only measure of a project’s worth. Figure 1-10 includes the Of calculation for our example project Determine Break-Even Point Another common approach to measuring a project’s merhew/) is defined as the number of years it takes a firm to recover its original investment in the project from net cash flows. As shown in Figure 1-10, the project’s net cash flows “pay back” the initial investment during the fourth ycar, this is the year in which the cumulative cash flow ligure becomes positive. Dividing the differ ence between that year’s cash flow and its cumulative cash flow by that year’s cash flow determines how far into the year the break-even will occur. See Appendix IA for the break-even calculation The break-even point is casy to calculate and understand and does give an indication of a project’s liquidity or the speed at which the project will gencrate cash returns. Also, projects that produce higher returns early in the project’s life are thought to be less risky, since we can anticipate near-term events with more accu- racy than we can long-term events. The break-even point does ignore cash flows that occur after the break-even point has been reached and therefore is based against long-term projects. Determine Net Present Value The sinuple cash flow method, return on investment, and break-even point, as shown in Figure 1-10, all share the weakness of not recog. nizing the time value of money. In these analyses, the timing of cash flows is ignored. A dollar in ycar 3 of the project is considered equal to a dollar in year 1. Nel present walue (NPV) is used to compare the present value of all cash inflows and outflows for the project in today’s dollar terms. The key to understand- ing present values is to recognize that if you had a dollar today, you could invest it and recive some rate of return on your investment. Therefore, a dollar received in the future is worth less than a dollar received today, since you forgo that potential return. Appendix 1A shows the present value of a dollar received in the future for different numbers of years and rates of return. If you have a friend who owes you a dollar today, but instead gives you that dollar in three years–you’ve been had! Given a 10% rate of return on an investment, you’ll be receiving the equivalent of 75 cents in today’s terms. The basic formula to convert a future cash flow to its present value is shown in Appendix 1A. In Figure 1-11, the present value of the costs and benefits has been calculated and added to our example spreadsheet, using a 6% rate of return. The NPV is simply the difference between the total present value of the benefits and the total present value of the costs. As long as the NPV is greater than zero, the project is considered economically feasible. Organizational Feasibility The final technique used for feasibility analysis is to assess the organizational feasibility of the system: how well the system ultimately will be accepted by its users and incorporated into the ongoing operations of the organization. There are many organizational factors that can have an impact on the project, and scasoned developers know that organizational feasibility can be the most difficult feasibility dimension to assess. In essence, an organizational feasibility analysis attempts to answer the question “If we build it, will they come?”
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