The decision to spend some amount of money on something precedes any project or program. Given the expectation of a return on the investment, managers need to be knowledgeable about financial strategies and techniques. Here are the three most important financial concepts.
The 3 basic concepts are Internal Rate of Return (IRR), Net Present Value (NPV), and Sunk Costs. Let’s take a look at each.
Internal rate of return (IRR)
Internal rate of return (IRR) is an average rate of return of all the cash flows resulting from a project over time. The IRR, or internal rate of return, can be illustrated by example. A rate of 10% could reflect the ROI, or return on investment, as represented by discounted cash flows over the years. In other words, the IRR for the investment is the discount rate that makes the NPV, or net present value, of the cash flows total to zero.
A project is a good potential investment if its IRR is exceeds the rate of return that could be earned by alternate investments of equal risk. Thus, the IRR should be compared to any alternate rates of return, adjsuted for risk. The challenge for any project is clearly understanding and accurately quantifying the risks.
Net Present Value (NPV)
Net present value is a similar concept, but the metric is monetary value, not a rate. Like IRR, it looks at the cash flows over time, derived from estimates of capital expenditures, costs and revenues over a period of time during which the product of the project will have an impact on operations.
Projects that have a higher NPV produce a greater positive cash flow, and thus create more value. It is important to estimate our cash flows as accurately as possible and then to monitor closely after the project has been implemented.
It is vital to note that majority of project decisions are anchored on their possible future outcome. These forward looking criteria are based on the delta cash flow resulting from the project over time.
Sunk costs, as the name implies, are gone and cannot be recovered. They represent money spent that is irretrievable. Many people either misunderstand or have an emotional attachment to money that was spent. As project managers, this is a challenge that we must recognize and learn to overcome. Here is an example.
In a changing economic environment, we often find that the original justification for a project changes. In this example, original calculations might show that investing $1,000,000 in new plant facilities could annually generate an additional $250,000 in cash flow. This may have been an attractive project at the time, but maybe that anticipated increased cash flow is now only $100,000. Perhaps $600,000 has already been expended on this additional plant capability, and if we stop now, no increased cash flow will be achieved. However, if the final $400,000 is spent, the $100,000 of additional cash flow will be achieved. While a 10% return on the full $1 million might be a very marginal investment, this is irrelevant at this point, since the first $600,000 is a “sunk cost”. The real metric of interest is the expected 25% return of $100,000 on the remaining $400,000 investment. It is important to distinguish the sunk costs and to realistically really look at what can be achieved going forward.
Using Financial Metrics as a Project Manager
As project and program managers, we always need to be forward looking. In looking at something like sunk costs, we need to leave them behind and look at future costs as well as future revenues. We need to look at future cash flows. Projects and programs are always forward looking. The best time to look back into the past is to recognize what lessons have been learned along the way. We need to be disciplined enough to be forward looking and we need to have the leadership skills to articulate what sunk costs are and to differentiate between sunk costs and costs going forward. Also, unlike financial managers, project managers need to look at the future (ignoring sunk costs) project cash flows and expected returns, assess risks, and develop risk mitigation plans, should things change. Understanding all of the financial metrics is one input to executing that project management responsibility effectively.