SOFTWARE PROJECT MANAGEMENT

LESSON 28:
GD

This Lecture I shall Discuss Cost Benefit Evaluation - Net Present Value
Cash flow analysis Sum of all incoming and outgoing payments, discounted
Various cost-benefit evaluation techniques using an interest rate, to a fixed point in time (the present).
In the previous lecture you had learned the Economical Present value is the value of which a future amount worth
Assessment Cost-Benefit Analysis. Today we are going to learn at present
about the how you can evaluate cost-benefit and cash flow It takes into account the profitability of a project and the
analysis. timing of the cash flows
Let us first you understand about the Cost-benefit evaluation Discount rate is the annual rate by which we discount
techniques as fallows: - future earning
Cost-benefit Evaluation Techniques Net Profit e.g. If discount rate is 10% and the return of an
Difference between total cost and total income investment in a year is Rs. 110, the present value of the
investment is Rs. 100.
It Advantages
Let n be the number of year and r be the discount rate, the
Easy to calculate
present value (PV) is given by
Its Disadvantages
Does not show profit relative to size investment value in year n
PV =
Does not consider timing of payments (1 + r ) n
Cost Benefit Evaluation - Payback Period Issues in NPV
Time taken to break even Choosing an appropriate discount rate is difficult
Its Advantages Ensuring that the rankings of projects are not sensitive
Easy to calculate to small changes in discount rate
Gives some idea of cash flow impact Guidelines:
Its Disadvantages Use the standard rate prescribed by the organization
Ignores overall profitability Use interest rate + premium rate
Not very useful by itself, but a good measure for cash flow Use a target rate of return
impact. Rank the projects using various discount rates
Cost Benefit Evaluation - Return on Investment It Advantages
Average annual profit compared to total investment Takes into account profitability
It Advantages Considers timing of payments
Easy to calculate Considers economic situation through discount rate
Its Disadvantages Its Disadvantages
Does not consider the timing of payments Discount rate can be difficult to choose
Misleading - should not be compared to bank interest Standard measure to compare different options.
rates
Cost Benefit Evaluation - Internal Rate of Return
Following equation is used in the above method to calculate the Net present value in reverse
ROI (Return on Investment)
Calculate discount rate for which the net present value is 0
average annual profit It Advantages
= 100%
total investment Calculates figure which is easily comparable to interest
rates
Cost Benefit Evaluation - Net Present Value
Its Disadvantages
Calculation of present value = (value in year t)/(1+r)^t
Difficult to calculate (iterative)
In this you assume discount rate r=10%
Standard way to compare projects.
Then Rs. 100 next year = 100/(1.10)^1 = Rs. 91 now

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 EA Cash Flow Forecasting

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Net Present Value ($)

9000
(Contd)
6000
3000
Discount rate (%)
0

Income
8 9 10 11 12
-3000

You will now learn the Cash flow Forecasting, which is another

Expenditure
type of Economical Assessment Evaluation.
What Cash Flow Forecasting?
It is the Estimation of the cash flow over time
Income
Expenditure

Why Cash Flow Forecasting is Necessary?

Following are the reason for its necessity: -
An excess of estimated benefits over the estimated costs is
not sufficient EA Cash Flow Forecasting
Need detailed estimation of benefits and costs versus time
(Contd)
Need to forecast the expenditure and the income
Accurate forecast is not easy Need to forecast the expenditure and
Need to revise the forecast from time to time the income
Points to Ponder
Accurate forecast is not easy
EA Cash Flow Forecasting Need to revise the forecast from time to
time
What?
Estimation of the cash flow over time
Why?
An excess of estimated benefits over the
estimated costs is not sufficient
Need detailed estimation of benefits and costs
versus time

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 Cost-benefit Evaluation Cost-benefit Evaluation
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Techniques Techniques IRR (contd)

Net profit Advantages
= Total income Total costs Convenient
Directly comparable with rate of return on other
Payback period projects and with interest rates
= Time taken to break even Useful
Return on Investment (ROI) Dismiss a project due to its small IRR value
Indicate further precise evaluation of a project
average annual profit
= 100% Supported by MS Excel and Lotus 1-2-3
total investment

Cost-benefit Evaluation
Techniques -NPV
Cost-benefit Evaluation present value = (value in year t)/(1+r)^t
Techniques IRR Assume 'discount rate' r=10%
Internal Rate of Return (IRR) Then Rs. 100 next year = 100/(1.10)^1 = Rs.
The percentage discount rate that would produce 91 now
a NPV of zero Sum of all incoming and outgoing payments,
A relative measure discounted using an interest rate, to a fixed
point in time (the present).
This is Review Test for You

Year Project 1 Project 2 Project 3 Project 4

0 -100000 1000000 100000 120000
1 10000 200000 30000 30000
2 10000 200000 30000 30000
3 10000 200000 30000 30000
4 20000 200000 30000 30000
5 100000 300000 30000 75000
Net 50000 100000 50000 00
Profit

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1. Consider the above projects and calculate the payback

SOFTWARE PROJECT MANAGEMENT

period for each of them.
2. Calculate ROI for project 1 the net profit is Rs 50000 and
the total investment is Rs 100000, then the ROI is what?
3. Calculate the net present value for each of the project 1 to 5
using the discount rate 5%, 10%, 15%, 20% and 25%. For
each discount rate, decide which is the best project. What
can you conclude from these results?

Notes

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