unit 2 project evaluation. syllabus strategic assessment technical assessment cost benefit analysis...

Unit 2

PROJECT EVALUATION

Syllabus

• Strategic Assessment

• Technical Assessment

• Cost Benefit Analysis

• Cash Flow forecasting

• Cost Benefit Evaluation techniques

• Risk evaluation

Introduction

• How project is selected ?– Evaluation process

• Strategy of the business organization• Technical viability• Financial viability (Both investments and returns)

and• Risk factors

Strategic Assessment

• Organizations has ‘organisational goals’– Profit / product / domain leader etc…

• Directs / focuses activities towards achieving these goals• Multiple projects are taken up to stay competitive ~

“Program” (interdependant, managed in a coordinated way)

• ‘Project portfolio’ - group of projects carried out under a management

• resources are scarce • full use of the available resources in multiple projects• cost effective • Dev process manageable ( use of reusable components)

Portfolio models

• Market driven portfolio model – Adhoc projects taken based on need of the market

e.g. Y2K• Economic – Return model

– Profit alone is the motive ( may switch businesses) e.g Computer business to cinema business !

• Cost Benefit model – Relative benefit of each project, under the portfolio

( so that one gain compensates for one loss)• Market Research model

– New products based on market survey ( e.g digital teaching)

Project Portfolio Management (PPM)

• ~ collectively analyzing and managing a group of current or proposed projects

• Goal - to determine the optimal mix and sequencing of proposed projects to best achieve the organization's overall goals

PPM objective

Organisational Goal

Goal of portfolio of projects

Goal of project 1 Goal of project 2 Goal of project N……….

Strategic Assessment …

• Coexistence with other existing SW products • Effect of the SW on the organisation’s structure /

working practice ( resistance must be managed)• How the output of the proposed system would

enhance the decision making process of the top management ?

• How morale of the employee will affect by the proposed system

• Will the customer feel at home ?

Strategic Assessment …

Strategic Assessment

Fit of the proposed system into existing information - coexistance

Organisation’s objective

Enhancement to MIS

Employee’s skill development and morale

Customer’s image on organisation

Effects on organizational structure

Who takes strategic assessment ?

• Investor

• Top management– MD / GM / CEO / CFO / CIO / CTO / COO

• Senior Management– VP ( marketing)– VP ( technical)– VP (HR)

TECHNICAL ASSESSMENT

• Evaluate the various – Functionalities to be built, – Required expertise

– Knowledge

– Required hardware and– Required software / Tools

– Availability

– Required training– Update knowledge / skill

TECHNICAL ASSESSMENT…

• Constraints– standardized on a specific hardware/software

infrastructure– use available technologies , not be futuristic– Integrations between technologies – high end technology requiring high investment

• Cost benefit analysis must be done

COST BENEFIT ANALYSIS

• Basic concept– Income and benefit must exceed the

investment to make the project worth while taking up.

• Steps for cost benefit analysis– Step 1: Identify costs– Step 2: Identify Benefits– Step 3: Compare both

COST BENEFIT ANALYSIS…• Step 1: Identify costs

– Development cost• salaries,• employee benefit costs and all associated costs ( PF, Health Insurance, LTA, Car

allowance)– Set up cost

• hardware• Software• Installation• ancillary equipment• data taken on/ data conversion.

– Training cost• cost of trainer, equipments and other needs of training

– Operating cost• Help desk• hands on training• maintenance

COST BENEFIT ANALYSIS…

• Step 2: Identify Benefits

– Direct cost savings• Bottom line Profit• Reduction in cost due to procurement of goods, employing

new recruits

– Indirect cost savings• Diff. bet earlier and current working environment ( e.g

overtime, less maintenance, saving on electricity bcos of no overtime etc..)

– Intangible benefits, which cannot be quantified (E.g. improvement in morale of an employee)

COST BENEFIT ANALYSIS…

• Step 3: Compare both– Express both cost and benefits in a common

unit ( so that comparison is easy)

– What is the most common unit ?• MONEY.

Types of benefits

• Quantified and valued – direct financial benefit

• Quantified but not valued – decrease in number of complaints– Reduction in AR collection time

• Identified but not easily quantified – satisfying the mandatory government’s new

regulations

CASH FLOW FORECASTING

• What is ~ ?– How much and when money is required ?

