Category: Project Management

Internal rate of return Economic Model for Project Selection

Internal rate of return is yet another economic model for project selection. Internal rate of return is defined as the rate of interest at which the revenue of the project and the cost of the project are equal. This value is also known as a break even value, where the present value of the future cash flow is equal to the initial investment. The rate of return is referred to as internal because of the fact that you do not consider environment factors, such as inflation, when calculating this rate of return.

To understand this model better, you can consider an investment you make. When making a investment, you always expect certain returns from the investment and select an investment option that offers the highest rate of return from the investment. Similarly, when the organization has multiple projects to invest in, you calculate the rate of return for all the projects and select the one with highest rate of return.

You use internal rate of return to measure and compare the profitability of the project with respect to the investment. Calculating the internal rate of return not only enables you to decide on investing in a project, but also compare the profitability of the projects and select a project that has a better profitability than others. You always select a project that has higher internal rate of return. If you have multiple projects that require similar investment, then calculating and comparing internal rate of return would help you to select the project among the candidate projects. Higher is the internal rate of return more profitable would the project.

Calculating the internal rate of return is quite complicated and you need expertise to calculate it. You can use the following formula to calculate the internal rate of return:

economic-model-for-project-selection-internal-rate-of-return-tutorial

Here:

  • NPV is the net present value.
  • N is the total number of time periods.
  • n is a positive integer.
  • C is the cash flow. Cash flow is a positive value of it is a revenue and negative if it is an investment.
  • r is the internal rate of return.

You can either use expertise to calculate the internal rate of return my using the preceding formula or use specialized software, such as Microsoft Excel, to calculate the internal rate of return.

Always remember that you can never have a negative value for internal rate of return. Additionally, the calculating the internal rate of return enables you to use it as a decision tool to select a project. However, the internal rate of return might not always be equal to the compounded rate of return on the investment you make in the project.

Net Present value ( NPV) Economic Model for Project Selection

In the Present Value economic model for project selection, you calculate the present value of a future cash flow from the project. You do not deduct anything from the value you have calculated. However, when calculating a Net Present Value (NPV), you deduct the costs incurred on the project from the present value of the project.

When calculating the net present value of the project, you first calculate the present value of the project revenue as well as the project cost over many periods of time. After calculating the present value of the project revenue and the project cost, you deduct the present value of the project cost form the present value of the project revenue to get the net present value of the project. If the resultant net present value is positive, it would be fruitful to select the project. Else, it would result in a loss making proposition.

net-present-value-npv-in-economic-model-for-project-selection

You calculate the cost incurred on a project over multiple time periods the same way as you do for the present value for the project revenue. The only difference is that while calculating present value for the revenue, the value is always lower than the actual value because you lose on the interest that you would have otherwise accrued. However, in case of present value of the cost, the effective cost is lesser because you have already earned an interest on the amount.

Consider the following example. In a project you have to invest an initial amount of $ 6,000 and another $ 3,000 each in the first and second years. The projects is expected to generate revenue of $ 500 in the second year, $ 1,000 in the third year, $ 5,000 in the fourth year, and $ 10,000 in fifth year. Now, calculate the net present value of the project and evaluate if it is worth considering going ahead with the project.

To calculate the net present value of the project, you must calculate the present value of the cost as well as revenue by using the present value formula and then add the respective values. In this example, consider the prevailing rate of interest as 10% per annum. You can use a table similar to the following to make the calculations:

Time Period Revenue Calculate PV of Revenue Present Value of Revenue Cost Calculate PV of Cost Present Value of Cost
0 0 – 0 6,000 6,000/(1.1)0 6,000
1 0 – 0 3,000 3,000/(1.1)1 2,727
2 500 500/(1.1)2 413 3,000 3,000/(1.1)2 2,479
3 1,000 1,000/(1.1)3 751 0 – 0
4 5,000 5,000/(1.1)4 3,415 0 – 0
5 10,000 10,000/(1.1)5 6,209 0 – 0
Total   10,788   11,206

Net Present Value = 10,788 – 11,206 = -418

Notice that the total revenue generated from the project is $ 16,500. As a project manager, you might not want to consider this project because the net present value of the project is negative (-418). You always consider a project that has a positive net present value.

You can calculate net present values for all projects under consideration and select the one with highest and positive net present value.

Present value Economic Model for Project Selection

A bird in hand is worth two in the bush. This prose is true whenever you consider any investment, which encourages you to calculate time value money for an investment. Time value money is a concept that mentions that it is more important to receive an amount today that receiving the same amount a year down the line. For example, it is more valuable to receive $ 1000 today than receiving the $ 1000 a year or two down the line.

present-value-in-economic-model-for-project-selection

The present value of $ 1000 that you receive after a year is less than $ 1000. This is because the $ 1000 that you will receive includes the interest accrued over the year. Therefor, according to the time value money, the present value of this amount would be $ 1000 actually be $ 1000 – the interest amount. If you take 10% as the prevailing interest rate, the present value of this amount would be $ 1000 – $ 100, which amounts to $ 900. Therefore, notice that the calculation of the present value removes the interest part.

