Financial Management - ENVS 238 - Module 4 PDF

Course Module Environmental Project Management - ENVS 238 Financial Concepts in Project Management ENVS 238 Module 4 MacPhail School of Energy Revised: July 2007 redefine yourself www.sait.c...

Course Module Environmental Project Management - ENVS 238 Financial Concepts in Project Management ENVS 238 Module 4 MacPhail School of Energy Revised: July 2007 redefine yourself www.sait.ca Introduction Most projects take place in the private sector and this is also true of environmental technology projects. Consequently, it is useful for environmental project managers to understand a few financial terms and concepts which are used in evaluating environmental projects within profit oriented organizations. This module briefly introduces some of the financial concepts that are considered when projects are undertaken by such profit oriented organizations. Rationale Why is it important for you to learn this material? Most projects take place in the private sector and this is also true of environmental technology projects. Consequently, it is useful for environmental project managers to understand a few financial terms and concepts which are used in evaluating environmental projects within profit oriented organizations. Since environmental projects are undertaken in profit oriented organizations it is beneficial for environmental project managers to understand some financial terms and concepts that relate to their projects. This understanding will benefit environmental project managers in presenting their projects with equal business acumen as project managers in other disciplines. Learning Outcome When you complete this module you will be able to …. Describe cost-benefit analysis as it relates to environmental projects, describe the payback period, describe the time value of money, describe the net present value (NPV) method and calculate the NPV for the example provided. Learning Objectives Here is what you will be able to do when you complete each objective. 1. Describe cost-benefit analysis as it relates to environmental projects. 2. Describe the payback period as a method of assessing the value of a project. 3. Describe the time value of money and discuss its importance to environmental project management. 4. Describe the net present value method as a method of evaluating potential projects. 5. Calculate the NPV for the project described and compare your answer with the solution provided. 1 To show you have mastered the material, here is what you will be asked to do. Do the Self-Test questions at the end of the Module. Check your answers with the Self-Test Answer Guide to test your understanding of the Module Material. Do the Assignment question(s) on the back of the module for submission and marking. 2 Introduction Module 3 described planning functions related to the implementation of the project and also introduced the concept of project budgeting. Most projects take place in the private sector and this is also true of environmental technology projects. Consequently, it is useful for environmental project managers to understand a few financial terms and concepts which are used in evaluating environmental projects within profit oriented organizations. This module briefly introduces some of the financial concepts that are considered when projects are undertaken by such profit oriented organizations. This module discusses the time value of money, cost-benefit analysis, the payback period and the net present value method for comparing competing activities. 3 OBJECTIVE ONE When you complete this objective you will be able to… Describe cost-benefit analysis as it relates to environmental projects. Learning Material Cost-benefit analysis is an economic framework for evaluating competing activities. Just like individuals, private sector organizations such as corporations and government sector organizations have limited financial resources and organizations are motivated to make the best use of the resources they have under their control. When more than one potential activity or project is presented to organizational leaders, the leaders of the organization must decide which projects should be supported with scarce financial resources and which ones should not. Environmental projects are no different from all other projects in the sense that organizations need to make the best use of the financial resources they control. As a result, environmental projects are compared against information technology projects, new product and service development projects, physical infrastructure projects, etc… Similarly, each individual environmental project must be compared against all other potential environmental projects to identify the one that makes the best use of financial resources under the control of the organization. One method of evaluating multiple, competing projects is cost-benefit analysis. Cost benefit analysis compares all the financial costs of completing the project against all the benefits associated with completion of the project. For some projects it is fairly straightforward to identify cost and benefits and to compare the two to identify the cost-benefit for the project. For example, assume a company intends to replace all the incandescent light bulbs in its buildings with compact fluorescent light bulbs. The costs associated with the project would be equal to the cost of the new light bulbs, the cost of physically replacing the existing light bulbs and the cost of disposing the light bulbs that are removed. Similarly, the calculation of the cost savings associated with the project is also straightforward. The benefit would be equal to the cost of the energy saved as a result of the change. An example of the cost-benefit for such a project may be as shown in table 1. 