MODULE OF PROJECT MANAGEMENT

Lecturer: Dr. MUHIRE Simon Charles, PhD.

Email: muhicharles02@yahoo.com
 Chapter 1: INTRODUCTION TO PROJECT
MANAGEMENT
1 What Is a Project?

A project is a non repetitive enterprise, characterized by a clear and logical

sequence of events, with a beginning, middle, and end, focused on the
accomplishment of a clear and defined objective on deadline, with costs,
resources, and quality parameters specified.

The following can be mentioned as project examples:

• Building a new industrial plant
• Writing a book
• Restructuring a sector or department of a company
• Preparing a marketing and publicity plan
• Launching a new product or service
• Developing a new software
• Building a house
• Undertaking a trip
 Projects can be implemented in practically all areas of human activity,
including administrative, strategic, and operational works, as well as in
personal life.

The following can be mentioned as the main areas for the application of project
management techniques:

• Engineering and civil construction

• Development of computer programs
• Military strategy
• Business administration
• Marketing and publicity
• Research and development
• Plant and capital equipment maintenance

2 Project Characteristics

A project is a temporary endeavor undertaken to create a unique product,

service, or result.
2.1 Temporary (Temporariness)

Temporary means that every project has a definite beginning and a definite end.
The end is reached when the project’s objectives have been achieved, or it
becomes clear that the project objectives will not or cannot be met, or the need for
the project no longer exists and the project is terminated.
Temporary does not necessarily mean short in duration; many projects last for
several years. In every case, however, the duration of a project is finite
(limited). Projects are not ongoing efforts. In addition, temporary does not
generally apply to the product, service or result created by the project. Most
projects are undertaken to create a lasting outcome.

For example, a project to erect a national monument will create a result expected
to last centuries. Projects also may often have intended and unintended social,
economic and environmental impacts that far outlast the projects themselves.
The temporary nature of projects may apply to other aspects of the endeavor as
well:

• The opportunity or market window is usually temporary—some projects

have a limited time frame in which to produce their product or service.
• The project team, as a working unit, seldom outlives the project a team created for
the sole purpose of performing the project will perform that project, and then the
team is disbanded and the team members reassigned when the project ends.

2.2 Unique Products, Services, or Results:

The individuality of the product or service turned out by a project means the
accomplishing of something not done before A project creates unique
deliverables, which are products, services, or results.

Projects can create:

• A product or artifact that is produced, is quantifiable, and can be either an end

item in itself or a component item
• A capability to perform a service, such as business functions supporting
production or distribution
• A result, such as outcomes or documents. For example, a research project
develops knowledge that can be used to determine whether or not a trend is
present or a new process will benefit society.
Uniqueness is an important characteristic of project deliverables. For example,
many thousands of office buildings have been developed, but each individual
facility is unique—different owner, different design, different location,
different contractors, and so on. The presence of repetitive elements does
not change the fundamental uniqueness of the project work.

Based on these two main characteristics, the others can be described as follows:

Non-repetitive enterprise/Activity: A project is an event that is not part of the

company’s routine. It is something new for the people who work on it.

Clear and logical sequence of events: Projects are characterized by logically

linked activities so as to allow accurate tracking and control during their
execution.

Beginning, middle, and end: Every project follows a certain life cycle, which
means it has a temporary nature. Many times, the completion of one project
coincides with the beginning of another.

However, a project without completion is not a project, but a routine activity.

Clear and defined objective:
Every project has well-defined targets and results to be achieved on its
completion.

Conducted by people:
The fundamental core of any project consists of people. Without them, the
project does not exist, even when modern management control tools are
available.

Projects use resources:

Every project uses resources specifically allocated to certain works.

Predefined parameters:
Every project requires the establishment of rates for time, costs, personnel,
material, and equipment involved, as well as the desired quality of the project. It
is impossible to establish such parameters with total accuracy, in advance. All of
them will be clearly identified and quantified in the project plan. However, the
initial parameters will act as reference points for the project and its evaluation.
 2.3 Project Management Benefits

Among the main benefits of project management, the following can be

mentioned:

