Calculate Project ROI using NPV, IRR and Packback period

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Calculate Project ROI

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6/11/2013 10:08 PM

Calculate Project ROI using NPV, IRR and Packback period

http://www.governancetraining.com/calculate-project-roi.htm

Identify tangible and intangible benefits (Work with the project owner and convert intangible benefits to tangible factors). All most all intangible benefits can be converted to tangible factors with clear understanding of the benefit. Example: Benefits like increasing employee morale (intangible) can be converted to be tangible as follows: Increase employee morale can increase employee retention, which can save new employee recruiting and training costs. Based on the employee turnover last year, HR dept can provide tangible figures like Reduce Employee turnover by 5% and save $5000 in new recruiting costs.

Understand cash flow Understand the project cash flow (if applicable) Example: Project to create ecommerce website to sell your products online may provide the following cash flow: Current Year: Expected to spend $10,000 to develop the website.(One year time-frame not a capital project) Year-1: After website is deployed, it is expected to generate $4,000 in the first year. Year-2: Expected to generate $5,000 in the second year. Year-3: Expected to generate $5,000 in the third year Year-4: Expected to generate $2,000 in the fourth year. Year-5: Expected to generate $2,000 in the fifth year Understand your discount rate Discount rate is the minimum expected rate of investment, based on analyzing other alternate investment options for the capital. Example: If a bank would give you a 10% interest on the investment if deposited then projects should return more than 10% to be a better investment option. Calculate ROI factors Based on your organizational standards (environment factors, accounting, finance, IT governance and other standards) identify the ROI factors (NPV, IRR, Payback period are typically used to calculate ROI). In the example above, you may have considered the website as a better return on investment because of the following: Amount Spend: $10,000 Amount Earned: $4,000+$5,000+$5,000+$2,000+$2,000 = $18,000.00 Net Diff = $18,000 - $10,000 = $8,000 (Profit over 5 year period). But, you cannot assume the above, without considering the discounted cash flow analysis. What is discount cash flow? Discounted cash flow is a cash flow analysis based on time value for money (considering money is relative A Dollar is worth more today than it is worth in the future). Net Present Value (NPV) : Net present value is calculated by discounting all future income amounts based on the discount rate and adding the discounted income stream. Net Present Value calculation = (Cash flow amount) / ((1 + Discount Rate) to the power of number of years) For example in the above example, if the discount rate is 10%, the cash flow should be as follows: Scenario-1: Assuming the payment $10,000 as made at the beginning of the year

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Calculate Project ROI using NPV, IRR and Packback period

http://www.governancetraining.com/calculate-project-roi.htm

Year

Expected Cash Flow

Discounted Cash Flow Value

Year - 1

$4,000

4,000/(1.1) to power of 1 = $3,636

Year - 2

$5,000

5,000/(1.21) to power of 2 = $4,132

Year - 3

$5,000

5,000/(1.331) to power of 3 = $3,756

Year - 4

$2,000

2,000/(1.464) to power of 4 = $1,366

Year - 5

$2,000

2,000/(1.610) to power of 5 = $1,242

Total

NPV = $14,132 - $10,000 = $4,132

Scenario-2: Assuming payment $10,000 as made at the end of the year Then the cost need to considered in year-1 as follows:

Year

Expected Cash

Discounted Cash Flow Value

Year - 1 (Outflow)

- $10,000

10,000/(1.1) = $9,090

Year - 2

$4,000

4,000/(1.21) = $3,305

Year - 3

$5,000

5,000/(1.331) = $3,756

Year - 4

$5,000

5,000/(1.464) = $3,415

Year - 5

$2,000

2,000/(1.610) = $1,242

Year - 6

$2,000

2,000/(1.771) = $1,129

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Calculate Project ROI using NPV, IRR and Packback period

http://www.governancetraining.com/calculate-project-roi.htm

Total

NPV = $12,847 - $9,090 = $3,757

Internal Rate Of Return (IRR): Internal rate of return is the discount rate that makes the net present value equal 0. In the above example, IRR is 27.3% (appox). It is the discount rate that makes the NPV zero (close to zero). Payback Period: The payback period is how long it will take to recover amount invested in a project (it is recommended to use discounted flows to calculate payback period ) In the above example, in scenario -1 the payback period is calculated by adding the discounted amounts every year until you meet or exceed the amount spend ie $10,000 in the example ) :

Year

Discounted Cash Flow Value

Payback Amount

Year - 1

4,000/(1.1) to power of 1 = $3,636

$3,636

Year - 2

5,000/(1.21) to power of 2 = $4,132

$7,768

Year - 3

5,000/(1.331) to power of 3 = $3,756

$11,524

Year - 4

2,000/(1.464) to power of 4 = $1,366

$12,890

Year - 5

2,000/(1.610) to power of 5 = $1,242

$14,132

Total

NPV = $14,132 - $10,000 = $4,132

Payback in 3 years

As seen in the above example, payback period is in year 3. Analyze ROI factors Based on the calculated ROI factors, analyze each project and compare their return on investment and use project portfolio management standards to approve projects. Please see the following multimedia article about Portfolio Management from Technology Governance Solutions. For example :

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Calculate Project ROI using NPV, IRR and Packback period

http://www.governancetraining.com/calculate-project-roi.htm

ROI Factor

Value

Comments

NPV

> 0 (positive)

Acceptable (Invest in a project with higher NPV)

0 (Zero)

May or may not be acceptable. Consider Other factors

< 0 (Negative)

Usually not acceptable

IRR

Number

Invest in a project with higher IRR.

Payback Period

Number

Invest in a project with small payback period.

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