4  Project costs and benefits (Cost) / Benefit Costs New incandescent bulbs $(100,000) Labour cost to replace $(20,000) Disposal cost $(5,000) Total Cost $(125,000) Energy savings per year $150,000 Net benefit / (cost) $25,000 Table 1: Cost-Benefit for light bulb replacement project Note: In financial reporting, negative numbers are normally represented with closed brackets (). For most environmental projects the estimation of project costs is relatively straightforward and often consists of the cost of equipment, materials, labour, services, etc… However, for many environmental projects, the estimation of benefits is much more difficult. In the example above, the estimation of project benefits is straightforward, but the calculation of the benefits associated with the clean up a contaminated site may not be so simple. There may be many potential benefits associated with the project such as protection of human health, avoidance of future legal and financial liability, protection of other species, etc. however, it may be very difficult to convert these benefits into financial terms. Another more extreme example relates to the benefits associated with aversion of global environmental concerns such as climate change. Although many people agree that precautionary actions should be taken to avoid potential future consequences of climate change, it is unlikely that profit oriented organizations will undertake projects to reduce greenhouse gas emissions on their own because corporations are unlikely to achieve tangible financial benefits related to the aversion of this global issue. Due to these issues, environmental projects present a particular problem when we attempt to apply well known and accepted financial principles to many environmental projects. This problem can be at least partially overcome with the intervention of governments and the public in the protection of public goods. This was discussed in module 2 with respect to the role of the public and governments as important stakeholders in environmental projects. Despite the issues related to the conversion of benefits into financial terms for some projects, for many other environmental projects, such as the light bulb conversion project described above, the conversion of benefits to financial terms is fairly straightforward. It is these types of projects that are the focus of the remainder of this module. 5 OBJECTIVE TWO When you complete this objective you will be able to… Describe the payback period as a method of assessing the value of a project. Learning Material The payback period is another economic framework that goes along with cost- benefit analysis to evaluate potential activities or projects. The payback period is equal to the number of years that it takes to payback the original financial investment in the project. Most projects do not result in benefits that are greater than the original project investment in the first year and projects such as the one described in objective 1 are rare. More often, the original project investment is paid back over a number of years but after the original investment is paid back the benefits associated with the project continue into the future. Using the light bulb replacement example from objective 1, assume the benefits were estimated to be as shown in table 2 below. Project costs and benefits (Cost) / Benefit Costs New incandescent bulbs $(100,000) Labour cost to replace $(20,000) Disposal cost $(5,000) Total Cost $(125,000) Energy savings per year $50,000 Table 2: Cost-Benefit for light bulb replacement project We can calculate the payback period using the formula: Payback period = Investment / Annual Benefit Using the light bulb replacement project as an example, the payback period is: Payback period = $125,000 / $50,000 per year = 2.5 years In other words, the initial investment will be paid back in 2.5 years and the energy cost savings will continue beyond that point. One of the advantages of the payback period is that it allows multiple projects to be evaluated comparatively. Organizations normally have many investment 6 opportunities and it is the job of business leaders to determine which investments are best for the financial success of the organization. To illustrate, assume you had the following project opportunities and it was your job to decide which project should be implemented. Project 1 Project 2 Project 3 Project 4 Project 5 Cost (125,000) (50,000) (100,000) (75,000) (150,000) Annual benefit 50,000 25,000 45,000 30,000 60,000 Table 3: Potential Project Costs and Benefits One way to evaluate these projects is to calculate the payback period for each project and select the project that would payback the original investment in the shortest time period as shown in table 4. Project 1 Project 2 Project 3 Project 4 Project 5 Cost (125,000) (50,000) (100,000) (75,000) (150,000) Annual benefit 50,000 25,000 45,000 30,000 60,000 Payback 2.5 2 2.2 2.5 2.5 Table 4: Potential Project Costs and Benefits From table 4, we can see that project 2 has the shortest payback period and given our selection method, would be chosen as the most advantageous project. However, there may be other reasons that other projects are more attractive. For example, if project 2 was expected to provide benefits for only two (2) years, would it still be considered to be an attractive project? Similarly, if project 5 was expected to provide benefits of $100,000 per year for every year after year 5 to year 10, would it still be considered to be less attractive than project 2? Other evaluation methods and concepts have been developed to address questions such as those posed above and these are the focus of the remaining objectives in this module. 7 OBJECTIVE THREE When you complete this objective you will be able to… Describe the time value of money and discuss its importance to environmental project management. Learning Material Another basic economic concept is the time value of money. This concept deals with the fact that the purchasing power of a given amount of money is not the same in the future as it is today. For example, assume that the average price of a car in the city of Calgary in 2007 is $25,000. It would be logical to assume that in 2017 the price of an equivalent car may have increased to something more than $25,000, for example, $30,000. Although there have been exceptions, in general, the price of goods and services in an economy tends to increase over time and the goods that can be purchased by a given amount of money decreases over time. We can approximate the relative purchasing power of a given amount of money by converting the amount to a period in the past or in the future using an inflation or interest rate over the given period of time. For example, if you were offered the following two options, which would you choose? Option #1 Option #2 A $1,000 payment now A $1,000 payment one year from now Most people would select option 1. People often identify the risk associated with waiting for a year to receive the payment as one reason for wanting to have it today. People tend to select instant gratification over delayed gratification when the choice is given. Whatever the reason, given the option, most people would select option #1. Continuing with the example, assume that you given a new choice as shown below. Which would you choose? Option #1 Option #2 A $1,000 payment now A $1,200 payment one year from now Given the second set of options, many people would still choose option 1, but some would be willing to select option 2 because people recognize the additional payment for waiting one year. This simple, well known fact is the basis of the time value of money concept which is the value of money today is not the same as the value of money in a future period. 8 Continuing with the example, assume that you were comfortable with option 2 and would be willing to accept the $1,200 payment in one year but nothing less. In other words, you are indifferent between the $1,000 payment today and the $1,200 payment one year from now. We can use these figures to determine the interest rate where you are indifferent between the two options. Interest Rate = (Future Value / Present Value) -1 (1) = ($1,200 / $1,000) -1 = 20% Following this logic then, $1,200 one year from today is equal to only $1,000 today. We can rearrange the formula above as follows. Present Value = Future Value / (1 + Interest Rate) (2) = $1,200 / (1.2) = $1,000 Variations of this formula can be used to calculate the Present Value of money from any period in the future. For example, assume that you were given two new choices as shown below, which would you choose? Option #1 Option #2 A $1,000 payment now A $1,440 payment two years from now Assuming that you are still comfortable with an interest rate of 20%, we can calculate the present value of the future payment using the following formula. Present Value = Future Value / (1 + Interest Rate)n (3) = $1,200 / (1.2)2 = $1,000 Where n represents the number of periods (years) Formula 3 can be used to calculate the present value of any future amount of money but it is important to note that the difficulty in applying this formula is in the calculation of the interest rate. A variety of different rates may be used for different purposes. In some cases it is appropriate to use the bank rate, in others it may be appropriate to use the Consumer Price Index (CPI) and in some cases, organizations calculate their own organization specific rate. For the purposes of this course, the interest rate will be given. 9 OBJECTIVE FOUR When you complete this objective you will be able to… Describe the net present value method as a method of evaluating potential projects. Learning Material Net Present Value (NPV) is another potential method for evaluating potential projects, however NPV incorporates the time value of money in its calculation. Profit oriented organizations have become more and more aware that their investments must create a positive return on investment for the owners of the business and as a result, NPV has become increasingly popular as an evaluation method. NPV is another expansion on the cost-benefit analysis approach however NPV addresses the fact that many benefits may be received in some future year and recognizes the time value of those future benefits. For example, assume that the costs for the light bulb replacement project are the same as described in objective 1 but that benefits (energy savings) are expected to increase in the future due to increasing future energy prices. Assume the costs and benefits are as shown in table 5. Further assume that no additional benefits are expected after year 5 because government regulations are expected at that point which would force organizations to adopt incandescent light bulbs anyway. Project costs and benefits (Cost) / Benefit Costs New incandescent bulbs $(100,000) Labour cost to replace $(20,000) Disposal cost $(5,000) Total Cost $(125,000) Energy savings year 1 $20,000 Energy savings year 2 $25,000 Energy savings year 3 $35,000 Energy savings year 4 $50,000 Energy savings year 5 $65,000 Total Benefit $155,000 