• Avoids surprises during the execution works

• Allows the development of competitive advantages and new techniques, because
the entire methodology is structured
• Anticipates problematic situations that may be found, so preventive and
corrective actions can be taken before such situations become actual issues
• Adapts the work to the consumer market and to the client
• Makes the budget available before the expenditures start
• Expedites/Quick decisions, as the information is structured and made available
• Increases management control on all phases to be implemented, thanks to
previous detailing
• Facilitates and guides project framework reviews arising from changes in the
market or in the competitive environment, thus enhancing the project’s adaptation
capabilities
• Optimizes the allocation of necessary people, capital equipment, and material
 2.4 Causes of Project Failure

Another important aspect of project management is the appropriate

identification of the causes of project failure.
A project fails mainly because of the following reasons:
• Targets and objectives are poorly defined or are not understood by the lower
ranks.
• There is little acknowledgment of the project’s complexity.
• The project includes many activities with not enough time to accomplish them.
• Financial estimates are poor and incomplete.
• The project is based on insufficient or inadequate data.
• The control system is inadequate.
• The project lacks a project manager or has too many, thus creating power
circles parallel to those previously established.
• There is excessive dependency on project management software.
• The project estimates are based on the intuitive experience, or gut feeling, of
the people involved, with little importance given to the historical data of similar
projects or statistical analyses.
• Training and development are inadequate.
• The project manager lacks leadership.
• No time is spent on revising and improving the estimates.
• The needs for personnel, equipment, and material have not been evaluated.
• Integration of the key elements of the project scope has failed.
• The client and project team have different, often opposite expectations.
• The key areas of the project are unknown.
• Nobody has checked whether the people involved in the activities have the necessary
knowledge to perform them.
• People are not working to the same standards, or work standards have not been
established.

3. What is Project Management?

Project management is the application of knowledge, skills, tools and techniques to
project activities to meet project requirements.
Project management is accomplished through the application and integration of the
project management processes of initiating, planning, executing, monitoring and
controlling, and closing.

The project manager is the person responsible for accomplishing the project
objectives.
Managing a project includes:

• Identifying requirements
• Establishing clear and achievable objectives
• Balancing the competing demands for quality, scope,
time and cost
• Adapting the specifications, plans, and approach to
the different concerns and expectations of the various
stakeholders.

Project managers often talk of a “triple constraint”—project

scope, time and cost in managing competing project
requirements. Project quality is affected by balancing these
three factors. High quality projects deliver the required
product, service or result within scope, on time, and within
budget. The relationship among these factors is such that if
any one of the three factors changes, at least one other factor
is likely to be affected.
 In management literature, this equilateral triangle is also
referred as the “Quality triangle” of the project.
Project managers also manage projects in response to
uncertainty. Project risk is an uncertain event or condition
that, if it occurs, has a positive or negative effect on at least
one project objective. The project management team has a
professional responsibility to its stakeholders including
customers, the performing organization, and the public.
It is important to note that many of the processes
within project management are iterative because of the
existence of, and necessity for, progressive elaboration in a
project throughout the project’s life cycle. That is, as a project
management team learns more about a project, the team can
 Chapter 2: THE PROJECT LIFE CYCLE

1. Introduction

The project lifecycle describes the tasks that must be completed to produce a
product or service.
The project management lifecycle defines how to manage a project.
While no two projects are exactly alike, all projects should progress through the
same four project management phases:

1. At the beginning there is, Project Initiation,

a Project Manager is assigned. The Project Manager works with the Project
Sponsor to identify the necessary resources and team members needed to
further develop the key project parameters – Cost, Scope, Schedule, and
Quality (CSSQ). The Project Team documents its charge in the form of a
Project Charter, which is based on the Project Proposal, which includes the
initial Business Case.
Approval of the Project Charter by the Project Sponsor authorizes the
designated team to begin the initial planning effort. The initial Project Plan
resulting from Project Initiation differs in the level of detail and the validity of
its estimates from Project Origination, and must be at a level sufficient to
acquire any additional resources needed to progress to the next phase. The
Project Plan also includes plans for involving and communicating with all the
parties that are affected by the project, as well as identification of an initial set
of foreseeable risks that can threaten the project. At the conclusion of Project
Initiation, based on the initial planning documents, the Business Case is revised
and re-evaluated and a decision is made to either halt the project, or proceed to
Project Planning.

