Investment Decisions in Project Management
Cocaine, according to Ben Dunne Jr, is God’s way of telling you that you have too much money. While gigantic, trans-national corporations do not develop appetites for narcotics, their multi-billion dollar war chests clearly indicate that they too have too much money. It is ironic that, by exploiting globalization and through Olympian tax avoidance, these corporations find that their shared prime directive – maximizing profits – is actually not conferring benefits any more.
While the rest of us can take comfort that too much money is not a curse that is liable to strike soon, we have to accept the fact that we need to eat and, as Project Managers, we need to have budgets that allow our projects to proceed. One of the first project management processes we encounter during the Project Management Professional (PMP)© exam preparation course is Develop Project Charter. This document includes (or at least references) the business case for embarking on the venture.
A business case will, ultimately, have to state how the proposed project will contribute to the bottom line. This may not be a simple calculation along the lines of: If I buy this old car for €1,000, then spend €500 fixing it up and making it street legal, I can sell it on for €2,000. Some projects – such as serialization in the medical device sector – concern regulatory compliance. The project is justified by the fact that existing revenues will screech to a halt if we are no longer conforming to the U.S. Food and Drug Administration’s rules.
Making the business case for a project, or choosing between projects, means using tools that PMPs© should be familiar with. The Guide to the Project Management Body of Knowledge (PMBOK© Guide) lists five financial success measures for projects.
The first of these we consider is “payback period”. How soon will we cover the costs associated with creating this revenue stream? Small companies are often very concerned about this figure. Their seed funding is finite and, the sooner revenues start coming in, the better. So projects might get chosen because they have a shorter payback period.
A more sophisticated technique is to calculate the Return on Investment (RoI). This involves a simple formula: (Gains - Costs) / Costs. So the RoI figure for our car purchase above would be: (€2,000 - €1,500) / €1,500 = 0.33 or a 33% return on the original investment.
This calculation becomes more interesting if we are looking at returns over a long period of time. Suppose we are proposing to develop a product that is expected to yield annual sales worth €100,000 for five years. If the cost of developing this product is €150,000, our expected RoI is (€500,000 = €150,000) / €150,000 = 2.33 or a 233% return. Also note that the payback period is 18 months after the project ends.
Another way of rating a project is in terms of its “internal rate of return” (IRR). The “internal” part means that environmental factors, such as interest rates or inflation are not included in the calculations. It can be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or, in other words, the rate at which an investment breaks even: the higher the internal rate of return, the better. This involves some complicated calculation but, thankfully, this is all done for us in Excel:
For PMP© exam students, calculation is not required – just remember that the project with the higher IRR is the one to go for.
The IRR definition above mentions “present value” and this is another factor in deciding on which project to select. Explained in detail in another article, “present value” is based on the fact that a dollar today is not the same as a dollar tomorrow. Inflation erodes the purchasing power of cash and, the decision to spend on one thing, precludes spending in on something else – what is called the opportunity cost. Present value really plays its part when the expected returns do not accrue until many years into the future. For instance, if annual inflation is running at 2% and we buy an item today for €1,000. If we sell it in five years’ time for €1,200, we will make a profit. But if we sell it for the same price in ten years’ time, we make a loss.
“Net present value” is when you obtain the present value of all costs and incomes and total them together - the higher the figure, the better.
The final technique listed is the "Benefit / Cost Ratio". This is similar to the Return on Investment idea in that we want to see if the benefits of doing the work outweigh the costs. This is often the first step to more complex analysis, such as Net Present Value.