Table 5: Light Bulb Replacement Project Costs and Benefits In evaluating this project, the first step is to determine whether or not the project could return a profit to the organization. Using the cost-benefit criteria from objective 1, the net benefit is equal to $195,000 - $125,000 = $70,000. However, 10 we know from objective 3 that the present value of money from future periods is not equal to the value of money today. We can use formula 3 from objective 3 to calculate the present value of all future amounts and compare against the original investment. Year 0 1 2 3 4 5 $(125,000) 20,000 25,000 35,000 50,000 65,000 Figure 1: Light Bulb Replacement Project illustration of timing of financial transactions Figure 1 illustrates the timing of financial transactions. It is assumed that the entire $125,000 investment to change all the light bulbs occurs today or at time 0. It is also assumed that the entire savings of $20,000 in the first year is received at the end of the first year, the $25,000 savings in the second year is received at the end of the second year and so on. To calculate the net present value, the first step is to calculate the present value of all future financial transactions. To do this, we can use formula 3 from objective 3, but in order to use this formula we require the interest rate. Profit oriented organizations are interested in creating returns for owners and it is not uncommon for such organizations to expect returns of at least 15%. Using 15% as the interest rate and formula 3, we can calculate the present value of the 20,000 benefit at the end of year 1 as follows: Present Value = Future Value / (1 + Interest Rate) = $20,000 / (1.15)1 = $17,391 Similarly, we can calculate the present value of the remaining amount as shown below. Present Value = Future Value / (1 + Interest Rate) = $25,000 / (1.15)2 = $18,903 Present Value = Future Value / (1 + Interest Rate) = $35,000 / (1.15)3 = $23,013 Present Value = Future Value / (1 + Interest Rate) = $50,000 / (1.15)4 = $28,588 11  Present Value = Future Value / (1 + Interest Rate) = $65,000 / (1.15)5 = $32,316 The present value of each financial transaction is illustrated in figure 2. Year 0 1 2 3 4 5 $(125,000) 20,000 25,000 35,000 50,000 65,000 $17,391 $18,903 $23,013 $28,588 $32,316 Figure 2: Present Value of financial transactions Figure 2 shows that the present value of future transactions is much different from the value in the future. For example, the $65,000 benefit in 5 years is equivalent to only $32,316 in present value terms. The final step in the NPV calculation is to sum the present values for all the transactions as shown in table 6 below. Project costs and benefits (Cost) / Benefit Total Cost $(125,000) Present value of benefits Energy savings year 1 $17,391 Energy savings year 2 $18,903 Energy savings year 3 $23,013 Energy savings year 4 $28,588 Energy savings year 5 $32,316 Total Present Value of benefits $120,211 Net Present Value $(4,789) Table 6: Net Present Value for Light Bulb Replacement Project Table 6 shows that the NPV for the project is less than zero. This means that from a financial perspective, owners and management in a profit oriented organization, expecting a return of at least 15% on their investments, are likely to be 12 dissatisfied with this investment opportunity. It is interesting to note that in this case, the project would create benefits of $70,000 in excess of costs but because much of the benefit is not realized until a period far into the future, the project is likely to be viewed unfavourably from a financial perspective. It is in this context that environmental projects are likely to be evaluated and it is important for environmental practitioners to understand this context. Too often, people argue that companies should invest in expensive projects due to the benefits that would be created for the environment. However, profit oriented organizations seeking only to create environmental benefits may quickly find themselves uncompetitive. As a result, environmental practitioners must strive to identify as many tangible and intangible benefits as possible for their environmental projects. It is only by understanding that environmental projects are evaluated as only one project in a large pool of potential projects that environmental practitioners can work to present their own projects as worthwhile and beneficial to organizations as a whole. 13 OBJECTIVE FIVE When you complete this objective you will be able to… Calculate the NPV using an example. Learning Material Calculate the NPV for the project described below and compare your answer with the solution provided. Learning Activity 1. Assume the light bulb replacement benefits and costs are the same as described above in objective 4. Project costs and benefits (Cost) / Benefit Costs New incandescent bulbs $(100,000) Labour cost to replace $(20,000) Disposal cost $(5,000) Total Cost $(125,000) Energy savings year 1 $20,000 Energy savings year 2 $25,000 Energy savings year 3 $35,000 Energy savings year 4 $50,000 Energy savings year 5 $65,000 Total Benefit $155,000 Table 7: Light Bulb Replacement Project Costs and Benefits 2. Calculate the NPV assuming the interest rate is 10%. 3. Compare your answer with the solution provided. 14 Solution: Project costs and benefits (Cost) / Benefit Total Cost $(125,000) Present value of benefits (10%) Energy savings year 1 $18,182 Energy savings year 2 $20,661 Energy savings year 3 $26,296 Energy savings year 4 $34,151 Energy savings year 5 $40,360 Total Present Value of benefits $139,650 Net Present Value $14,650 Table 8: Net Present Value for Light Bulb Replacement Project It is important to note here that by changing the interest rate to 10% from 15%, the NPV changes from a negative value to a positive value. Some researchers argue that the expectation of high returns on investments results in a focus on short term investments and rapid development as a means of satisfying shareholders at the expense of the environment. It has been argued that if investors were satisfied with lower interest rates and returns on investment, developments could be taken with a longer term perspective thereby reducing the pace of development. 15 Module Self-Test Directions:  Answer the following questions.  Compare your answers to the enclosed answer key.  If you disagree with any of the answers, review learning activities and/or check with your instructor.  If no problems arise, continue on to the next objective or next examination. 1. What is const benefit analysis? 2. Why do corporations need to evaluate competing activities? 3. Describe one concern associated with the application of cost-benefit analysis to some environmental projects. 4. Describe the payback period. 5. What is the time value of money? 6. What is the present value of $1,000 one year from now if the interest rate is 10%? 7. What is the future value of $1,000 one year from now if the interest rate is 10%? 8. What is the present value of $1,000 ten years from now if the interest rate is 10%? 9. What is the net present value of the following if you assume you could earn interest at 5% if you were to put your money in the bank instead of buying a piece of equipment. You spend $20,000 today to buy a piece of equipment that will allow you to save $5,000 in the first year and $7,000 in the second year, $6,000 in the third year and $4,000 in the fourth year. 10. What is the net present value of the following if you assume you could earn interest at 4% if you were to put your money in the bank instead of buying a piece of equipment. You spend $25,000 today to buy a piece of equipment that will allow you to save $3,000 in the first year and $4,000 in the second year, $10,000 in the third year and $12,000 in the fourth year. 16 Module Self-Test Answers 1. Cost benefit analysis is an economic framework for evaluating competing activities. It compares all the financial costs of completing the project against all the benefits associated with completion of the project. 2. Just like individuals, private sector organizations such as corporations and government sector organizations have limited financial resources and organizations are motivated to make the best use of the resources they have under their control. 3. For some environmental projects it is very difficult to convert benefits into financial terms. For example, assume a project is proposed to clean up a contaminated site. There may be real benefits associated with the clean up such as protection of human health, avoidance of future legal and financial liability and protection of other species. However, it is very difficult to identify the exact monetary value of any of these and as a result it is difficult to compare benefits against results. 4. The payback period is equal to the number of years that it takes to payback the original financial investment in the project. 5. The time value of money is an economic concept that deals with the fact that the purchasing power of a given amount of money is not the same in the future as it is today. 6. Present Value = Future Value / (1 + Interest Rate) = $1,000 / (1.1) = $909 7. Future Value = Present Value * (1 + Interest Rate) = $1,000 * (1.1) = $1,100 8. Present Value = Future Value / (1 + Interest Rate)n = $1,000 / (1.1)10 = $385 9. NPV = $-415 10. NPV = $730 17 References 1. Lewis, JP, Fundamentals of Project Management, 2002, AMACOM, New York, pg. 59. 18 Glossary Cost Benefit Analysis: An economic framework for evaluating competing activities where financial costs are compared against financial benefits resulting from the execution of the project. Future Value: The future value of a financial transaction made in some earlier period. It is calculated by multiplying the value of the earlier financial transaction by one plus the interest rate. Interest Rate: The rate of interest that could be received by investing in an equally risky investment. The interest rate depends on the application and may be the bank rate, the CPI or the some other rate such as an organization specific rate. Net Present Value: An economic framework for comparing competing activities which incorporates the time value of money into the calculation. Payback Period: The number of years it takes to pay back the original financial investment in a project. Present Value: The present value of a future financial transaction which is calculated by dividing the value of the future financial transaction by one plus the interest rate. Time Value of Money: An economic concept that deals with the fact that the purchasing power of a given amount of money is not the same in the future as it is today. 19 Course Module SAIT’s vision is sharply focused – to be recognized as Canada’s premier polytechnic, one of the world’s finest, setting the standard in education, training and innovation. SAIT shall be an innovative organization equipping people to compete successfully in the changing world of work by providing relevant, skill-oriented education. ALL RIGHTS RESERVED: This material may not be reproduced in whole or part without written permission from the Director, Centre for Instructional Technology and Development. Southern Alberta Institute of Technology, 1301 16 Ave. N.W. Calgary AB T2M 0L4 Printed in Canada on Recycled Paper