e3.2 - financial models

8/8/2019 E3.2 - Financial Models

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Selecting Projects:Using Financial Models

Prashant ReddyPrashant Reddy -- s98006573s98006573 Rupen NandRupen Nand -- s91027870s91027870

MBA 430MBA 430


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ContentContent

ProjectProject ClassificationClassification

ProjectProject GoalsGoals

SelectionSelectionC

riteriaC

riteria

ApplicationApplication toto ScenarioScenario

RankingRanking && SelectionSelection

PaybackPayback

ROIROI

NPVNPV

IRRIRR

FinancialFinancial ModelsModels

ConclusionConclusion


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Project ClassificationProject Classification

StrategicStrategicProjectProject

ComplianceComplianceProjectsProjects

OperationalOperationalProjectsProjects

st ost o reg lationsreg lationsemergencyemergency

S pport c rrentS pport c rrent

operationsoperations -- cost, cost,

efficiency efficiency

performanceperformance

S pport longS pport long--termterm

missionmission -- reven e reven e

market sharemarket share

ComplianceCompliance projectsprojects ignoresignores selectionselection criteriacriteria asas itit isis aa m stm st oo projectproject..

AllAll otherother projectsprojects areare eval ateeval ate anan selecteselecte singsing criteriascriterias linkelinke toto

organizationorganization strategystrategy


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Project GoalsProject Goals

StrategicStrategic

AlignmentAlignment

Portfolio ManagementPortfolio Management

Project ManagementProject Management

Adopted from Project Management The Managerial Process

SelectionSelection criteriacriteria needneed toto ensureensure thatthat eacheach projectproject isis prioritizedprioritized andand

contributescontributes toto strategicstrategic goalsgoals howeverhowever somesome organizationsorganizations failfail toto dodo thisthis..

EvidenceEvidence showsshows organizationsorganizations dodo notnot developdevelop aa processprocess toto alignalign projectproject

selectionselection toto strategicstrategic goalsgoals resultingresulting inin underutilizationunderutilization ofof resourcesresources..

Strategy isStrategy is

implementedimplemented

throughthrough

projectsprojects

Every projectEvery project

should haveshould have

clear link toclear link to

strategystrategy


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Selection CriteriaSelection Criteria

SelectionSelection criteriacriteria areare typicallytypically identifiedidentified asasfinancialfinancial oror nonfinancialnonfinancial..

UsingUsing purelypurely eithereither oneone ofof thesethese forfor selectionselection oftenoften leadsleads toto unbalancedunbalanced

portfoliosportfolios andand projectsprojects thatthat arentarent strategicallystrategically orientedoriented..

AA numbernumber ofof modelsmodels havehave beenbeen developeddeveloped forfor eacheach ofof thesethese criteriacriteria..

NonNon--financial Modelsfinancial Models

Checklist ModelChecklist Model

MultiMulti--Weighted Scoring ModelWeighted Scoring Model

Financial ModelsFinancial ModelsPayback PeriodPayback Period

Return on Investment (ROI)Return on Investment (ROI)

Net Present Value (NPV)Net Present Value (NPV)

Internal Rate of Return (IRR)Internal Rate of Return (IRR)


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Payback ModelPayback Model

AdvantagesAdvantages::1.1. PaybackPayback modelmodel isis thethe simplestsimplest && mostmost widelywidely usedused..

2.2. EmphasizesEmphasizes cashcash flowflow whichwhich isis aa keykey factorfactor inin businessbusiness..

LimitationsLimitations::

1.1. IgnoresIgnores timetime valuevalue ofof moneymoney..

2.2. DoesDoes notnot taketake intointo accountaccount cashcash flowflow beyondbeyond paybackpayback periodperiod..

3.3. DoesDoes notnot considerconsider profitabilityprofitability..

Payback model measures the time taken to recover the project investment.Payback model measures the time taken to recover the project investment.

PaybackPaybackTotalTotalProjectProject CostCost

----------------------------------------------------------------

Average Annual ReturnAverage Annual Return


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Return on Investment (ROI) ModelReturn on Investment (ROI) Model

AdvantagesAdvantages::

1.1. ROIROI modelmodel isis simplesimple toto calculatecalculate && isis widelywidely usedused..

2.2. EmphasizesEmphasizes cashcash flowflow andand profitprofit bothboth integralintegral toto businessbusiness..


1.1. ComparisonComparison betweenbetween projectsprojects ignoresignores initialinitial investmentinvestment valuevalue..

2.2. DoesDoes notnot taketake intointo accountaccount thethe timetime valuevalue ofof moneymoney..

ROI model measures annual return (profit/cash) on total project investmentROI model measures annual return (profit/cash) on total project investmentin ratio or percentage.in ratio or percentage.

ROIROIAverage Annual ReturnAverage Annual Return

----------------------------------------------------------------

TotalProject CostTotalProject Cost


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Net Present Value (NPV)Net Present Value (NPV) ModelModel

AdvantagesAdvantages::1.1. ConsidersConsiders thethe timetime valuevalue ofof moneymoney (cash)(cash)..

2.2. EmphasizesEmphasizes cashcash flowflow throughoutthroughout thethe projectproject..

3.3. UsesUses multiplemultiple RRRRRR whenwhen consideringconsidering projectsprojects withwith differentdifferent risksrisks..



2.2. DoesDoes notnot provideprovide aa percentagepercentage returnreturn onon totaltotal investmentinvestment..

NPV model is based on time value of money and uses RRR to discount allNPV model is based on time value of money and uses RRR to discount all

thethefuturefuture net cash flows for a project to a present value.net cash flows for a project to a present value.

