Cost benefit evaluation techniques

 

Cost benefit evaluation techniques:

We will take a brief look at some common methods for comparing projects on the basis of their cash flow forecasts.

Net Profit: The net profit of a project is the difference between the total costs and the total income over the life of the project. The simple net profit takes no account of the timing of the cash flows.

            Net profit is equal to the gross profit minus overheads minus interest payable plus/minus one off items for a given time period (usually: accounting period) A common synonym for "net profit" when discussing financial statements (which include a balance sheet and an income statement) is the bottom line. This term results from the traditional appearance of an income statement which shows all allocated revenues and expenses over a specified time period with the resulting summation on the bottom line of the report.

 Payback period: The payback period is the time to break even or pay back the initial investment. Normally, the project with the shortest payback period will be chosen on the basis that an organization will wish to minimize the that a project is in debt.

            The advantage of the payback period is that it is simple to calculate and is not particularly sensitive to small forecasting errors.





Net present value: The calculation of net present value is project evaluation technique that takes into account the profitability of a project and the timing of the cash flows that are produced.
The main difficulty with NPV for deciding between projects is selecting an appropriate discount rate. Some organizations have a standard rate, but where this is not the case, then the discount rate should be chosen to reflect available interest rates plus some premium to reflect the fact that software projects are inherently more risky then leading money to a bank. The exact discount rate is normally less important than ensuring that the same discount rate is used for all projects being compared.

 

Internal rate of return: One disadvantages of NPV as a measure of profitability is that, although in may be used to compare projects, it might not be directly comparable with earnings from other investments or the cost of borrowing capital.  Such cost are usually quoted as a percentage interest rate. The internal rate of return attempts to provide a profitability measure as a percentage return that is directly comparable with interest rates. Thus, a project that showed an estimated IRR of 10%  would be worthwhile if the capital could be borrowed for less than 10% or if the capital could both be invested elsewhere for return greater than 10%.

 

            The IRR is calculated as that percentage discount rate that would produce an NPV of zero. It is most easily calculated using a spreadsheet or other computer program that provides functions for calculated the IRR. Microsoft excel, for example, provides IRR function which, provided with an initial guess or seed value, will search for and return an IRR.

 

This technique consists of guessing two values and using the resulting NPV (one of which must be positive and the other negative) to estimate the correct value. Note this technique will provide only an approximate value, but in many cases that can be sufficient to dismiss a projects  that has a small IRR.


 

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