2. Project Planning, builds on the work done in Project Initiation, refining

and augmenting CSSQ and Project Plan deliverables. Usually, additional
members join the Project Team, and they assist the Project Manager in further
elaborating the details of the Cost, Scope, Schedule and Quality. A number of
key elements are added to the Project Plan, including project-specific items
such as change control, acceptance management and issue management, as well
as externally-focused items such as organizational change management and
project transition. The initial list of project risks is augmented, and detailed
mitigation plans are developed. Project Planning marks the completion of the
Project Plan
i.e., no work is left uncovered. However, some of the later phases of the project
work may continue to be planned in more depth (e.g., Transition and
Implementation details may not be developed until later in Project Execution).
At the conclusion of Project Planning, the Business Case is revised and re-
evaluated based on the completed planning documents and a decision is again
made to either halt the project, or to commit the resources necessary for Project
Execution and Control.

3. Project Execution and Control is where most of the resources are

applied/expended on the project. A significant number of team members will
join the project at the beginning of this phase.
The primary task of the Project Manager during Project Execution and Control
is to enable the Project Team to execute the tasks on the defined Project
Schedule
and develop the product or service the project is expected to deliver.
The Project Manager uses the processes and plans prepared during Project
Initiation and Project Planning to manage the project, while preparing the
organization for the implementation of the product/service and for
transitioning the product/service responsibility from the Project Team to
the Performing Organization.
4. In Project Closeout, the Project Team assesses the outcome of the project, as
well as the performance of the Project Team and the Performing Organization.
This is accomplished primarily through soliciting and evaluating feedback from
Customers, Project Team members, Consumers and other stakeholders. The
primary purpose of this assessment is to document best practices and lessons
learned for use on future projects. Key project metrics are also captured to
enable the Performing Organization to compare and evaluate performance
measurements across projects.

As there are four phases within the project life cycle, there are four main
sections in this Chapter. Each of these sections describes a particular project life
cycle phase in detail, by providing the activities and tasks required to complete
the phase in its entirety. Students will then learn how to initiate projects by
developing a business case, undertaking a feasibility study, establishing the
terms of reference, appointing the team and setting up a project office.
This chapter includes the activities required to create a project plan, resource
plan, financial plan, quality plan, risk plan, acceptance plan, communications
plan and procurement plan. The entire tender process is also defined, allowing
you to create a suite of tender documentation to help you select a preferred
supplier and create a supplier contract.
Let us analyze in depth the different phases of the project management

1. Project Initiation

The first phase of a project is the initiation phase. During this phase a business
problem or opportunity is identified and a business case providing various
solution options is defined. Next, a feasibility study is conducted to investigate
whether each option addresses the business problem and a final recommended
solution is then put forward. Once the recommended solution is approved, a
project is initiated to deliver the approved solution. Terms of reference are
completed outlining the objectives, scope and structure of the new project and a
project manager is appointed. The project manager begins recruiting a project
team and establishes a project office environment. Approval is then sought to
move into the detailed planning phase.
Within the initiation phase, the business problem or opportunity is identified, a
solution is defined, a project is formed and a project team is appointed to build
and deliver the solution to the customer.
The following Figure shows the activities undertaken during the initiation
phase:
 Undertake a Establish the
Develop a Appoint the
feasibility terms of
project plan project team
study reference

Perform
Set up the
the stage
project office
gate

Develop a business case: The trigger to initiating a project is identifying a

business problem or opportunity to be addressed. A business case is created to
define the problem or opportunity in detail and identify a preferred solution for
implementation. The business case includes:

• A detailed description of the problem or opportunity;

• A list of the alternative solutions available;
• An analysis of the business benefits, costs, risks and issues;
• A description of the preferred solution;
• A summarized plan for implementation.
An identified project sponsor then approves the business case and the required
funding is allocated to proceed with a feasibility study.

"Undertake a feasibility study:

At any stage during or after the creation of a business case, a formal feasibility
study may be commissioned. The purpose of a feasibility study is to assess the
likelihood of each alternative solution option achieving the benefits outlined in
the business case. The feasibility study will also investigate whether the forecast
costs are reasonable, the solution is achievable, the risks are acceptable and the
identified issues are avoidable.

