Issue link: https://industrialmanagement.epubxp.com/i/656209
march/april 2016 13 three scenarios: worst-case scenario, best-case scenario and a middle scenario representing the average or the likeliest outcome. That would represent 12 analyses. Financial and qualitative analysis: Financial analysis is the main engine of the business case. Unfortunately, KPMG reports that nearly one in three organi- zations do not always define financial benefits in their business cases. The business case should be robust, credible and fit with the organizational approach to decision-making. Where possible, convert qualitative items to quantitative ones. Quantitative analysis methods include payback, net present value (NPV), internal rate of return (IRR) and breakeven. The payback method is quite popular. To illustrate, if an investment of $1,000 yields a cash return of $1,000 in 12 months, the payback period is one year. Its simplicity is attractive. However, this analysis is criticized widely because it assumes that the value of $1,000 Where possible, convert qualitative items to quantitative ones. today is the same as the value of $1,000 one year from now, ignoring the time value of money. NPV provides an improved way of evaluating options. The NPV method properly accounts for the differences in the value of cash over a time horizon by discounting the cash flows. The net present value is determined using the equation NPV(i) in the top right corner of Figure 2, which compares projects B and C. Both have an investment of $1,000, but cash flows vary over a three- year period. Using NPV as the criterion, option B would be selected because it has the highest NPV, or $1,746.06 when compared to the $1,486.85 NPV for option C. A positive NPV project does not guarantee approval, and a negative NPV project does not guarantee rejection. A positive NPV project that is out of step with the organizational strategy or fails to achieve the NPV threshold may not get approved. A negative NPV project that addresses safety concerns mandated by OSHA, for example, may be approved because it is needed to assure business continuity. The rate "i" used in this example often is provided by the organi- zation's finance department in the form of a rate of return that is required for projects, or hurdle rate. Often, it is the weighted average of cost of capital. The IRR method is similar to the NPV method. However, instead of solving for the NPV term, that term is set to zero and the equation is solved for "i." It indicates the rate of return the project would deliver over its life. Figure 2 shows that IRR B (NPV B (0)) is 0.68 and that IRR C (NPV C (0)) is 0.84. If IRR is the criterion, option C would be selected. Breakeven analysis identifies the sales needed to recover the investment. Another option, cost-benefit analysis, compares the cost to the project's benefits. Additionally, other criteria might be unique to the organization. And criteria such as a social good or public benefit might come into play in the public sector or with nonprofits. If credible and acceptable correla- COMPARE AND CONTRAST Figure 2. Which fnancial analysis method your organization prefers could lead to different conclusions when evaluating a project's bottom line. -500 0 500 1000 1500 2000 2500 3000 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 NPV(i) i (rate of return) NPV and IRR Example (0.1) = 1,486.85 : (0.68) = 0 (0.1) = 1,746.06 : (0.84) = 0 () = −$,+ $ ( + ) + $ ( + ) + $, ( + ) () = −$,+ $, ( + ) + $, ( + ) + $, ( + ) B C NPV Equation: