Master in Decision Making & Innovation
It has been a pleasure to be your mentor during this project appraisal module. I hope you have enjoyed it as well. This master program is about decision making, so we want you to have all the tools you need to decide if a project is worth doing or not. Project Appraisal aims at finding the most efficient way to achieve the project objective with the limited resources we have at our disposal. For this purpose, we have several tools such the one introduced in this workout: Financial Cost-Benefit Analysis.
Financial Cost-Benefit Analysis rests in calculating the present value of the future flows of projects. Here are the keys points to remember about discounting future flows to present value:
- Costs and benefits accumulate over the life of the project. We cannot compare the cost of year 1 to the benefit of year 10.
- We must bring all the costs and all the benefits of the project during its lifetime to the present time.
- The discount rate reflects the risks of the project and the opportunity cost.
- Once we have discounted all the costs and benefits from all the years of the project, we can calculate the Net Present Value.
- Net Present Value is the difference between the present value of benefits and the present value of costs, and it is the main metric to evaluate project profitability.
Also, There are several dimensions you must consider when calculating a cost-benefit analysis.
1) We are talking about the profitability of a project; therefore, we need to identify all the revenues and costs to see if the project has positive net cash flows (profits) or negative cash flows (losses).
2) We are evaluating the profitability in a given time frame. Therefore, we must analyze if this project is profitable during a time frame, and for this purpose we use NPV, discounting the project Net cash flows to present. If NPV is positive, it means the project is profitable.
3) IRR is the Rate at which NPV=0. The internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable.
So IF IRR>Discount Rate, the project is desirable.
IF IRR<Discount Rate, the project is not desirable.
Finally, I would like to quickly summarize the keys of the workout. WifiMad was divided into two questions. One theory question regarding the steps to evaluate a project and a Cost-Benefit Analysis exercise.
You can find the steps to evaluate a project in your Project Appraisal Ebook: 1) project objective; 2) Identify alternatives; 3) Identify costs & benefits; 4) Assessing the cost & benefits of the project; 5) Calculate the Present Value; 6) Risk and uncertainty analysis; 7) Obtaining a measurement of profitability.
The main exercise in this workout was the Cost-Benefit Analysis. The 6 most common questions were:
- Calculation of replacement costs: You need to calculate the cost from year 1 to year 12 using the replacement rate over the accumulated number of kiosk deployed in the streets (722 in year 1, 1444 in year 2, 2166 from year 3 to year 12).
- Calculation of sponsorship revenues: Since it is a onetime revenue per kiosk, you need to calculate the revenue from year 1 to year 3 over the amounts of kiosks purchased every year (722 per year from years 1 to 3). They should be constant amounts every year.
- Calculation of Wifi Access, Electricity Consumption, and Sales Platforms: All these cost and revenue streams were presented in monthly terms, so you had to multiply by 12 to calculate yearly amounts.
- Discounting cash flows: Some of you asked about starting to discount at t=0 or in year 2. You must start discounting the cash flows in year 1. When we talk about year 1, it means at the end of the this year – one year from today (we do not use t=0 in this exercise).
- IRR calculation: some of you asked about calculating the IRR over the discounted cash flows instead of the net cash flows. Remember the IRR is the rate at which we discount the cash flows to get an NPV equal to 0. So we have to calculate the IRR over the original net cash flows of the project.
- IRR interpretation: Some of you stated that the IRR changes with a new discount rate. IRR does not change if we modify the discount rate because it depends on the original net cash flows of the project (that do not change with a different discount rate). In conclusion, IRR holds but our discount rate (opportunity cost) increases, so our discount rate gets closes to the project IRR meaning the project is less desirable than before.
The power point presentation I prepared for you to solve this exercise contains all the required details to complete the cost-benefit analysis successfully. Remember that it has been uploaded to Project Appraisal unit>Contents section>page 3.
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