Turning Project Financial Analyses into a Painless Exercise
“No Pain, No Gain” is a popular exercise slogan that promises greater rewards for the price of hard work to achieve physical excellence. In the field of information technology (IT), most people think that performing financial analyses on new projects is hard work, but it doesn’t have to be if you know what you are doing.
First off, you have to realize there are three types of projects – Directives, Problems, and Opportunities. Directives can be imposed by management (for example, to improve the image of a company), by government (like the Dodd-Frank Act to meet financial compliance regulations), and/or by external stimulus. Problems are unwanted situations that prevent an organization from attaining its goals. A company might face upgrading outdated hardware with faster processors, so users can get information in a timelier manner to do their work. Outdated equipment is a typical problem that needs a solution. Most organizations find it’s easier to get project approval and funding to address directives and problems. Regardless, financial analyses should still be done on these typical “sure projects,” so you can find out how much is left over in your budget for opportunity projects. An example of an opportunity project would be creating a new product that could be the future of your business. Let’s take a look at the different ways of performing project financial analyses on these types of mentioned projects.
Performing Financial Analyses on Potential Projects
Capital budgeting refers to the period of time required for the return on the entire investment if the returns are evenly distributed over the years with little or no salvage value. Assume an investment of $500,000 is expected to produce annual returns of $100,000 for ten years. The Payback (PB) period for the investment to be recovered would be five years. The ratio of the investment to the annual return is 5:1. Expressed in another way, the unadjusted rate of return is 20%, can could be described as follows: the $100,000 returns is divided by the $500,000 investment, which equals a 20% rate of return which is a good annual return. As anyone should see, the math is simple to follow, but the payback period has some drawbacks. For example, it ignores cash flows after the payback period ends and ignores the time value of money. Net Present Value (keep reading!) does take into account the time value of money (the net cash flows at different points in time), which gives a more accurate picture of financial performance. Small companies often focus on PB because they like to recoup their investments in a year or two. Of course, it is always ideal to get a quick payback, but larger firms are less interested in using PB because they can afford to wait for longer paybacks and cash flows.
Net Present Value
Net Present Value (NPV) is one of the most widely used financial attributes because it measures the financial return of an investment taking into account external factors like inflation, investment risk, and the cost of borrowing money. See Figure 1.1 which shows the NPV for two projects. Following are a few notes explaining what you’re seeing:
- The Excel financial formula for NPV (i.e., Discount Rate and values) is shown. Note: Excel’s NPV function is not perfect and has some quirks, so the NPV numbers you see are close, but not exactly the correct number.
- The Discount Rate (cell B1) is the act of discounting future cash flows. It answers the question of how much money would have to be invested currently, at a given rate of return (let’s say 10%), to yield the forecasted cash flow, at its future date.
- Notice the cash flow totals ($3,000) are the same for both projects, but NPVs are not the same. This is due to the time value of money.
Return on Investment
Since some executives prefer to see an annual return per project, they might look at the profitability index or Return on Investment (ROI), which is the NPV divided by the initial investment or cost to get the best combination of projects. This ratio basically gives you the biggest bang for your buck for each project, and the higher the profitability index, the better. ROI could be negative or positive. A high positive ROI is outstanding. Figure 1.2 shows seven highlighted projects using the highest profit index. Since many executives like to see the profit index as a percentage, I’ve show the index and the index multiplied by 100% in the last column.
Internal Rate of Return
You may want to determine what Discount Rate (see Figure 1.1) will yield a zero NPV for your particular project. A higher Internal Rate of Return (IRR) means that the investment is less exposed to risks that could corrode the value of the investment. The IRR is found through trial and error. Again, Excel’s IRR function is not perfect and has some quirks, so the IRR numbers you see are close to the correct number although not exact. In my experience with many different companies and industries, IRR is the biggest driver behind making financial decisions for most projects. Recent surveys indicate most executives prefer IRR over NPV because they find it easier to compare investments of different sizes in terms of percentage rates of return, rather than by the dollars shown in NPV analysis. However, some executives and most academics feel NPV remains the more accurate reflection of value to business. The following figure shows an IRR (or Discount Rate) of .181781059. This is approximately 18% of Project 2’s cash flow from Figure 1.1. If the Discount Rate in Figure 1.1 was changed to 18%, then the NPV for Project 2 would be close to zero.
Using a Weighted Scoring Model
A weighted scoring model is a good tool because it provides an organized process for selecting projects based on many criterions. Each organization has to assign weights to each criterion they choose based on importance. Over time and with experience, your company may update the criterions it uses (for example, you’ll begin to use multiple financial measures like PB, NPV, and/or IRR). Figure 1.4 provides an example of a weighted scoring model used to evaluate three different projects. The weighted score is calculated by multiplying the weight % for each criterion by its score and adding up the results. For example, you calculate the weighted score for the highest rated project (2) as:
(10% * 90) + (10% * 70) + (10% * 90) + (5% * 50) + (15% * 90) + (50% * 90) = 86.
There are many other things you can do with this model like stating acceptable thresholds for a specific criterion. For example, you may choose to not accept a project that has a score of less than 50 for availability of resources. As you can see, weighted scoring model can be an important tool in aiding your organization in project selection decisions.
A balance scorecard is a strategic planning and management system that helps organizations align business activities to their strategy and goals. This scorecard has evolved over time, and the Gartner Group estimates that over half of large U.S. Organizations use this approach. You can find several examples of balanced scorecards from different manufacturing companies like Shat-R-Shield. I hope you have learned that performing financial analyses on projects can actually be “No Pain, All Gain.”