Calculate return on investment and net present value for project alternatives. ROI and NPV are tools that project leaders should use to understand the financial implications of project options. Financial analysis of projects using ROI and NPV can enable improved decision making and higher value results.
- Project leaders need to understand the cost and benefits when they're investigating their options. In this movie, we'll look at the two most common methods for analyzing the financial benefits of a proposed solution. The two approaches to financial analysis that are used most often are net present value, NPV, and return on investment, ROI. What's useful about the NPV is that you end up with one number. If the number is positive, that's good, you'll make money, and the bigger the number is, the more money you'll make.
Calculate the NPV by figuring out how much the project would cost each year, how much it would earn each year, and what you expect the inflation rate will be, or in more technical terms, NPV adds up discounted cash flows over the life of the project. By adding each years value together while adjusting for inflation, you estimate how much the project is worth in today's money, the net, or total present value.
Since NPV calculates the value of the project as a monetary value, the higher the NPV is for an option, the more beneficial the project, and the stronger the argument for choosing that option. Let's look at how this is helpful for H+ Sport. They have several options on the table, such as building a new distribution center, eliminating online ordering, and reducing the number of customers they serve. How in the world would you choose? Well, we can do an NPV analysis on each of these alternatives to better understand the financial impact they would have on the business.
The option that has the biggest, positive NPV is the one that would be the most profitable in the long run. By doing an NPV analysis on each of the options that you're considering, you can do an apples to apples comparison of their value, no matter how different the details of those options are. The other common approach to financial analysis of projects is return on investment, or ROI. ROI compares the amount that a project would earn to the amount that a project would cost, and gives a percentage increase in value.
A project with a positive ROI will be profitable, and a project with a negative ROI will lose money. The higher the ROI, the more attractive the project. Since money isn't free, companies often decide whether to invest in a project based on how much interest they have to pay on a loan. This is called the cost of capital, or the hurdle rate. So, if a company uses a hurdle rate of 15%, then a project needs to have an ROI of at least 15% to be considered beneficial.
Any amount above 15% would be profit. Okay, this is a high level introduction to the two most common approaches to financial analysis. While the concepts are straight forward, gathering the numbers and calculating the values can be challenging, so this is an area where you can definitely benefit from having the help of an economist and an accountant. If you want a deeper dive into doing the NPV or ROI calculations yourself, there's a lot more to know and you can find some excellent lessons in Rudolph Rosenberg's course, Making Investment Decisions.
Understanding the financial aspects of the options you're considering is an important part of being a project leader. Knowing the total value and the relative benefits of each alternative will make it much easier for you and your team to make thoughtful decisions about the costs and benefits of your project.
- Name who is responsible for approving the resources for the project.
- Recall what the spine of a fishbone diagram represents.
- List characteristics of the environment.
- Identify the tools used for mapping processes.
- Recognize what needs to be captured on the action item list.
- Recall what project metrics should be related to.