Page 47 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes however, cash flows will become positive. The project is acceptable if the sum of the net
present values of all estimated cash flows over the life of the project is positive. A simple
example will suffice. Using our $100,000 investment with a net cash inflow of $25,000 per
year for a period of eight years, a required rate of return of 15 percent, and an inflation rate
of 3 percent per year, we have.
Because the present value of the inflows is greater than the present value of the outflow—
that is, the net present value is positive—the project is deemed acceptable.

Example: PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked pots and other
cracked items, is considering the installation of a new marketing software package that will, it
is hoped, allow more accurate sales information concerning the inventory, sales, and deliveries
of its pots as well as its vases designed to hold artificial flowers.
The Information Systems (IS) department has submitted a project proposal that estimates
the investment requirements as follows: an initial investment of $125,000 to be paid up-
front to the Pottery Software.
Corporation, an additional investment of $100,000 to modify and install the software; and
another $90,000 to integrate the new software into the overall information system. Delivery
and installation is estimated to take one year; integrating the entire system should require
an additional year.
Thereafter, the IS department predicts that scheduled software updates will require further
expenditures of about $15,000 every second year, beginning in the fourth year. They will
not, however, update the software in the last year of its expected useful life.
The project schedule calls for benefits to begin in the third year, and to be upto a particular
speed by the end of that year. Projected additional profits resulting from better and more
timely sales information are estimated to be $50,000 in the first year of operation and are
expected to peak at $120,000 in the second year of operation.
Project life is expected to be 10 years from project inception, at which time the proposed
system will be obsolete for this division and will have to be replaced. It is estimated,
however, that the software can be sold to a smaller division of PsychoCeramic Sciences,
Inc. (PSI) and will thus, have a salvage value of $35,000. The Company has a 12 percent
hurdle rate for capital investments and expects the rate of inflation to be about 3 percent
over the life of the project. Assuming that the initial expenditure occurs at the beginning
of the year and that all other receipts and expenditures occur as lump sums at the end of the
year, we can prepare the Net Present Value analysis for the project.

The Net Present Value of the project is positive and, thus, the project can be accepted. (The
project would have been rejected if the hurdle rate were 14 percent.) Just for the intellectual
exercise, note that the total inflow for the project is $759,000, or $75,900 per year on
average for the 10 year project. The required investment is $315,000 (ignoring the biennial
overhaul charges). Assuming 10 year, straight line depreciation, or $31,500 per year, the
payback period would be: A project with this payback period would probably be considered
quite desirable.
4. Internal Rate of Return (IRR): If we have a set of expected cash inflows and cash outflows,
the internal rate of return is the discount rate that equates the present values of the two sets
of flows. If At is an expected cash outflow in the period t and Rt is the expected inflow for
the period t, the internal rate of return is the value of k that satisfies the following equation
(note that the A 0 will be positive in this formulation of the problem). The value of k is
found by trial and error.

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