"Establish the terms of reference:

After the business case and feasibility study have been approved, a new project
is formed. At this point, terms of reference are created. The terms of reference
define the vision, objectives, scope and deliverables for the new project. They
also describe the organization structure; and activities, resources and funding
required undertaking the project. Any risks, issues, planning assumptions and
constraints are also identified.
Appoint the project team: The project team is now ready to be appointed.
Although a project manager may be appointed at any stage during the life of
the project, the manager will ideally be appointed prior to recruiting the
project team. The project manager creates a detailed job description for each
role in the project team, and recruits people into each role based on their
relevant skills and experience

Set up a project office: The project office is the physical environment

within which the team is based.
Although it is usual to have one central project office, it is possible to have a
virtual project office with project team members located around the world. A
project office environment should include:

• Equipment, such as office furniture, computer equipment, stationery and

materials;
• Communications infrastructure, such as telephones, computer network, e
mail, Internet access, file storage, database storage and backup facilities;
• Documentation, such as a project methodology, standards, processes,
forms and registers;
• Tools, such as accounting, project planning and risk modeling software.
 Perform a phase review: At the end of the initiation phase, perform a phase
review. This is basically a checkpoint to ensure that the project has achieved its
objectives as planned.

2. Project Planning
Once the scope of the project has been defined in the terms of reference, the project
enters the planning phase. This involves creating a:

• Project plan outlining the activities, tasks, dependencies and timeframes;

• Resource plan listing the labor, equipment and materials required;
• Financial plan identifying the labor, equipment and materials costs;
• Quality plan providing quality targets, assurance and control measures;
• Risk plan highlighting potential risks and actions to be taken to mitigate those
risks;
• Acceptance plan listing the criteria to be met to gain customer acceptance;
• Communications plan describing the information needed to inform stakeholders;
• Procurement plan identifying products to be sourced from external suppliers.
At this point the project will have been planned in some detail and is ready to
be executed.

Summary: By now, the project costs and benefits have been documented, the
objectives and scope have been defined, the project team has been appointed
and a formal project office environment established. It is now time to
undertake detailed planning to ensure that the activities performed during the
execution phase of the project are properly sequenced, resourced, executed and
controlled. The activities shown in the following figure are undertaken.
 Create a Create a Create a Create a Create a
project plan resource plan financial plan quality plan risk plan

Create a Create a Create a

Perform Contract with procuremen communicati acceptance
Stage-gate suppliers t plan on plan plan
Create a project plan: The first step in the project planning phase is to
document the project plan. A 'work breakdown structure' (WBS) is identified
which includes a hierarchical set of phases, activities and tasks to be undertaken
to complete the project. After the WBS has been agreed, an assessment of the
level of effort required to undertake each activity and task is made. The
activities and tasks are then sequenced, resources are allocated and a detailed
project schedule is formed. This project plan is the key tool used by the project
manager to assess the progress of the project throughout the project life cycle.

Create a resource plan: Immediately after the project plan is formed, the level
of resource required undertaking each of the activities and tasks listed within the
project plan will need to be allocated.
Although generic resource may have already been allocated in the project plan,
a detailed resource plan is required to identify the:
• Type of resource required, such as labor, equipment and materials;
• Quantity of each type of resource required;
• Roles, responsibilities and skill sets of all human resource required;
• Specifications of all equipment resource required;
• Items and quantities of material resource required.
A schedule is assembled for each type of resource so that the project manager
can review the resource allocation at each stage in the project.
Create a financial plan: A financial plan is created to identify the total
quantity of money required to undertake each phase in the project (in other
words, the budget). The total cost of labor, equipment and materials is
calculated and an expense schedule is defined which enables the project
manager to measure the forecast spend versus the actual spend throughout the
project. Detailed financial planning is an extremely important activity within
the project, as the customer will expect the final solution to have been delivered
within the allocated budget.

Create a quality plan: Meeting the quality expectations of the customer can be
a challenging task. To ensure that the quality expectations are clearly defined
and can reasonably be achieved, a quality plan is documented. The quality plan:
• Defines the term 'quality' for the project.
• Lists clear and unambiguous quality targets for each deliverable. Each quality
target provides a set of criteria and standards to be achieved to meet the
expectations of the customer.
• Provides a plan of activities to assure the customer that the quality targets will
be met (in other words, a quality assurance plan).
• Identifies the techniques used to control the actual quality level of each
deliverable as it is built (in other words, a quality control plan).
"Not only is it important to review the quality of the deliverables produced by
the project, it is also important to review the quality of the management
processes that produced them. A quality plan will summarize each of the
management processes undertaken during the project, including time, cost,
quality, change, risk, issue, procurement, and acceptance and communications
management.

Create a risk plan: The next step is to document all foreseeable project risks
within a risk plan. This plan also identifies the actions required to prevent each
risk from occurring, as well as reduce the impact of the risk should it eventuate.
Developing a clear risk plan is an important activity within the planning phase,
as it is necessary to mitigate all critical project risks prior to entering the
execution phase of the project.

Create an acceptance plan: To deliver the project successfully, you will need to
gain full acceptance from the customer that the deliverables produced by the
project meet or exceed requirements.
An acceptance plan is created to help achieve this, by clarifying the completion
criteria for each deliverable and providing a schedule of acceptance reviews.
These reviews provide the customer with the opportunity to assess each
deliverable and provide formal acceptance that it meets the requirements as
originally stated.

Create a communications plan: Prior to the execution phase, it is also necessary

to identify how each of the stakeholders will be kept informed of the progress of
the project. The communications plan identifies the types of information to be
distributed to stakeholders, the methods of distributing the information, the
frequency of distribution, and responsibilities of each person in the project team
for distributing the information.

Create a procurement plan: The last planning activity within the planning phase
is to identify the elements of the project to be acquired from external suppliers.
The procurement plan provides a detailed description of the products (that is,
goods and services) to be acquired from suppliers, the justification for acquiring
each product externally as opposed to from within the business, and the schedule
for product delivery. It also describes the process for the selection of a preferred
supplier (the tender process), and the ordering and delivery of the products (the
procurement process).
Contract the suppliers: Although external suppliers may be appointed at
any stage of the project, it is usual to appoint suppliers after the project plans
have been documented but prior to the execution phase of the project. Only
at this point will the project manager have a clear idea of the role of suppliers
and the expectations for their delivery. A formal tender process is undertaken
to identify a short list of capable suppliers and select a preferred supplier to
initiate contractual discussions with. The tender process involves creating a
statement of work, a request for information and request for proposal
document to obtain sufficient information from each potential supplier and
select the preferred supplier.
Once a preferred supplier has been chosen, a contract is agreed between the
project team and the supplier for the delivery of the requisite products.

Perform a phase review: At the end of the planning phase, a phase review is
performed. This is a checkpoint to ensure that the project has achieved its
objectives as planned.
3. Project Execution

This phase involves implementing the plans created during

the project planning phase. While each plan is being
executed, a series of management processes are
undertaken to monitor and control the deliverables being
output by the project. This includes identifying change,
risks and issues, reviewing deliverable quality and
measuring each deliverable produced against the
acceptance criteria. Once all of the deliverables have been
produced and the customer has accepted the final solution,
the project is ready for closure. The activities of this phase
are shown in the following figure.
The execution phase is typically the longest phase of the project in terms of
duration. It is the phase during which the deliverables are physically
constructed and presented to the customer for acceptance.
To ensure that the customer's requirements are met, the project manager
monitors and controls the activities, resources and expenditure required to build
each deliverable. A number of management processes as shown are undertaken
to ensure that the project proceeds as planned.

Build the deliverables: This phase involves physically constructing each

deliverable for acceptance by the customer. The activities undertaken to
construct each deliverable will vary depending on the type of project being
undertaken. Activities may be undertaken in a 'waterfall' fashion, where each
activity is completed in sequence until the final deliverable is produced, or in
an 'iterative' fashion, where iterations of each deliverable are constructed until
the deliverable meets the requirements of the customer.

Regardless of the method used to construct each deliverable, careful monitoring

and control processes should be employed to ensure that the quality of the final
deliverable meets the acceptance criteria set by the customer.
Monitor and control: While the project team is physically
producing each deliverable, the project manager implements a
series of management processes to monitor and control the
activities being undertaken by the project team. An overview of
each management process follows.

Time Management: Time management is the process of

recording and controlling time spent by staff on the project. As
time is a scarce resource within projects, each team member
should record time spent undertaking project activities on a
timesheet form. This will enable the project manager to control
the amount of time spent undertaking each activity within the
project. A timesheet register is also completed, providing a
summary of the time spent on the project in total so that the
project plan can always be kept fully up to date.

Cost management: Cost management is the process by which

costs/expenses incurred on the project are formally identified,
approved and paid. Expense forms are completed for each set of
related project expenses such as labor, equipment and materials
costs. Expense forms are approved by the project manager and
Quality management: Quality is defined as the extent to which the final
deliverable conforms to the customer requirements. Quality management is the
process by which quality is assured and controlled for the project, using quality
assurance and quality control techniques. Quality reviews are undertaken
frequently and the results recorded on a quality review form.

