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Project Return Forecasting

This one is really fantastic because it looks into forecasting and maybe figuring out whether we want to spend money on a particular project or on another particular project. It really gets into into the meat of it before you kick off or initiate your project, and that’s what makes it really really great to learn about and to know about these forecasting techniques.

Using Future Value, Net Present Value, and Internal Rate of Return

For your project returns, there are many different ways to forecast these these things and as you initiate your project you may need to show your stakeholders the potential benefit that might come out of your project or what you’re going to deliver. Are you delivering a million dollars, or is it something else in benefit – maybe it’s customer value or customer goodwill as some soft benefits. Or is it some amount of value over time, potentially every month or every year for example.

To do this there are three common methods of forecasting that you will see on the PMP exam and in your project management career as well. You’ve got Future Value (FV) where we’re looking at what the value of a dollar today is in the future. Net Present Value (NPV where we’re looking at what the total outcome of our project three years into the future is, what that’s actually worth today. And our Internal Rate of Return (IRR), where if we’re delivering a million dollars over three years, what’s the actual percentage return in today’s figures?

For all of these on your PMP exam you really just need to choose the highest for each of them – so Net Present Value if you’ve got a choice between a hundred thousand dollars and a hundred and twenty thousand dollars, you choose the hundred and twenty thousand dollar one. It’s the same with Future Value – choose the highest future value, and choose the highest percentage for your Internal Rate of Return.

We’re also going to show you how to calculate these, just so know them, and it’s a little bit of fun as well.

Future Value

Future value asks “What would our money be based on a certain rate of return?” For example an interest rate, if we’re earning five percent a year or ten percent a year, in this example our future value equals our current (present) value multiplied by 1 plus our interest rate (so 1 plus 0.10 for example so it ends up as 1.10) to the power of the time – so in this case we’ve got three years. Let’s look at this example.

The value of a thousand dollars, in three years time, at ten percent interest.

We’ve got a thousand dollars, times 1.1 – so 10 percent (0.10) is our interest plus 1, to the power of 3. “To the power of” means 1.1 times 1.1 times 1.1, that’s three times we multiply those by each other. And that ends up to be 1.331 when you multiply all of those together. So we end up with a thousand times 1.331 and that gives us our future value of 1331. That’s how we figure out the future value at a certain rate of return.

Let’s say our project is going to give us a return of 10 per year, that’s very promising and that’s our potential return. We can do this the other way as well. We could say if we’ve got 1331 dollars in the future, and we want to figure out what that’s worth today then we actually just use divide instead of multiplication. So we just we go 1331 divided by 1.331 or our 1.1 times 1.1 times 1.1, and that will give us a thousand dollars in today’s value. So that’s how we do that looking backwards, and that’s important because that’s what we’re going to use for our Net Present Value.

Net Present Value

Now you might see this come up in financial accounting and statistics and that sort of thing, it’s a really cool technique to figure out what the project returns would be worth today, versus a certain rate of return and the future cash flows that we’re going to get out of our project.

Net present value equals the cash flow of year 1, divided by 1 plus our internal rate of return (which is our interest rate) and again, this is sort of foreshadowing for our next one which is the internal rate of return, but let’s say it is in this case 10 percent again. So it’s a 0.10, and we’ve got 1.1 again. So looking at the example we’ve got cash flow in year one or month one or whatever the the actual time frame is (it’s your choice), we’ve got $500 and we’re dividing that (now we’re looking backwards) instead of multiplying it, so we divide it by 1.10 and that gives us 454.

Great! Very easy. Now we’ve got our second year, or our second month or our second day, with $500 again. Now we divide that by 1.10 to the power of 2, so it’s 1.10 times 1.10 which equals 1.21. Then 500 divided by 1.21 gives us 413, and so on and so on, to the power of 3, to the power of 4, to the power of five – you could do as many of these as you see fit. You add them all together and then you minus the initial investment (we invested a thousand dollars into this project) because that’s a cost to us, it’s not a benefit that we’re getting. And all in all we get 243 dollars.

Now of course in the real world this might be 243,000 dollars, or 243 million dollars. Whatever size project you’re working with, or if it’s a personal project maybe it is 243 and that’s wonderful. But any positive return, that’s what we’re looking for, and the higher the better as we said.

Internal Rate of Return

Which brings us to the Internal Rate of Return. The Internal Rate of Return naturally flows here because we’re using the Net Present Value again, except what we’re doing now is we’re trying to figure out what that Internal Rate of Return is. It’s that interest rate we’re trying to figure out, usually through trial and error. So basically we have to figure out what that rate of return is, and we go up a little bit, down a little bit until we get to the stage where it’s the percentage that makes our Net Present Value equal zero, or as close to zero as we possibly can.

So again, the higher the Internal Rate of Return the better. Let’s go through an example just so it’s not too confusing. The initial outlay for our project is a thousand dollars, and we send that out to create our project – that’s our cost, so minus a thousand dollars. And then what we’re doing is we’re adding all of the benefits to that over time, so in this case we’ve got 400 cash flow, 400 cash flow, 400 cash flow coming in for each time period – let’s just call it every year. Let’s say we’ve got three years and each of those years we’ve got 400 coming in.

Now remember we’re doing that “dividing” instead of multiplying, because we’re trying to figure out the current value of these future cash flows. So using that dividing instead of multiplication. Let’s go through it. We’ve got 400 divided by 1.10 – we’re going to have a guess and say 10 percent is our is our interest rate – and that gives us 363. Now 1.1 to the power of 2 (so 1.1 times 1.1) equals 1.21, so 400 divided by 1.21 is 330. And so on and so on – again we could do this for as many time periods as we want – and then the next one to the power of three for our third year gives us 300.

So minus a thousand, then we’re adding 363, adding 330, and adding 300, and that gives us 993 which is just shy of a thousand so that’s that’s really close now we could fiddle around with this a little bit if we wanted to, we could say maybe it’s going to be a higher percentage maybe it’s 1.11 maybe it’s 1.12, or maybe we go the other way and we try and figure out which way do we need to go to get the closest percentage, to get it as close to 0 or just above as possible.

And that is our internal rate of return, remembering that when you get the question on the exam you might have three projects, one with an internal rate of return of 10 percent one with 12 and one with 15 percent, and for our purposes we want to choose the highest internal rate of return.

And these are all of the forecasting project return techniques that you will see on your exam and in your project management career.

– David McLachlan

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