• Initial stage ( cash out flow)– salaries, purchase of capital goods, training etc.. – Source of funds - company’s assets or bank loan or VC funds

• Operational stage ( cash inflow)– when and how much money is expected ?

• Decommissioning stage ( cash outflow)– Data conversion programs– Parallel Run– Corrections in new software

Typical product life cycle cash flow

Income

Expenditure Time

COST BENEFIT EVALUATION TECHNIQUES

• Project evaluation from economic perspective

• Techniques used – Net profit– Payback period– Return on investment (ROI)– Net present value (NPV)– Internal rate of return (IRR)

Example cash flow

Year Project 1 (Rs) Project 2 (Rs)

Initial investment

(100,000) (100,000)

1 30,000 20,000

2 30,000 20,000

3 30,000 20,000

4 30,000 20,000

5 30,000 75,000

Net profit

• Definition– Net profit of a project is the difference between

the total costs (cash outflow) and the total income (cash inflow)

– Net profit (Project 1) = • cash inflow – cash outflow

Rs.1,50,000 – Rs.1,00,000 = Rs.50,000- Net profit (Project 1) = Rs 55,000

Conclusion : Project is positive ( profitable)

Net profit …

• Advantages– simple subtraction …very easy to calculate

• Disadvantages– does not take care of the timing of the cash

inflow ( e.g in proj 2 wait for 5 years to get a sizable profit- distant future ? )

Payback period

• Definition– Payback period is the time taken to

breakeven i.e. in other words, getback the initial investment.

– Proj 1 -- payback in 4 years ( net profit = Rs. 50,000)

– Proj 2 -- payback in 5 years ( net profit = Rs. 55,000)

Payback period…

• Advantages– simple , very easy to calculate– Small errors do not greatly affect

• Disadvantages– ignores the profitability of the project

Return of investment (ROI)

• Definition– Return on investment is the percentage of the

ratio of average annual profit to total investment

Average annual profitROI 100%

Total investment

Return of investment (ROI)…

• Project 1, gives a ROI as below

• For project 2,

1

50,000 / 5ROI 100 10%

100,000

2

55,000 / 5ROI 100 11%

100,000

Return of investment (ROI)…

• Advantages– Simple and easy to calculate ( only one formula)

• DisadvantagesIt does not take care of the timing of the

cash flow.

For example, if the same money is invested in bank, then for the number of years, Bank provides cumulative rate of interest. This aspect is not considered in the above formula for ROI.

Net Present Value (NPV)

• Definition

• where r is the rate (also called discount rate) expressed in decimal value (0.1 here)

• and t is the number of years into the future the cash flow occurs.

t

Value in year ' t 'Pr esent Value

1 r

NPV …

• Assume we have Rs.100 now and we put that in a bank which gives an interest of 10% a year. So, next year the amount accrued will be Rs.110.

• In different words, Rs.110 received next year, would have a present value of Rs.100 with a discount rate of 10%.

NPV …

• Here t = 1 year

• r = 10% i.e. (r expressed in decimal value)

•

•

» = Rs.100

100.1

100

t

Value in year tNet Pr esent Value

1 r

1

110

101

100

NPV …

• Advantage– NPV take care of both profitability and the timing of

the cash flow.

• Disadvantage– Does not take care of other investment avenues– Choosing the the most appropriate ‘discount rate’

• The parameters which would affect the discount factor are– Financial risk ( global US$ fluctuation)

– Market risk ( more time taken- value goes down- competition would have entered and profitted)

Internal Rate of Return (IRR)

• IRR gives a profitability measure as a percentage return that is directly comparable with other investment avenues (E.g. bank interest rate on fixed deposit).

• Explained in simple terms, if a software project yields a return of 15%, then, we can invest in it if – The investment for the project is borrowable from a

source at a rate less than 15%.– Our money cannot yield 15% income in any other

investment.

IRR …

• Advantages– Simple percentage, so it is easy to compare the IRR

of a software project with that of other investments (E.g. Bank interest)

– MS Excel has a function to calculate IRR

• Disadvantage – a percentage and not absolute value

• Invest Rs.100 and get a return of Rs120. The IRR in this case is 20% and Absolute value is Rs.20.

• Invest Rs.1000 and get a return of Rs.1100. the IRR in this case is 10% but the absolute value is Rs.100.

DCF methods

• Discounted Cash Flow methods– NPV– IRR

Conclusions

• No single technique can indicate whether our investment on a software project is worth or not.