When calculating the present value, you compound the interest. The interest accrued for a time period is added to the principal amount before interest for the next time period is calculated.

Calculating the present value of the makes an important check when selecting a project. In this economic model, you evaluate the current value of the future cash flow of the project. To calculate the current value of the future cash flow, you can use the following formula:

PV = FV / (1 + r)n

In this formula:

  • PV is the present value of the amount
  • FV is the future value of the amount
  • r is the rate of interest used to discount the future value of the amount
  • n is the number of time periods after which the future value is received

For example, for a project that you expect to receive revenue of $ 500,000 after five years with prevailing interest rate as 10%, then you can calculate the present value of the amount as follows:

Here:

  • PV is to be determined
  • FV = $ 50,000
  • r = 10% or 0.1
  • n = 5

Therefore, in this case:

PV = 500,000 / (1 + 0.1)5

= 500,000 / 1.61

= 310,559

You can notice that the present value of the $ 500,000 revenue you will receive after five years is 310,559.

If you expect more than one future values form the project, as expected in a real life project, you can calculate the present value of all of these future values individually, and then add all the present values to get a single present value for the project.

You can calculate the present value of all the candidate projects and select the one that provides you the highest present value for the amount invested in the project.

Economic Model of Project Selection Overview

One of the most important activities in project management is the selection of a project. As it seems, it is not simple activity. For an organization, it could be a make or a break situation. Whereas selecting a successful project that aligns to the business objectives can turnaround the organization, a casually selected project not aligned to the business objectives might create a havoc and even result in wastage of critical resources. Therefore, you must use utmost care when selecting a project that is a viable one instead of the one that might not produce desired results.

At any given moment, you might realize that there are multiple projects lined up that the organization could consider. One of the models that you can use to select a project is an Economic Model of project selection. An Economic Model of project selection enables you to ensure that the project is economically viable. Among the available choice of projects, you compare the economic viability of the projects and select the most viable project.

economic-model-of-project-selection-overview-tutorial

The Economic Model of project selection not only enables you to ensure that you select a project that has high chances of success, but also has good economic returns.

You can use the following economic models to when selecting a project:

  • Present Value (PV): In this economic model, you evaluate the current value of the future cash flow of the project. To know more about this economic model, refer Economic Model for Project Selection – Present Value.
  • Net Present Value (NPV): In this economic model, you calculate the net present value of a project by deducting cost incurred on the project over multiple periods of time from the present value of the project. If the NPV of a project is positive, it is a good idea to select the project. To know more about this economic model, refer Economic Model for Project Selection – Net Present Value.
  • Internal Rate of Return (IRR): In this economic model, you calculate the rate of interest at which the cash inflow to the project is equal to the cash outflow from the project. The higher is the value of IRR more profitable is the project. To know more about this economic model, refer Economic Model for Project Selection – Internal Rate of Return.
  • Payback Period: In this economic model, you calculate the time period required to recover the investment the organization has made in a project before the project starts returning profits. To know more about this economic model, refer Economic Model for Project Selection – Payback Period.
  • Benefit cost Ratio: In this economic model, you calculate the ratio between the cost of the project and benefits form the project. The benefits include all forms of revenue you generate from the project and not just the profits. A benefit cost ratio greater than one indicates projects generates more benefits than the cost incurred. To know more about this economic model, refer Economic Model for Project Selection – Benefit-cost Ratio.

Initiating a Project using PRINCE2 Way Processes

The Projects in Controlled Environments – version 2 (PRINCE2) is a project management methodology developed by Central Computer and Telecommunication Agency (CCTA) as UK Government standard for Information Technology project management. This standard includes quality management, organization, and control of projects. Even though Prince2 was developed for Information Technology projects, it is widely accepted to manage many non-Information Technology projects.

Prince2 majorly focuses on breaking a project into small, manageable, and controllable chunks of stages. To successfully manage a project by using PRINCE2 methodology, you must conform to seven processes. In this article you will know about first two processes that are closely interwoven. These processes are:

starting-up-and-initiating-a-project-prince2-way-processes-tutorial

Starting up a Project

This is the first process of PRINCE2 wherein you create a project board. Then, you assign the project to a project manager and appoint a project management team. The project management team prepares a short description of the project and defines the project approach. The team prepares a high level business case and requests the project board to authorize this stage. The project then moves into the next process.

Initiating a Project

In this process you continue with the work that you started in the Starting up a Project process. You complete the business case and plan for the next stage of the project. Additionally, you create project files and plan for the quality of the project. The output of this process is a Project Initiation Document, which you send to the project board to authorize the project. A typical Project Initiation Document consist of the following sections:

 

Purpose

In this section, you define the purpose of the project. You also define the desired output of the project.
 

