Risk Assessment: Discounted Cash Flow

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Risk Assessment Discounted Cash Flow

• COMM80 Risk Assessment of Systems Change
• Unit 8

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Objectives of Session Coverage

• Be able to describe cost benefit analysis
• Know how it is calculated for ERP systems change
• Appreciate the difference between CBA and DCF
• Be able to apply the DCF formula to calculate
  present value
• Be able to apply DCF to find the Net Present
  Value for a project
• Be able to assess the viability of a project from
  the NPV
• Be able to conduct a sensitivity analysis for a
  what-if scenario analysis

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5 basic elements of a cost benefit analysis

• Project definition and identification
• Complete enumeration of the consequences of going
  ahead with the project
• Aggregation of consequences at each time period
  in the projects life to get time series for
  project costs and benefits
• Aggregation of the cost and benefit streams over
  time to get a figure for the projects net
  present value
• Sensitivity analysis

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Aggregation stage

• Uses prices to aggregate over the desirable
  consequences (e.g.more apples available) to get
  the benefits series B0...BT
• Uses prices to aggregate over the undesirable
  consequences (e.g. more sulphur emissions) to get
  the C0....CT series.

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Enumeration stage

• This involves the physical consequences of the
  project
• its output is in terms of
• hours of labour,
• hardware costs,
• inventory costs,
• cost of new staff
• At this provided for each date from 0 through to
  T.
• N.B. May be difficult to put a value on people
  factors e.g. motivation - but some financial
  equivalence is needed if the approach is to be
  used.

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Discounting the future

• Money invested today in a project is worth less
  in the future because of losses due to the
  interest rate ( discount rate)

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Achieving a Net Present Value Requires

• Aggregation of consequences at each time period
  in the projects life to get time series for
  project costs and benefit.
• Aggregation of the cost and benefit streams over
  time to get a figure for the projects net
  present value.
• Sensitivity analysis.

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Discounted Cash Flow

• Discounting is the process of transforming future
  money sums into their equivalent present values.
• Similar to cost benefit analysis but the costs
  and benefits are converted into an income stream.
• The calculation looks complicated but is easier
  understood when set out in a spreadsheet.

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Example formula for calculating present value
Present value after 2 years Present value
Future value (100discount rate)2 The
formula for Present value after n years (where
n can take any value 0, 1, 2, .) is Present
value Future value((100discount
rate)/100)-n An example of the equivalent
formula in the Excel spreadsheet is Present
ValueE27((100B19)/100)-A27 Where Cell E27
holds the value of Future value Cell B19 holds
the value for the discount rate Cell A27 holds
the value of the number of years considered (n)
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Mathematical expression to calculate Net Present
Value (NPV)
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Spreadsheet model assumptions

• The first part of the spreadsheet shows the
  assumptions made.
• The analysis part contains the formulae to
  calculate the net cash flow for each year of the
  project and the present value for each year.

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Assumptions Benefits
(ERP cost benefit analysis)
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Assumptions Costs
(ERP Cost benefit analysis)
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Analysis Component of the spreadsheet

• This contains the formulae to calculate
• the net cash flow for each year of the project
  and
• the present value for each year

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Sensitivity analysis

• In the given example a positive NPV makes project
  viable.
• Altering different variables one at a time will
  show which variables the project is sensitive to.
• i.e. small changes in one variable affect NPV
  significantly.

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Activities and Thoughts

• Using the spreadsheet provided do the tutorial to
  practise the technique.
• Can you create a similar spreadsheet for a
  systems purchase in your workplace?
• What would the relevant variables be?
• How does this approach help in the consideration
  of the riskiness of a project?