retention as a result of 100 percent in-house design||
The payback time for this project = $139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months. Inevitably, these benefit estimates are mostly subjective, and there is a degree of uncertainty associated with the anticipated revenue increase. However, given this favourable CBA the owners decide to go ahead with the project.
Net Present Value (NPV)
When such costs and benefits are significant and occur over a period of years, the most common financial tool used in conjunction with the CBA is Net Present Value (NPV) when a financial analyst assesses the difference between the estimated streams of costs and benefits of the project, both discounted to present value. NPV is the sum of discounted net cash flows over the appraisal period. NPV discount tables are readily available. See “The Framework” page 128 or www.investopedia.com/calculator/netpresentvalue.aspx. If you are one of those few people who understand the NPV formula you won’t need the tables.
An intuitive justification for NPV discounting is that most people would prefer receiving a dollar today rather than receiving a dollar in a year’s time – recognising the time value of money. In effect, the discount rate is the desired return. NZ Treasury currently recommends a default discount rate of 8% when there is no other agreed discount rate. Private industry uses the Weighted Average Cost of Capital, which calculation is peculiar to each company. Also, the risk-neutral discount rate might be increased to account for an organisation’s risk attitude or appetite.
NPV calculations might be performed using different combinations of worst and best case scenarios. The analysis might also consider the consequences of risk. Analytical techniques for assessing risk and uncertainty include:
Sensitivity Analysis. This illustrates what would happen to costs and benefits if key variables changed. Consider whether better information about the values of these variables could be obtained to limit the uncertainty.
Risk Analysis. This requires we identify and analyse the risks of proceeding with the project. Costs and benefits then need to be adjusted accordingly. A risk premium can be included in the NPV discount rate – say an extra 5%.
Scenario Planning. This requires we consider various possible situations or future scenarios. Scenario planning usually focuses on long-term rather than short-term horizons and is used to illustrate a range of technical, economic, social, and political uncertainties which may affect the success of a project. While both optimistic and pessimistic scenarios should be considered, more attention is usually given to the development of pessimistic or conservative scenarios. Areas where a bias towards optimism may occur are in the under-estimation of future costs and over-estimation of benefits.
A project is financially viable if the Net Present Value is greater than zero. That is the total discounted value of benefits is greater than the total discounted costs. If projects offer alternative solutions to a single problem or opportunity, the project with the highest Net Present Value is usually selected. It may be helpful to consider CBA as a process:
- Confirm with the client the required project outcomes.
- Decide over what period the analysis should occur. This is the useful life of the asset, but usually not beyond 20 years since impacts beyond this timeframe are usually insignificant given the time value of money (discount effect). And residual, terminal or disposal value of the asset also needs to be considered.
- List stakeholders – those who would be affected by the project.
- Identify significant benefits and costs throughout the life of the project and its deliverables. Force Field Analysis (FFA) or structured brainstorming may help.
- Assign monetary values to benefits and costs where possible, which process might also account for uncertainty. For example a $100,000 benefit of 90% likelihood might be reduced to $90,000.
- Discount benefits and costs to present values using prevailing discount rates based on the Weighted Average Cost of Capital (WACC) for private organisations and whatever rate Treasury determines should apply to Government project propositions for which 8% is the current default rate allowing for both inflation and opportunity cost.
- We may or may not consider the effect of any intangible costs and benefits that could not be reliably assigned monetary values.
- Calculate the payback period.
- Perform a sensitivity analysis.
- Rank options.
During the project the CBA, might be reassessed periodically to ensure the project is still a financially viable investment. Sunk costs are not part of this review. Sunk costs are costs that cannot be recovered once they have been incurred. Yet sometimes sunk costs are given as the reason for continuing a failing project. And once the project is completed there may be periodic post-project evaluations to assess whether the anticipated benefits are being or have been achieved. Without such post-project benefit reviews our business case quality will not improve. But such reviews are only completed occasionally, perhaps because the sponsor has moved on or it is thought that the lessons learned will not be applicable to future projects.
While CBA is the favoured way to assess and compare the financial viability of longer-term and more risky or expensive projects, the tool has some limitations:
- Identifying all relevant costs and benefits and determining whether they are assured, probable, possible or unlikely. We can compensate an older person for the loss of part of their front yard, but how do we compensate for the fact that they no longer feel safe or confident crossing the road to visit friends? And the value attached to the destruction of a habitat is to some “priceless” and to others “worthless”.
- Deciding how far into the future the analysis should reach, how wide the analysis should (ie, to what extent intangible and indirect costs and benefits should be considered?)
- Some large projects have many stakeholders who may be positively or negatively affected by the project. CBA cannot hope to include all stakeholders’ views. And enthusiastic sponsors may under estimate costs and/or over estimate benefits to enhance the chances of project approval.
- Should future generations and “non-human” stakeholders be included in the analysis? Sustainable developments meet the needs of the present without compromising the ability of future generations to meet their own needs.
- The current NPV discount rate may not be applicable in the future. A risk premium might be added.
Another financial assessment technique is Internal Rate of Return (IRR), which is the discount rate at which the NPV of the investment becomes zero. IRR is also used to evaluate the financial attractiveness of a project. If the IRR of a proposed project exceeds an organisation’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project would be rejected. See “The Framework” pages 114-135 for more detail this and other financial tools used for project evaluation.
While financial evaluation is very important, there are also other factors that determine the suitability of a project – see “The Framework” pages 135-137.