Factors involved in Evaluation

Evaluation of individual projects

Evaluation of individual projects depends mainly on 3 important factors: 1. Technical Feasibility 2. The balance of costs & Benefits 3. Degree of risk associated with the project

Technical Assessment
Evaluating the required functionality against hardware & software available. Organizational policy aimed at the provision of uniform & consistent hw/sw infrastructure, is likely to place limitations on the nature of technical solutions that might be considered. The constraints will, of course, influence the cost of the solution & this must be taken into account in the cost-benefit analysis

Cost benefit analysis (CBA)

Economic assessment of the software product Two steps are:
1. Identifying & estimating all of the costs & benefits of carrying out the project & operating the delivered application Expressing these costs & benefits in common units

2.

 Identify all the costs which could be: Development costs Set-up Operational costs Identify the value of benefits Check benefits are greater than costs

Cash flow forecasting

Forecast the cash flows that will take place & their timing Indicates when expenditure & expense will take place The following slides explain the methods for comparing projects on the basis of their cash flow forecasts

Net profit
Year 0 1 2 3 4 5 Net profit Cash-flow -100,000 10,000 10,000 10,000 20,000 100,000 50,000
It is the difference between the total costs & total income over the life of the project Year 0 represents all the costs before system is operation Cash-flow is value of income less outgoing Net profit value of all the cashflows for the lifetime of the application

Pay back period

It is the time taken to break even or pay back the initial investment This is the time it takes to start generating a surplus of income over outgoings. What would it be below?

Year 0 1 2 3 4 5

Cash-flow -100,000 10,000 10,000 10,000 20,000 100,000

Accumulated -100,000 -90,000 -80,000 -70,000 -50,000 50,000

Return on investment (ROI): Accounting rate of return (ARR) provides a way of comparing the net profitability to the investment required.

ROI =

Average annual profit Total investment

X 100

In the previous example average annual profit = 50,000/5 = 10,000 ROI = 10,000/100,000 X 100 = 10%

Net present value

This calculation takes into account the profitability of a project & the timing of the cash flows that are produced. The value of 100 today is not the same after 1 year. If I gave you 100 now you could put it in savings account and get interest on it. If the interest rate was 10% how much would I have to invest now to get 100 in a years time? This figure is the net present value of 100 in one years time

Discount factor
Discount factor = 1/(1+r)t r is the interest rate (e.g. 10% is 0.10) t is the number of years In the case of 10% rate and one year Discount factor = 1/(1+0.10) = 0.9091 In the case of 10% rate and two years Discount factor = 1/(1.10 x 1.10) =0.8294

Applying discount factors

Year Cash-flow Discount factor @ 10% Discounted cash flow

0 1 2 3 4 5

-100,000 10,000 10,000 10,000 20,000 100,000

1.0000 0.9091 0.8264 0.7513 0.6830 0.6209

NPV

-100,000 9,091 8,264 7,513 13,660 62,090 618

Internal rate of return

It attempts to provide a profitability measure as a percentage return that is directly compatible interest rates Internal rate of return (IRR) is calculated as that % discount rate that would produce an NPV of 0 for the project Can be used to compare different investment opportunities There is a Microsoft Excel function which can be used to calculate

Dealing with uncertainty: Risk evaluation

Helps make a decision whether to proceed with the project Risk identification & Ranking identify risks & quantify effects Could draw up draw a project risk matrix for each project to assess risks Likelihood classified as High, Medium, Low For riskier projects could use higher discount rates A more sophisticated approach is to consider each possible outcome & estimate the probability of its occurring & the corresponding value of outcome. Use a set of cash flow forecasts with associated probability of occuring

Example of a project risk matrix

Risk profile analysis

This approach attempts to overcome some of the objections to cost-benefit averaging is the construction of risk profiles using sensitivity analysis. This involves varying each of the parameters that affect the projects cost or benefits to ascertain how the projects profitability is to each factor.

Decision trees

Remember!
A project may fail not through poor management but because it should never have been started A project may make a profit, but it may be possible to do something else that makes even more profit A real problem is that it is often not possible to express benefits in accurate financial terms Projects with the highest potential returns are often the most risky