The Financial Soup in Project Management: DCF, EVA, IRR, and NPV
The Financial Soup in Project Management: DCF, EVA, IRR, and NPV
By John C. Goodpasture
Is your project being held hostage to the financial alphabet of the CFO’s office? Is there anything you can do to break it loose and get on with managing the project? Yes, certainly, if you have some understanding and familiarity with the concepts and the ways in which you can influence the outcomes of financial analysis. We are talking about the arcane acronyms of DCF, NPF, EVA, and IRR. The important idea embodied in all of these financial measures is risk management. As project managers, we know a fair amount about risk management. By applying the skills we have and adding a measure of extra knowledge about these risk-adjusted calculations we as project managers can greatly help the CFO and the Controller make good business decisions.
DCF is the root of the system. DCF stands for “discounted cash flow”. Let’s start with the easy stuff: cash. Cash in business is the actual monies paid out for salaries, supplies, materials, vendors, and the like. Cash is the monies received in revenues and monies saved in reduced cash expenses like labor and materials and so forth. Flow refers to the difference of cash on-hand at the beginning and end of an accounting period. There are sources of cash and uses of cash. These must balance: for every use there must be a source.
Discount is where the risk management comes in. Discount is the factor applied to cash uses and sources to account for the risk that these cash items may not actually happen as planned. Risks include: inflation, interest rates on borrowed money, returns demanded by equity investors, market changes, customer credit performance or insolvency, vendor performance or insolvency, project performance [late or over budget], regulatory risks, and perhaps other project risks.
By applying a discount to cash estimates to be paid out in the future or received in the future, the CFO hedges the investment bet on the project. Thus, DCF is not a simple interest rate; DCF may be different for different projects in the same company, or for the same project in a different time frame. Typical discount rates may range from about 4% to 15% or more for risky projects.
NPV is the net present value of all the cash, paid out or paid in, resulting from the project, accounting for risk. That is: the net of the present value is the net of the paid out and the paid in cash, and the present value is the cash face value with the discount applied.
So for example, if the discount rate is 8%, then the present value of $1000 expected one year from now is = $1000 / (1 + 0.08), or $1000 * 0.9259, or $925.90.
In effect, the CFO would be happy with $925.90 right now versus the opportunity to wait one year for $1000.
Here’s how this works for your project. Supposing you require $100,000 today to do your project. That is cash paid out. You and your marketing team expect a payback of $200,000 two years from now. The CFO believes the risk of actually getting the $200,000 should be represented by discounting the possibility by 8% each year.
In present value, how much is the $200,000 worth?
Answer: $200,000 / [(1 + .08) * (1 + .08)].
Running the math through the answer is: $171,468. The NPV = -$100,000 [cash paid out] + $171,468 [risk-adjusted value of cash paid in] = $71,468.
Suppose there is another project with the same cash possibilities, but less risky, say only a 5% discount: the resulting NPV is $81,406. If the business can only do one project, yours may not be selected!
Here’s an important point: in some situations where the cash benefits of the project are close to the investment cost, the NPV could actually be negative. Such an outcome would mean that more cash is paid out than is paid in, and the cash flow is unfavorable as a consequence of doing the project. In that case, the project will not be approved even if there is not an alternative and competing project!
Obviously, to save your project and get it rolling, your job is to work with the CFO to understand and allay the risks so that the discount rate is more favorable.
What if the CFO comes at you with EVA instead of NPV? Now what? EVA is economic value added. It also is a concept of risk-adjusted financial measurement, but instead of looking at the cash paid out and paid in, EVA focuses on the profits of the business, specifically the profit after tax [PAT].
The idea is this: if your project is going to tie up $100,000, then that $100,000 is not available to invest and earn elsewhere. The CFO could take the $100,000 and fund another project or buy a bond or something if the $100,000 did not go into your project. Therefore your project should earn more in profit than the $100,000 would earn elsewhere. The elsewhere earnings are an opportunity cost, though such costs do not show up on the P&L of the business. If your project cannot earn profits in excess of the opportunity cost, then don’t do the project and invest the $100,000 in a more profitable venture. The difference in the two earning possibilities is the EVA.
Where does the risk come in? Well, the two earning possibilities have to be evaluated in the same time frame else they might have different risks. Thus, earnings are discounted so that their present value is obtained. Again, you have an opportunity to influence the risks. After all, you will not get to do your project if the EVA is less than zero!
Which is the more favorable evaluation, given a risk discount factor, EVA or NPV? Actually neither. They are both exactly the same under the following conditions: when accounting profits [after tax] that show up on the P&L are recalculated to find cash profits, and these cash profits are discounted by the same factor as the cash flow, the resulting NPV of the cash profits will exactly equal the EVA. Cash profits defined as described are often referred to as the net cash flow, NCF.
What are accounting profits and how are they different from cash profits? One recalls the ditty: Cash is a fact but profits are an opinion reflecting the fact that profits are a combination of cash earnings and earnings generated by the favorable tax savings of depreciation and other non-cash entries on the P&L. What entries can be put on the P&L that are not cash is in the opinion of the accountants, though compliance to the Generally Accepted Accounting Practices [GAAP] is required. Depreciation is not cash because it is just an accounting adjustment of earnings for cash paid earlier for capital purchases.
Is there a limit to the discount factor that makes sense for these risk adjustments, whether EVA or NPV? Actually, yes, that limit is called the IRR. IRR is internal rate of return. It is the maximum discount rate that can be applied and have the NPV or EVA be positive. Precisely, the IRR is the discount rate that exactly makes the NPV or EVA equal $0.
So, to sum it all up: the alphabet soup of the CFO is all about risk management. Although the Controller runs the numbers and sets the discount rate, in point of fact most of the data in the calculations comes from the project management team. The project manager has an opportunity to influence these analyses and make their project a go!
John C. Goodpasture, PMP and Managing Principal at Square Peg Consulting, is a program manager, coach, author, and instructor specializing in technology projects and risk management. He is the author of several books, articles, and training courses in the field of project management. He blogs at johngoodpasture.com, and his work products are found in the library at www.sqpegconsulting.com, and at www.slideshare.net/jgoodpas. His full profile is at www.linkedin.com/in/johngoodpasture
Mr. Goodpasture’s most recent book is “Project Management the Agile Way: making it work in the enterprise”, published in January, 2010. Other books include: “Managing projects for value” and “Quantitative Methods in Project Management”.
