Investment Decisions - Overview | PMQ D3.3a
QA | APM PMQ | Digital
In this video, we discuss the factors that form investment decisions and the tools and techniques that surround these decisions.
- The investment in your project and the return it generates can support the project's success. As a project manager, you need to understand why your organization is investing in a project, the language of investment and the implications this has on your operational efforts. The project's business case puts a value on the anticipated benefits to justify the costs of running the project. In this video, we'll talk about the importance of doing careful examination of investment in projects, some of the factors that form part of the investment decisions, as well as discuss some of the techniques and terminology around investment. There are four main reasons why your organization needs to carry out careful examination of its investments, and if you don't feel like this has been done before a project formally kicks off, you should raise it with the relevant people. Cash or capital is a scarce resource. Cashflow is a key factor in the success of any organization. The rate of return for your project must normally be higher than the return that could be gained using the money elsewhere. There is usually a limited number of projects that your organization can afford. It needs to assess the viability of the proposed projects and choose between them. The benefits provide a direct link between the project outputs and the business, both strategic goals and operational needs. There are also many other factors that might play a part in investment decisions, from affordability and return on investment through to portfolio effects, risks, practicality and more. Okay, so we've covered some of the reasons a proper examination of investment is important. Let's move on to the final part of this video and talk about some of the techniques you or your organization can use to make some of these decisions. It's important to remember that investment decisions shouldn't just come down to financial costs and returns. There could be intangible costs and benefits that might be hard to quantify, but these could be really important. The first and most basic technique is called "payback period". This technique is as simple as asking, "How much time will it take for the project to recover the initial investment?" This technique is fine, but it does have its weaknesses. It ignores the time value of money. What I mean by this is that over time, things tend to get more expensive. Think about these two scenarios. Scenario one, you can choose between a return of £5000 in three years or £5000 in five years. Scenario two, you can choose between a return of £5000 in three years or £6000 in five years. Which investment do you think is better? Well, in scenario one, the better choice to take is to take the money in three years. In scenario two, it's not as simple. It might be better to hang on until year five for the higher sum. However, will £6000 be worth as much as £5000 two years later at year five instead of year three? So how do you go about answering this question? You need to work out what the future value of the investment will be. There are a few parts to this calculation, and I'll try my best to keep it as simple as possible. Okay, so the first thing you need to do is to apply the discounted cashflow to the value of the investment in a specific year. Basically, what you're doing is figuring out what the value of your money right now will be at some future date. As a general rule, the present value will reduce as the future period increases. The discount rate that needs to be applied to figure this out is a percentage that should be chosen by the organization and is normally the weighted average cost of capital, or WACC rate. This looks at two elements, equity and debt. It considers your organization's cost to borrow money and determines whether it's profitable to finance a new project. The higher the WACC, the more difficult it is to make a profit. Okay, so the next think you need to do is add up the values across the years and deduct the amount you invest to get the net present value, or NPV. If the NPV is positive, you're making a profit, and if it's negative, a loss. Figuring out the future value of the project and the NPV is dependent on getting the discount rate right. But what if your organization gets this wrong? If they do, it could mean that the investment is a big mistake. To help make sure this doesn't happen, they can use the internal rate of return, or IRR. The IRR works out the discount rate at which the NPV is zero. This means that the future cashflow is equal to the investment, so it gives an indication on how safe the investment is. The IRR tests how likely your project's cost and returns are to change. And that's it for this video. Making sure that the proper investigations into investing in a project is important for the sustainability and success of the project. As a project manager, you need to know how these decisions have been reached, and to make sure that the proper procedures have been followed before a project begins.