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Project Management Professional Certification
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Management Accounting Foundation
Project management common practice borrows heavily from the best practices of management accounting and business administration. Project capital budgeting tools and their associated financial analysis techniques are important success factors for competent project managers and business analysts. Project managers and business analysts support effective strategic decision making by applying project capital budgeting tools as project selection criteria. Bad projects can be stopped before they start, and good projects can be funded at levels appropriate to their strategic value. Project capital budgeting is a key component of project opportunity assessment. It integrates relevant enterprise environmental factors before one or more projects are initiated. Stakeholders have the greatest influence on the outcome of the project at this point in the project life cycle.
Additional Reading MaterialAdditional reading material on project capital budgeting may be found on the D. Hughes & Co. PMP exam study materials Web page. The books by Horngren and Silbiger are particularly good. If you are interested specifically in the systems approach to project management, please consult the Kerzner text. You should focus on chapter 14, sections 21 through 28. Section 29 contains cost management study tips for the PMP certification exam.
Time Value of MoneyProject selection decision making using project capital budgeting tools is based to a large extent on the concept of the time value of money (TVM). In simplest terms, this concept applies a rate of return generating compound interest against an amount of money known as the principal. TVM can flow forward with the arrow of time, meaning that value is accumulated from the present into the future. Alternatively, TVM can flow backward against the arrow of time, meaning that value is discounted from the future back to the present.
The formula which predicts the TVM for any particular period of time in either direction is given below.
If the period is a positive number, TVM flows forward with the arrow of time, yielding an accumulated value factor. For example, given a rate of return of 6% and a target period of five years, the accumulation factor is (1.0 + 0.06) to the fifth power, or 1.33823. For a principal amount of $1,000.00, the accumulated value at the end of the fifth year will be $1,338.23, based on compound interest over the period. In other words, if $1,000.00 were invested today at 6% compound interest per year, the principal amount would grow to $1,338.23 over five years.
If the period is a negative number, TVM flows backward against the arrow of time, yielding a discount value factor. For example, given a rate of return of 6% and a target period of five years, the discount factor (also known as the present value factor) is (1.0 + 0.06) to the negative fifth power, or 0.74726. For a target amount of $1,000.00 at the end of five years, the discounted value today will be $747.26, based on compound interest over the period. In other words, if $1,000.00 are required at the end of a five-year period with compound annual interest at 6%, a principal amount of $747.26 must be invested today.
The figure, below, illustrates a five-year window for both accumulated and discounted values for $1,000.00 at a compound rate of 10%.
Download a working Excel time value of money spreadsheet. Download a printable PDF version of the time value of money spreadsheet.
Present Value TableA present value table is a tool for use in opportunity assessment. Candidate projects are likely to vary with respect to cash flow periods. Present value tables normalize the basis of financial comparison, enabling the construction of discounted cash flow (DCF) models which reduce the effect of personal bias and increase the likelihood of rational decision making.
The figure, below, illustrates a five-year window for discounted values for a target amount of $1,000.00 at a compound rate of 10%.
Download a working Excel present value table spreadsheet. Download a printable PDF version of the present value table spreadsheet.
Project Capital Budgeting ToolsThe most common project capital budgeting tools are:
Net Present Value - Abbreviated NPV. A discounted-cash-flow approach to capital budgeting that computes the present value of all expected future cash flows using a minimum acceptable rate of return (MARR).
Internal Rate of Return - Abbreviated IRR. A derivative of NPV which represents the rate at which the discounted cash flows in the future equal the value of the investment today. In other words, the IRR is the rate-point at which the NPV = 0. Tip: The IRR is defined if and only if cash flows over the entire period pass from negative (net outflow) to positive (net inflow). An undefined IRR is a valid result.
Return on Investment - Abbreviated ROI. A measure of income or profit divided by the investment required to obtain it. Within DCF modeling, ROI is a ratio of total discounted profit to the absolute value of total discounted costs. When performing opportunity assessment, "profit" is the estimated return on a project based on the total discounted benefits minus the absolute value of the total discounted costs.
Payback - No abbreviation. The time it will take to recoup, in the form of benefits (cash inflows), the initial money invested in a project. Payback modeling is independent of the time value of money.
Discounted Cash Flow ModelingFor DCF modeling, the critical variable is the minimum acceptable rate of return (MARR), also known as the discount rate or the hurdle rate. In management accounting circles, the MARR is called the required rate of return. For managers performing opportunity assessment, the primary danger is specifying an MARR which is unstable. Tip: When evaluating projects, it is an error to set the MARR equal to the cost of borrowing money. Discussion: The formal definition of MARR bases the rate on an enterprise's cost of capital. However, this is a capital budgeting concern based on an assumption about the stability of the cost of capital. Seldom are individual project estimates this stable. Therefore, managers must use a rate commensurate with the risk of each particular project.
The figure, below, illustrates a five-year window for a proposed project with an estimated cash flow of $7,000.00. All of the most common financial analysis tools used in project capital budgeting are applied.
Download a working Excel financial analysis spreadsheet. Download a printable PDF version of the financial analysis spreadsheet.
Enterprise Environmental Factor IntegrationNo single technique is sufficient for rational decision making in project capital budgeting. Experienced managers combine these techniques with other qualitative attributes derived from enterprise environmental factors. The combination is built into a weighted scoring model which is then used to assist in the making of a decision. Ultimately, expert judgment is the determining factor.
Learn MoreTo learn more about project capital budgeting tools and techniques, just click the orange send-an-email icon at the top of this page.
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