LECTURE 8 COST MANAGEMENT FOR SOFTWARE PROJECT - II CASH FLOW ANALYSIS TECHNIQUES PAYBACK PERIOD: The payback period is the length of time it takes the company to recoup the initial costs of producing the product, service, or result of the project. This method compares the initial in vestment to the cash inflows expected over the life of the product, service, or result. Example For example, say the initial investment on a project is $200,000, with expected cash inflows of $25,000 per quarter every quarter for the first two years and $50,000 per quarter from then on. The payback period is two years and can be calculated as follows: Initial investment (Cash outflow) = $200,000 Cash inflows = $25,000 4 (quarters in a year) = $100,000per year total inflow Initial investment ($200,000) year 1 inflows ($100,000) =$100,000 remaining balance Year 1 inflows remaining balance year 2 inflows = $0 Total cash flow year 1 and year 2 = $200,000 The payback is reached in two years. The fact that inflows are $50,000 per quarter starting in year 3makes no difference because payback is reached in two years. DISCOUNTED CASH FLOWS: As I just stated, money received in the future is worth less than money received today. The reason for that is the time value of money. If I borrowed Rs.2,000 from you today and promised to pay it back in three years, you would expect me to pay interest in addition to the original amount borrowed. If you had invested the money you d receive a return on it. Therefore, the future value of the Rs.2,000 you lent me today is Rs.2,315.25 in three years from now at 5percent interest per year. Here s the formula for future value calculations: FV = PV(1 + i) n Prepared by: Engr. M. Nadeem Page 1
In English, this formula says the future value (FV) of the investment equals the present value (PV) times (1 plus the interest rate) raised to the value of the number of time periods(n) the interest is paid. Let s plug in the numbers: FV = Rs. 2,000(1 +.05) 3 FV = Rs. 2,000(1.157625) FV = Rs. 2,315.25 The discounted cash flow technique compares the value of the future cash flows of the project to today s Rs. To calculate discounted cash flows, you need to know the value of the investment in today s terms, or the PV. PV is calculated as follows: PV = FV / (1 + i) n This is the reverse of the FV formula talked about earlier. So, if you ask the question, What is Rs.2,315.25 in three years from now worth today given a 5 percent interest rate? you d use the preceding formula. Let s try it: PV = Rs. 2,315.25 / (1 +.05) 3 PV = Rs. 2,315.25 / 1.157625 PV = Rs. 2,000 Rs. 2,315.25 in three years from now is worth $2,000 today. Apply the PV formula to the projects you re considering, and then compare the discounted cash flows of all the projects against each other to make a selection. EXAMPLE COMPARISON OF TWO PROJECTS USING THIS TECHNIQUE: Project A is expected to make Rs. 100,000 in two years. Project B is expected to make Rs. 120,000 in three years. If the cost of capital is 12 percent, which project should you choose? Using the PV formula used previously, calculate each project s worth: The PV of Project A = Rs. 79,719 The PV of Project B = Rs. 85,414 Project B is the project that will return the highest investment to the company and should be chosen over Project A. NET PRESENT VALUE(NPV): Prepared by: Engr. M. Nadeem Page 2
Example 1: The following table shows you what this might look like for a project that will bereleased over three years with predicted future values for each year with Interest rate is 6 percent. This value is your mystical NPV. The bigger the number, the more potential the project has. If you end up with a negative number, your project won t be profitable. Example 2: Projects might begin with a company investing some amount of money into the project to complete and accomplish its goals. In return, the company expects to receive revenues, or cash inflows, from the resulting project. Net present value (NPV) allows you to calculate an accurate value for the project in today s Rupees. Here s the rule: If the NPV calculation is greater than 0, accept the project. If the NPV calculation is less than 0, reject the project. Prepared by: Engr. M. Nadeem Page 3
INTERNAL RATE OF RETURN The internal rate of return (IRR) is the most difficult equation to calculate of all the cash flow techniques we ve discussed. It is a complicated formula and should be performed on a financial calculator or computer. IRR can be figured manually, but it s a trial-and-error approach to get to the answer. Technically speaking, IRR is the discount rate when the present value of the cash inflows equals the original investment. When choosing between projects or when choosing alternative methods of doing the project, projects with higher IRR values are generally considered better than projects with low IRR values. Nick has prepared the project overviews for three projects and called on the experts in marketing to help him out with the projected revenue figures. He works up the numbers and finds the following: 1. Project A: payback period = 5 years; IRR = 8 percent 2. Project B: payback period = 3.5 years; IRR = 3percent 3. Project C: payback period = 2 years; IRR = 3 percent Funding exists for only one of the projects. You need to know three facts concerning IRR: 1. IRR is the discount rate when NPV equals 0. 2. IRR assumes that cash inflows are reinvested at the IRR value. 3. You should choose projects with the highest IRR value. Example: Find the IRR of an investment having initial cash outflow of Rs.213,000. The cash inflows during the first, second, third and fourth years are expected to be Rs.65,200, Rs.96,000, Rs.73,100 and Rs.55,400 respectively. Solution PV = FV (1 + i)n PV = FV x [PV factor] Prepared by: Engr. M. Nadeem Page 4
Assume that interest rate is 10%. NPV at 10% discount rate = $18,371.63 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521.02 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $203.53 Prepared by: Engr. M. Nadeem Page 5
NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14% More Examples: Let's assume we are to receive $100 at the end of two years. How do we calculate the present value of the amount, assuming the interest rate is 8% per year compounded annually? Solution: Prepared by: Engr. M. Nadeem Page 6