Projects with positive NPV is eligible for further consideration.Projects with positive NPV is eligible for further consideration.

NPVNPV

n

tt= 0

CCtt

----------------------------------------

(1 + r)(1 + r)tt

Where:

C = net cash flow

t = time period

n= number of periods

r = required rate of return


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Internal Rate of Return (IRR) ModelInternal Rate of Return (IRR) Model

IRR is the discount rate at which NPV of a project is equal to zero.IRR is the discount rate at which NPV of a project is equal to zero.

Projects with higher IRR than the RRR is used for further consideration.Projects with higher IRR than the RRR is used for further consideration.

00

Discount Rate

%

NPV

$

0IRR (NPV = 0)

n

tt= 0

CCtt

----------------------------------------

(1 + r)(1 + r)ttII NPV NPV

AdvantagesAdvantages::

1.1. ProvidesProvides aa percentagepercentage returnreturn onon totaltotal investmentinvestment..

2.2. CanCan bebe easilyeasily comparedcompared toto benchmarksbenchmarks forfor selectionselection..



2.2. ComplexComplex toto calculatecalculate manuallymanually andand cancan bebe donedone byby trailtrail && errorerror..


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Application to ScenarioApplication to Scenario

Strategic Project AStrategic Project A -- Developing Real EstateDeveloping Real Estate

Initial investment of $350,000.Initial investment of $350,000.

Projected cash inflow :Projected cash inflow :$200,000 in the 2nd year.$200,000 in the 2nd year.$300,000 in the 3rd year.$300,000 in the 3rd year.$150,000 in the 4th year.$150,000 in the 4th year.

Operational Project BOperational Project B Buying Construction MachineBuying Construction Machine Initial investment of $100,000.Initial investment of $100,000.

Projected cash savings :Projected cash savings :$30,000 in the 1st year.$30,000 in the 1st year.$70,000 in the 2nd year.$70,000 in the 2nd year.$20,000 in the 3rd year.$20,000 in the 3rd year.$10,000 in the 4th year.$10,000 in the 4th year.

Strategic Project CStrategic Project C -- Constructing ApartmentsConstructing Apartments

Initial investment of $350,000.Initial investment of $350,000.

Projected cash inflow :Projected cash inflow :$150,000 in the 1st year.$150,000 in the 1st year.$250,000 in the 2nd year.$250,000 in the 2nd year.

$100,000 in the 3rd year.$100,000 in the 3rd year.


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Payback CalculationPayback Calculation

Real Estate Machine Apartment

Initial Invest ent $350,000 $100,000 $350,000

Subtract Year 1 cash inflow $0 $30,000 $150,000

Balance to be recovered $350,000 $70,000 $200,000

Subtract Year 2 cash inflow $200,000 $70,000 $250,000

Balance to be recovered $150,000 $0

Subtract Year 3 cash inflow $300,000

Ratio of final year deducted 0.5 0.0 0.8

Payback Period 2.5 Yrs 2.0 Yrs 1.8 Yrs

Payback was calculated using the following method.Payback was calculated using the following method.


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ROIROI CalculationCalculation


Initial Investment (I) $350,000 $100,000 $350,000

Total cash inflow (X) $650,000 $130,000 $500,000

Years of roject (Y) 4 Yrs 4 Yrs 3 Yrs

Average of inflow (Z = X/Y) $162,500 $32,500 $166,667

ROI (I/Z) 46.4% 32.5% 47.6%

For each of the project the average cash inflow was worked out for theFor each of the project the average cash inflow was worked out for the

entire project life.entire project life.

This was then divided with the initial investment to find ROI.This was then divided with the initial investment to find ROI.


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NPV CalculationNPV Calculation


Initial Investment -$350,000 -$100,000 -$350,000

Year 1 cash inflow $0 $25,000 $125,000

Year 2 cash inflow $138,889 $ 8,611 $173,611

Year 3 cash inflow $173,611 $11,574 $57,870

Year 4 cash inflow $72,338 $4,823 $0

NPV (total of all) $34,838 -$9,992 $6,481

Using the required rate of return of 20% as the discount rate the presentUsing the required rate of return of 20% as the discount rate the present

value of each cash flow was calculated as follows:value of each cash flow was calculated as follows:

ApartmentApartment

Year 0 Cash Outflow $350,000/(1+0.2)Year 0 Cash Outflow $350,000/(1+0.2)00 = $350,000= $350,000

Year 1 Cash Inflow $150,000/(1+0.2)Year 1 Cash Inflow $150,000/(1+0.2)11 = $125,000= $125,000

Year 2 Cash Inflow $250,000/(1+0.2)Year 2 Cash Inflow $250,000/(1+0.2)22 = $173,611 and so on= $173,611 and so on

This was done to all and then was netThis was done to all and then was net--off to find the NPV of the project.off to find the NPV of the project.


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IRR CalculationIRR Calculation


IRR 24.1% 13.8% 21.2%

IRR was calculated using excel. NPV was set at zero and the discount rateIRR was calculated using excel. NPV was set at zero and the discount rate

which is the IRR was found.which is the IRR was found.

The following shows how the value are used in the formula:The following shows how the value are used in the formula:

ApartmentApartment

IRR:IRR:NPV = 0 =NPV = 0 = --$350,000/(1+r)$350,000/(1+r)00 + $150,000/(1+r)+ $150,000/(1+r)11 + $250,000/(1+r)+ $250,000/(1+r)22

+ $100,000/(1+r)+ $100,000/(1+r)33

The value of r (IRR) was then calculated.The value of r (IRR) was then calculated.


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e3.2 - financial models

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