Financial Management in Projects

•        Types and Sources of Finance

▫        Senior debt- Debt financing.  This types of financing have to be paid first ( money borrowed from number of sources including banks. They have the first claim to the project organization’s assets should the project fail and the company goes into liquidation. 

▫        Mezzanine debt- comes from the project organization’s equity holders.  Involves a schedule f loan repayments and interest payments at a predetermined rate.  Considered secondary to the senior debt.  Higher risk and higher interest rates.

▫        Secured vs. unsecured debt – secured against the companies assets and has lower interest rates in contrast to the unsecured debt. More risk to the lenders as it is only given to the project and its assets. Should the project fail the lenders have no way of securing their money.

•        Cost of Financing

▫        Cost of equity- is the dividends paid to shareholders plus any estimate of the equity’s capital growth. The cost of equity is usually calculated using the capital asset pricing model (CAPM). (More can be learned about this model in any finance textbook.)

▫        Cost of debt- is the cost of debt financing, or the interest paid on the money borrowed. While the cost of equity is payable out of untaxed income, the cost of debt is payable out of taxed income.

▫        Cost of capital = Ratio of equity * Cost of equity + Ratio of debt * Cost of debt

•        The cost of capital is the average cost of various forms of finance used by the project organization

▫        Expected Monetary Value - is also the most appropriate financial measure when measuring future uncertainty, or when multiple project outcomes are possible, each with a different cost and schedule. It is defined as the summation of the value of each outcome in dollars ($), weighted by the probability of that outcome. For example, consider a project that needs to be redesigned, and assume that the new approach involves some risk to accomplish this goal. One possible monetary outcome is $200,000 with a 40 percent probability of achieving this outcome, while anothermonetary outcome is $150,000 with a 60 percent probability of occurrence. The EMV of this project is

EMV = $200,00 ∗ 0.4 + $150,000 ∗ 0.6 = $170,000

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What is the expected monetary value?

•        What is the expected monetary value?

It is a financial measure used when measuring future uncertainty. It is defined as the summation of the value of each outcome in dollars ($), weighted by the probability of that outcome. For example, consider a project that needs to be redesigned, and assume that the new approach involves some risk to accomplish this goal. One possible monetary outcome is $200,000 with a 40 percent probability of achieving this outcome, while another monetary outcome is $150,000 with a 60 percent probability of occurrence. The EMV of this project is

•        EMV = $200,00 ∗ 0.4 + $150,000 ∗ 0.6 = $170,000

•        Use of Functions

▫        Critical Success Factor

A project’s net return and risks are the two pivotal factors that determine

its ultimate success and the value it delivers. In the absence of thorough

risk assessment and proactive risk management at the valuation and

implementation stages, project success cannot be achieved.18

A simple example will serve to illustrate the importance of risk assessment

and risk management to project value. Let us consider a project

proposal with an expected gross return of $200,000 over five years, with

a cost of $150,000 to implement. Without factoring any risks into the

equation, the net return is $50,000 ($200,000 − $150,000). However,

risks to a project are inevitable, and this hypothetical project is no exception.

Therefore, let us assume the following risks and their impact on this

project:

1. There exists some uncertainty in the project requirements and

there is 40 percent probability that development efforts will cost

an additional $30,000. This will reduce the net return by $12,000

($30,000 ∗ 0.4).

2. The project team believes that there is 20 percent likelihood that

additional sales force training may be required. This will likely

reduce the net return by $10,000 ($50,000 ∗ 0.2).

3. There is a 10 percent probability that the entire project could fail or be

superseded by other projects because of technological uncertainties

or a strategic change in direction. This implies a net reduction of

$5,000 ($50,000 ∗ 0.1) in the project’s expected net return.

When the impact of all of the above risks is factored into account, the

reduction in the net return to the project is $27,000 ($12,000 + $10,000

+ $5,000), and the overall net return from the project now is $23,000

($50,000 − $27,000). The project is now considerably less attractive than

it originally appeared.

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Value Management

•        Concept of Value Management

·        Value Planning is a value study that occurs during the early

design or development stages of a project life cycle, before a preferred

alternative is selected. Value planning typically focuses on identifying

project objectives and developing functional components and general

approaches to meeting those objectives. It ensures that value is planned

into the project from its inception by addressing and ranking stakeholders’

requirements in order of importance. This makes it extremely important

for project team members to know who those stakeholders are. Value

planning should be used for most projects.

▫        Value Engineering is the title given to value techniques

applied during the design or engineering phases of a project. This value

study is conducted after the design alternatives have been developed,

and perhaps before a preferred alternative has been selected. Because

more information becomes available about the project as the project

design process progresses, VE studies are much more detailed than

VP studies.6 Value engineering employs many techniques that focus on

quantifying and comparing—it investigates, analyzes, compares, and

selects among various options that will meet the value requirements of

stakeholders.

▫        Value Analysis refers to value techniques that are applied

retrospectively. Value analysis analyzes or audits a project’s performance

by comparing a completed, or nearly completed, design or project against

predetermined objectives. Value analysis studies are normally conducted

during the post-manufacture/construction period, when a project is fully

operational. In addition, the term ‘‘VA’’ can be applied to the analysis of

nonmanufacture/construction-related procedures and processes, such as studies of organizational structure, or procurement procedures.

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Estimating Work Duration

1. Determine the availability of the resources
2. Show the availability as a percentage of the effort required to achieve the work package
3. Duration = (Effort/Productivity)/Availability

▫        If effort is in # of hours, the duration will be in # of hours

▫        To have duration in days, divide the value calculated above by the number of working hours per day

4. Cost = Duration* Unit cost

▫        Cost = (Effort/Productivity ) * Unit cost

▫        Determine duration as per number 3 above

▫        Unit  cost : e.g. $40/hour

Determining Durations of Work packages

•        PERT of each work package:

              

•        PERT of the entire project is the sum of the PERTs of all the activities on the critical path

•        Standard Deviation of a work package:

              

PERT, Sigma and probabilities

•        50% probability that a task’s duration equals its PERT

•        68% probability that a task’s duration is between ( PERT + 1 * Sigma) and (PERT – 1 * sigma)

•        95% probability that a task’s duration is between ( PERT + 2 * Sigma) and (PERT – 2 * sigma)

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Project Needs assessment and prioritizing the Needs

Depending on the project Time, Cost or Quality might have a higher importance

Needs identification is the first stage of the project life cycle.

During the project needs assessment phase, the needs of all project stakeholders must be clearly defined, with no ambiguity. At this juncture, it is not important to determine whether the project can satisfy all these needs, or to worry about the best approaches to meet them. All we are attempting to do during this stage is to identify the various and often-conflicting expectations of the different stakeholders. When the needs of the project are clearly understood and defined, several benefits can accrue:

•        After organization’s needs and requirements are identified and analyzed, SOW (Statement of Work) can be defined. It will then trigger the initiation of a project. The following items should be included in the SOW document

▫        Summary of Work Requested

▫        Major Deliverables

▫        Major Milestones

•        Project costs include:

▫        Direct , indirect

▫        Fixed, variable

▫        Recurring non-recurring

•        Project cost estimates has great value in project cost management; based on the estimates, everything else can be determined

•        The costliest ways to estimate cost is bottom-up, followed by the definitive method

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