NPV, IRR and payback

0:00Sara: Welcome to Project Management Exam Prep.

0:02This episode is about NPV, IRR and payback: the net present value,

0:08the internal rate of return and the payback period.

0:11Leo: They judge whether a project is worth its money, and every project management exam

0:16can ask about them. You will learn to discount, what each measure tells you,

0:21and where each one misleads. Keep a pen and a calculator ready for the drill.

0:27Sara: Let us start with the three lenses. What does IPMA® say?

0:31Leo: IPMA®, the International Project Management Association, sets out its standard in

0:36the Individual Competence Baseline, the ICB4.

0:41These methods have no element of their own.

0:43Its strategy element asks you to build the project's justification,

0:48sell it to the sponsors, and keep checking it.

0:51Its finance element lists return on investment and rates of return as things to

0:56know.

0:57Sara: And PMI®?

0:57Leo: PMI®, the Project Management Institute, publishes the PMBOK® Guide,

1:04its guide to the project management body of knowledge.

1:07In the eighth edition, the finance performance domain measures value with the IRR

1:13and payback, and checks it with the NPV.

1:16The outline of PMI®'s Project Management Professional exam, the PMP®,

1:22asks you to check business value throughout the project.

1:25Sara: And APM?

1:28Leo: APM, the Association for Project Management, publishes the APM Body of Knowledge.

1:34It calls this investment appraisal, and sets the NPV against the cost of capital

1:40or a hurdle rate. The syllabus of APM's Project Management Qualification,

1:46the PMQ, covers the business case but names no formula.

1:50So PMQ candidates need the purpose more than the arithmetic.

1:55Sara: Where do the words differ?

1:57Leo: In two places. First, the document. PMI® and APM say business case;

2:03the ICB4 says business or organisational justification.

2:08Sara: Second?

2:10Leo: Value beyond money. APM names net present social value, which also counts social

2:15benefits. PMI® says value can be social or environmental.

2:21Sara: What is the core, whichever exam you take?

2:24Leo: Three ideas. One: a euro in hand now is worth more than one next year,

2:30because it can earn interest meanwhile.

2:33So you discount future cash to today's money.

2:36Sara: At what rate?

2:38Leo: The one Finance sets: the cost of capital, or a hurdle rate, the lowest return the

2:44organisation accepts. Chan Park's engineering economics textbook notes that public

2:49bodies often use a lower rate, near government borrowing.

2:53State the rate, and show what a higher one does.

2:56Sara: Two?

2:57Leo: Each measure answers one question. Payback: how long is money at risk?

3:04NPV: how much value is added? IRR: what return is earned?

3:09Sara: And three?

3:10Leo: Numbers inform a decision; they do not make it.

3:15List the benefits you cannot price beside the NPV, and test what could change the

3:19answer.

3:20Sara: And in agile work?

3:22Leo: Iterative delivery can bring benefits forward, and an earlier saving is worth more.

3:27So teams order the backlog by value.

3:30Sara: Now the methods. The two model sheets, free in the description,

3:34work one example.

3:35Leo: A project costs two hundred thousand euros now, and saves eighty thousand a year

3:39for three years. When is the money back?

3:43Add the cash flows until the running total reaches zero.

3:45After two years, you are still forty thousand short.

3:49Year three brings eighty, so you break even halfway through it.

3:53The simple payback is two and a half years.

3:56Sara: What does it miss?

3:57Leo: Later euros count like today's, and nothing after payback counts at all.

4:02So discount. To get a year's discount factor, raise one plus the rate to the number

4:08of years, and divide one by the result.

4:10At five percent, year one's factor is zero point nine five two.

4:16Year two's is zero point nine zero seven.

4:19Year three's is zero point eight six four.

4:22Sara: And the net present value?

4:25Leo: Multiply each saving by its factor. In thousands, that gives seventy-six,

4:30seventy-three and sixty-nine. Together, two hundred and eighteen.

4:34Minus the two hundred invested, the NPV is plus eighteen thousand euros.

4:40Undiscounted, it looked like forty.

4:42Sara: And the rule?

4:43Leo: Accept a positive NPV: the project earns more than the rate.

4:48Reject a negative one. Among options for the same job, take the highest.

4:53Discounted payback runs the total on present values: about two point seven years,

4:58always later.

5:00Sara: Now the internal rate of return.

5:02Leo: The IRR is the rate that turns the NPV to zero: the project's own return.

5:08Find it by trial, or with a spreadsheet.

5:12At five percent, our NPV is plus eighteen thousand.

5:16At ten percent, it is minus one thousand.

5:19So the IRR is just under ten: about nine point seven percent.

5:24If it beats the hurdle rate, the project passes.