Scope

In this section, you define the scope of the project. The scope of the project includes what items are included and what are excluded from the list of stakeholder assumptions. Additionally, you define the boundaries of the project, such as type of work, problem, client, and geographical area. Ensure that you create a detailed scope such that there is no misunderstanding among stakeholders at a later stage of the project.
 

Background

In this section, you establish the reason for the taking up the project. Additionally, you must provide a rational behind selecting the project with respect to other projects being considered. A well defined background helps you to acquire resources required for the project.
 

Initial Project Plan

In this section, you specify the initial project plan while considering the proposed date from the stakeholders. You must provide justification for any deviation from the proposed date. Additionally, you must provide appropriate justification for any changes in the launch date and scope of the project.
 

Quality Plan

In this section, you include the project quality plan, which is typically prepared by the quality assurance team. This plan includes aspects to be delivered as a part of the project, high level design, use cases, test scripts and reports, and post development review. The quality plan defines checkpoints in the project life cycle to ensure the quality of the product.
 

Project Control

In this section, you define various controls you plan to place in the project life cycle. These controls include checks to the budget, schedules, and quality of the product. Defining controls help you to monitor the overall progress of the project.
 

Risks

In this section, you identify high level risks that you foresee when taking the project. In response to the risks you have identified, you define the risk mitigation plan and a detailed exception plan to make sure that the project keeps moving and the motivation level of the team is high.
 

Approval

Finally, you must get the Project Initiation Document approved and signed off by the stakeholders. Getting the document approved ensures that there is no misunderstanding among the stakeholders and everyone involved in the project have the same expectations.

Initiating a Project using PMBOK Way Processes

According to Project Management Body of Knowledge (PMBOK) published by Project Management Institute (PMI), the Initiating Process Group consists of those processes performed to define a new project or a new phase of an existing project by obtaining authorization to start the project or phase.

Every phase of project management consists of a set of processes. Initiating a project is the first step towards defining a project. This is the phase of the project where you conform to various processes to define a business case for the project and make initial analysis for the business case. As is the case with every process group, the initiating process group has a well defined output, which include:

initiating-a-project-pmbok-way-processes-tutorial
 

Project Charter

Project charter is an important document, which is an output of the Initiating Process Group. This document identifies and assigns a project manager for the project, who is authorized to use the resources of the organization to complete the project. A project charter document defines the high level scope of the project, its objectives, stakeholders, and the authority of the project manager. This document must provide the basic objectives of the project, shared understanding of the project, and is a contract among the project sponsor, stakeholders, and project team.

A project charter is a small document that contains reference to other documents for further details. A typical project charter document consists of the following sections:

 

Title and Description

In this section, you define the project. You must provide a meaningful title that you can use to identify the project. Additionally, in this section add a short description of the projects.
 

Project Manager and Authority Level

In this section, you identify the person who is authorized to lead the project and the level of authority to use the resources of the organization to complete the project. This section also identifies the level of authority to manage and change the scope of the project and resources.
 

Business Case

In this section, you define the need of the project. You provide a short justification of the project to explain the benefits the project will incur to the organization.
 

Resources Assigned

In this section, you identify and assign initial resources that are at the disposal of the project manager. Additionally, in this section, you determine the culture, such as mode of communication and language to be followed, and level of involvement of the resources in the project.

Note: You can refer to a document for a detailed list of resources.
 

Stakeholders

In this section, you identify the known internal and external individuals who can influence the project.

Note: You can refer to a document containing a detailed list of individuals.
 

Stakeholder Requirements

In this section, you define the scope of the project and product, as defined by various stakeholders.

Note: You can refer to a document containing detailed requirements from various stakeholders.
 

Deliverables

In this section, you identify the deliverables required and the ones that will be delivered at the end of the project.
 

Objectives

In this section, you identify how project meets the strategic organizational goals. You identify the project objectives that satisfy these goals. The objectives you identify must be measurable, such as high level schedule and budget of the project.
 

Approval Requirements

In this section, you identify the items that need to be approved and the signing off authority for the same. You define the criteria that identify the success of the project.
 

Risks

In this section, you identify the possible high level threats and opportunities for the project.
 

Approval

In this section, the sponsor of the project signs off the project charter.

After sponsors sign off the project charter, it provides authority to the project manager to officially start the project.
 

Stakeholder Register

Stakeholders are the individuals or entities that are capable of influencing the outcome of the project and, thereby, ensuring the success of the project. Identifying key stakeholders help you to understand key players that can potentially influence the project. Managing these key players will help you to focus your time and energy during the initial phases of the project.

After identifying the stakeholders, you need to create a stakeholder register. This register contains all details of the stakeholders, such as name, department, contact details, type of stakeholder, expectations, interest, and Influence on the project.

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