• Multiple factors must be considered– The cash flow to pay back interest and principal from the

borrowed source, + paying salaries to employees.– We are investing now and expecting return in future, and

future is very uncertain. We must add also some additional percentage on return to cover the risk.

– Technical evaluation, and financial evaluation only might not be enough to decide on investment. One must also consider our competence before actually putting our money into any project.

RISK EVALUATION

• What is Risk ?– Risks are future uncertain events in a project with a

probability of occurrence and a potential for loss

• Take calculated risk after evaluating risk• Risk evaluation process

– Risk identification– Risk ranking (magnitude of impact on the project)– Risk quantification

Risk Matrix

• Risk = Probability of occurrence * Impact

• Three levels of Risk– Low– Medium– High

Risk Identification

• Checklist– previous experiences– discuss with project

peers ,team members,

seniors– Reading prev proj dB

• example

Risk Details

1 Unavailability of a specific domain experts

2 Unavailability of key resources

from customer side.

3 Risk of a delay in delivery of a

specific hardware/software/tool 4 Project completion within the

given budget 5 Demands of the over enthused

customer with respect to

performance.

Risk Ranking

• Rank risk to assess its likelihood of occurrence – scale of zero to 5 – low/medium/high/unlikely

• Example

• Unavailability of a specific domain experts - Ranking 2

• Unavailability of a specific domain expert --- Importance – High Likelihood - Low

Risk Quantification

• 2 methods– NPV– Probable average expected value ( leading to

decision tree)

Risk Quantification

• NPV method – Based on single cash flow statement– Give Numeric value, easy for comparing 2

projects– Risk value of 2%, 4%, 6% (discount factor) are

arbitrary but parameters applied uniformly across all projects gives correct relative judgement

– what is required is the ‘relative judgment’ and not an ‘absolute estimate’!

Probable Average Expected Value Method

• Considers multiple cash flow, each with a probability factor

• E.g the sale of a product in a year • market situation• government policy • Etc

– Cannot predict exactly

Probable Average Expected Value Method…

• Assume 3 different situations• Bright sale, • Average sale and• Dull sale.

• Guestimate the probability of such situation – Result - three different cash flows

• Take sum of all these 3 • This reduces the risk of our estimate (compared to NPV

method • Accuracy depends on the guestimates ( experience

helps)

Probable Average Expected Value

Method…• Example : Investment = 1L ; profit / Loss ?

Rain forecast Sale value in Rs.

(V)

Probability factor

(P)

Expected sale in Rs

(ES = V * P)

Heavy 70,000 0.2 14,000

Average 100,000 0.25 25,000

No 200,000 0.55 110,000

Most probable sale value

149,000

Decision Tree

• Definition– A decision tree is a decision support tool that

uses a tree like graph model of decisions and their possible consequences, including chance event outcome, resource cost and utility

Decision Tree…

• Our product sale depends on – Market looking really ‘Bright’ - probability 0.2.– Market remains ‘Average’ - probability 0.5.– Market becoming ‘Dull’ - probability 0.3

– If market is ‘Bright’, the probability of a revenue generation of Rs.30 lakhs is 0.3 and Rs.50 lakhs is 0.7.

– If the market is ‘Average’, the probability of a revenue generation of Rs.5 lakhs is 0.8 and Rs.10 lakhs is 0.2.

– If the market is ‘Dull’, the probability of a revenue generation of Rs.15 lakhs is 0.9 and Rs.20 lakhs is 0.1.

Decision Tree…

Market = Bright (0.2)

Market = DULL (0.3)Market = Average (0.5)

PR = 50L (0.7) PR = 5L (0.8)

PR = 10L (0.2)

PR = 15L (0.9)

PR = 20L (0.1)

RAR = 0.2*0.3*30L = 1.8L

RAR = 0.2*0.7*50L = 7L

RAR = 0.3*0.8*5L = 1.2L

RAR = 0.3*0.2*10 = 0.6L

RAR = 0.5*0.9*15L = 6.75L

RAR = 0.5*0.1*20 = 1L

PR = 30L(0.3)

D

DDD

Decision Tree…

• RAR gives expected revenue under the assumed probabilities of the various events

• Various scenarios are analysed• Easy to make a more informed judgment whether to

develop the product or not

• Accuracy of the RAR depends on – various probability factors and

– projected revenue under various circumstances.

End

Unit 2