Change management: Change management is the process by which changes to

the project scope, deliverables, timescales or resources are formally requested,
evaluated and approved prior to implementation. A core aspect of the project
manager's role is to manage change within the project. This is achieved by
understanding the business and system drivers requiring the change, identifying
the costs and benefits of adopting the change, and formulating a structured plan
for implementing the change. To formally request a change to the project, a
change form is completed. The status of all active change forms should he
recorded within a change register.

Risk management: Risk management is the process by which risks to the

project are formally identified, quantified and managed. A project risk may be
identified at any stage of the project by completing a risk form and recording
the relevant risk details within the risk register.
Issue management: Issue management is the method by which issues currently
affecting the ability of the project to produce the required deliverable are formally
managed. After an issue form has been completed and the details logged in the issue
register, each issue is evaluated by the project manager and a set of actions
undertaken to resolve the issue identified.

Procurement management: Procurement management is the process of sourcing

products from an external supplier. Purchase orders are used to purchase products
from suppliers, and a procurement register is maintained to track each purchase
request through to its completion.

Acceptance management: Acceptance management is the process of gaining

customer acceptance for deliverables produced by the project. Acceptance forms are
used to enable project staff to request acceptance for a deliverable, once complete.
Each acceptance form identifies the acceptance criteria, review methods and results
of the acceptance reviews undertaken.

Communications management: Communications management is the process by

which formal communications messages are identified, created, reviewed and
communicated within a project. The most common method of communicating the
status of the project is via a project status report.
Each communications message released is captured in a communications
register.

Perform a phase review: At the end of the execution phase, a phase review is
performed. This is a checkpoint to ensure that the project has achieved its
objectives as planned.

4. Project Closure

Project closure involves releasing the final deliverables to the customer, handing
over project documentation to the business, terminating supplier contracts,
releasing project resources and communicating the closure of the project to all
stakeholders. The last remaining step is to undertake a post implementation
review to quantify the level of project success and identify any lessons learnt for
future projects.
Following the acceptance of all project deliverables by the customer, the project
will have met its objectives and be ready for closure. Project closure is the last
phase in the project life cycle, and must be conducted formally so that the
business benefits delivered by the project are fully realized by the customer. The
activities outlined in the figure above are undertaken:
 Perform the project Review project
closure completion

Perform project closure: Project closure, or 'close out', essentially involves

winding up/terminating the project.
This includes:
• Determining whether all of the project completion criteria have been met;
• Identifying any outstanding project activities, risks or issues;
• Handing over all project deliverables and documentation to the customer;
• Canceling supplier contracts and releasing project resources to the business;
• Communicating the closure of the project to all stakeholders and interested
parties.
"A project closure report is documented and submitted to the customer and/or
project sponsor for approval. The project manager is responsible for undertaking
each of the activities identified in the project closure report, and the project is
closed only when all the activities listed in the project closure report have been
completed.
Review project completion: The final activity within a project is the review of its
success by an independent party. Success is determined by how well it performed
against the defined objectives and conformed to the management processes outlined
in the planning phase. To determine how well it performed, the following types of
questions are answered:
• Did it result in the benefits defined in the business case?
• Did it achieve the objectives outlined in the terms of reference?
• Did it operate within the scope of the terms of reference?
. Did the deliverables meet the criteria defined in the quality plan?
• Was it delivered within the schedule outlined in the project plan?
• Was it delivered within the budget outlined in the financial plan?
To determine how well the project conformed, an assessment is made of the level
of conformity to the management processes outlined in the quality plan. These
results, as well as a list of the key achievements and lessons learnt, are documented
within a post-implementation review and presented to the customer and/or project
sponsor for approval.
Note how each phase described in the preceding pages ends with a Stage Gate or
Phase Review. A Phase review is defined as: "A checkpoint at the end of each
project phase to ensure that a project has achieved its stated objectives and
deliverables as planned" (for that phase).
 Chapter 3: THE LOGICAL FRAMEWORK APPROACH

1. Overview of the Logical Framework Approach (LFA)

The Logical Framework Approach (LFA) is a long established activity design

methodology used by a range of major multilateral and bilateral donors.
It is based on a systematic analysis of the development situation,
particularly key development problems, and of the options for addressing
those problems. It can be applied in a range of circumstances and to a range of
types of aid activity.

