Financial appraisal of projects

Big Idea

A financial appraisal of a project proposal considers the potential rewards of carrying out the project against the predicted costs. The evaluation will depend on; the size of the project and the time-span over which the costs and benefits are going to be spread. The justification is that the return will at least exceed the amount spent. This return/payback is analyzed in a number of ways in order to determine the net benefit:

• Payback analysis – simply considers the cash flow of costs and benefits
• Discounted cash flow – considers the ‘time value’ of cash flows
• Internal rate of return – sets basic return criteria on the time value of money

Payback analysis the most basic financial evaluation method, in which the income that will be generated with the initial investment. For example, an initial investment of $40 million will be paid back in 8 years if the revenue generated is $5 million per year. However, the analysis only include the costs within the payback period, and ignores the total life-cycle costs of a product – e.g. if there are high disposal or decommissioning costs (e.g. in building projects), the model does not provide a good financial model of reality.

Considering the ‘time value’ of the cash flow is done through a technique known as discounting. It is a comparison between the value of the return on an investment and the value of the same sum of money, had it been deposited in a bank account at a given rate of interest for the same period of time instead. Hence, the opportunity cost of the project is considered using this technique. However, a high degree of uncertainty appears when forecasting cash flows years into the future.

Another technique is to calculate the internal rate of return of the project – i.e. the discount rate for which the net present value (NPV) is 0. The NVP is the difference between the present value of benefits – the present value of costs. Finding this discount rate can be done mathematically involving many iterations until the desired NPV of 0 is gained. Thus, using IRR helps remove the need to choose a discount rate for a project, which can save considerable debate. However, the IRR technique cannot cope with changes in the discount rate over time, which is very problematic when rates change rapidly and by high percentages, e.g. during a financial crisis (as the one in 2008). Also, two project proposals may have the same IRR but result in very different NPV’s – then, the proposal yielding the highest NPV is the most preferable.

Application

Today, the use of discounted cash flow is widely spread and built into most financial appraisal systems (including functions in Excel!). Almost anyone can evaluate a project proposal financially without having to submit a formal project plan. This is very beneficial for the Project Manager, as the PM not only can create time-based models of the project, but also financial ones. Hence, the model can be interpreted by a non-financial expert to make necessary changes and evaluate the impact of those until a third-party is needed for the well-developed plan.

Limitations

The concept of ‘Financial appraisal’ works completely fine in a world where there is a well-defined benefit for a well-defined investment. Although, reality is not always that simple. A quantitative and conventional approach is particularly problematic where:

• There is no guaranteed return
• The benefit is made in terms of reduction of labour
• The project is considered to be strategic in nature – e.g. a new computer system being installed in a company, resulting in a speed up of the transfer of information and a more integrated organization – this will be challenging to show as a cash return.
• The organization is a non-profit sector – e.g. government or charity

The challenge for project managers and appraisers is to use the experience of similar projects to provide a critical approach to the financial appraisal, and be aware of the levels of risk or uncertainty attached to both costs and benefits.

Annotated Bibliography

(Maylor, Harvey, 2010, p. 184 - 193)