5:28Sara: So a higher IRR is always better?

5:32Leo: No. There are two traps. First, size. Invest twenty thousand,

5:37and get thirty thousand back a year later.

5:40That IRR is fifty percent, but the NPV is only about nine thousand,

5:45half of ours. To choose between options, use the NPV.

5:50Sara: Second?

5:51Leo: Signs. The IRR expects money out, then money in.

5:56A large cost later, such as replacing a system, changes the sign twice.

6:01Park shows that there can then be two IRRs, and neither is a reliable guide.

6:07Sara: What else does the sponsor need?

6:09Leo: The sensitivity. The savings could fall by only about eight percent before the NPV

6:15reaches zero. At ten percent, it is already negative.

6:19Say both.

6:20Sara: How does this change between Mid-level and Senior?

6:24Leo: First, the two levels. They are this series' own labels.

6:28Mid-level means leading moderately complex projects, the level of IPMA® Level C and

6:34PMI®'s PMP® exam. Senior means leading complex projects and people,

6:40the level of IPMA® Level B and of APM's chartered status, Chartered Project Professional.

6:47At Mid-level, you run the numbers and explain them.

6:50Take Parking Permits Online, a city project that moves resident parking permits

6:55online in eight months. The project manager, Anna, sets its cost of six hundred

7:00and forty thousand euros against four years of savings.

7:04At five percent, the NPV is about one hundred and forty thousand.

7:08She shows the steering group that it stays positive unless the savings fall by about

7:13eighteen percent.

7:15Sara: And at Senior level?

7:17Leo: You design the appraisal others work in.

7:20Take One City Account, a thirty-month city project that brings fourteen online services

7:26under one login, led by Anna some years later.

7:31The chief financial officer sets one rate for all.

7:35Each service owner signs up to its own savings, since Robert Buttrick,

7:39in his book The Project Workout, warns that projects can claim the same benefit

7:44twice. The board checks the case before releasing each phase's funds.

7:50Sara: Now the drill. A city has moved resident parking permits online,

7:55and wardens check them by licence plate.

7:58To speed up the checks, it will buy one of two tools.

8:01A scan car that reads plates costs one hundred and twenty thousand euros,

8:06and saves fifty thousand a year. An app for the wardens' handhelds costs fifteen

8:11thousand, and saves ten thousand a year.

8:14Both do the same job for four years. At five percent, the four discount factors

8:19add up to three point five four six. The finance controller prefers the app:

8:24it pays back sooner. What do you recommend?

8:27Leo: Pause and write your answer. You have forty-five seconds.

9:16Sara: First, payback.

9:18Leo: The car: one hundred and twenty over fifty, two point four years.

9:22The app: fifteen over ten, one and a half.

9:26Sara: And the NPV?

9:28Leo: Use a shortcut. The saving is the same each year, so fifty times each factor,

9:32added up, is fifty times their sum. For the car, fifty times three point five four

9:39six is about one hundred and seventy-seven.

9:42Minus one hundred and twenty: plus fifty-seven thousand.

9:45For the app, ten times the sum, minus fifteen: plus twenty and a half thousand.

9:51Recommend the car: it adds about thirty-seven thousand more.

9:55Payback ignores later years.

9:57Sara: What lifts that to Senior?

9:59Leo: Thirty-seven thousand, divided by three point five four six, is about ten thousand

10:05a year. So the car stays ahead while its savings stay above about forty thousand,

10:12a fall of a fifth. The head of parking services must own it.

10:17The car also risks eight times as much money: agree the city's tolerance with the

10:22sponsor. Weigh emissions too, and involve the wardens' supervisors.

10:27Then the steering group decides.

10:30Sara: How do the exams ask this?

10:32Leo: IPMA®'s exams ask for open answers. IPMA®'s certification also includes an interview,

10:38where assessors ask about your own projects: note one investment you helped justify.

10:45The PMP® exam uses scenarios, and questions built on a case study or a chart.

10:51APM's PMQ asks for short written answers, often on purpose: why are future benefits

10:57discounted?

10:58Sara: Let us recap.

11:00Leo: One. A euro later is worth less than a euro now: discount at Finance's rate.

11:06Sara: Two. NPV: present values minus the investment.

11:11Accept it above zero; for one job, take the highest.

11:15Leo: Three. The IRR turns the NPV to zero. It ignores size, and misleads when signs change

11:23twice.

11:24Sara: Four. Payback shows how long money is at risk, and ignores what follows.

11:29Leo: Five. Show the value you cannot price, and test what would flip the answer.

11:34Sara: The model sheet on NPV and IRR is free in the description.

11:40Leo: So are the payback sheet and the study handout.

11:43Next time: quality tools.