The LFA is an analytical, presentational and management tool which can help
planners and managers to:
 Analyze the existing situation during activity preparation
 Establish a logical hierarchy of means by which objectives will be reached
 identify the potential risks for achieving the objectives, and to sustainable
outcomes
 Establish how outputs and outcomes might best be monitored and evaluated
 If desired, present a summary of the activity in a standard format, and
 Monitor and review Activities during implementation.
 LFA can be used throughout NGO management as an aid activities in

 Identifying and assessing activity options

 Preparing the activity design in a systematic and logical way
 Appraising activity designs
 Implementing approved Activities, and
 Monitoring, reviewing and evaluating activity progress and
performance.

LFA is best started early in activity design. (It is more difficult to use the
LFA to review and/or restructure ongoing activities which were not
designed using LFA principles and practices). As LFA is an ‘aid to
thinking’, it has widespread and flexible application.

Activity planning and management should always be approached as a team

task. This means that adequate opportunity should be given to colleagues
and key stakeholders to provide input to the process and product of LFA.
 This can be supported by:

 Taking time to explain the principles of LFA and clarifying the terminology used
 Integrating effective team work and adult learning methods into meetings with stakeholder
groups, and
 Ensuring that stakeholder groups are involved in situation and/or problem analysis,
particularly in early design.
However, LFA is not a tool that all participants should necessarily be expected to
understand or use. While ‘logical’ in concept, its effective application poses many
challenges, even to the experienced user.

2 Use in activity design (plans)

During activity design (including identification, preparation and appraisal and approval)
the purpose of the LFA is to produce a soundly document an activity design for a proposed
new development activity which includes both:

 An activity description, which clearly specifies what the proposed activity is to do and
how, and
 A systematic and soundly based activity rationale, which clearly states the case for
implementing the proposed activity from the perspective of both the sponsors who would
The activity description typically specifies:
• The activity components, and what is to be done in each component
• Roles and responsibilities of all the main participants in implementation, and
• The proposed management and administrative arrangements for the activity,
particularly including the part to be played by each of the partners to
implementation.

The activity rationale

• Outlines the nature of the development situation, particularly the causes and
effects of the key development problems which the activity is designed to improve
• Outlines the cause/effect logic of the proposed activity design, and the expected
results of implementing the activity, and
• Justifies the use of partner resources in terms of the expected benefits of activity
implementation.

In this way the activity design makes explicit the means by which the desired ends
of the activity are to be attained. That is, it outlines the means-end relationship
between what the activity actually does and the attainment of its objectives, and
between the attainment of the lower level objectives of the activity and its higher
level (or ultimate) objectives.
 (For example, as explained later, the relationship between its immediate
Purpose, and its ultimate Goal).

3. The Logical Framework Matrix (LFM)

One standard analytical product of the LFA is the Logical Framework

Matrix (LFM).
It consists of a matrix (development) with four columns and a number of
rows, which summarize selected aspect of a project, namely:

 What the activity will do, and what it will produce (Activity Description)
 The activity’s hierarchy of objectives and planned results (also Activity
Description)
 The key assumptions that are being made and
 How the activity’s achievements will be measured, monitored and evaluated
(Indicators and Means of Verification).
The general structure of a Logframe Matrix is shown in Figure 1 below.
In order to help avoid common problems associated with the use of the LFM,
managers should:
• ensure their colleagues and partners have a common understanding of the key
analytical principles and terminology used
• emphasize the importance of the LFA process at least as much as the matrix
product
• ensure it is used as a tool to promote stakeholder participation, dialogue and
agreement on activity scope, rather to impose ‘external’ concepts and priorities
• avoid using the matrix as a blueprint through which to exert external control over
the activity
• treat the matrix as a presentational summary (keep it clear and concise), and
• refine and revise the matrix as new information comes to light.

4.Logical Framework Approach Terminology

A brief description of key LFA terms is given below.

Activity description provides a narrative summary of what the activity intends to
achieve and how. It describes the means by which desired ends are to be achieved
(the vertical logic). That is, it describes what the activity will actually do in order to
produce the planned outputs and outcomes.
Activity component: Constructing the activity description may involve
disaggregating (separate) the work to be undertaken into a number of ‘activity
components’. An activity component consists of a sub-set of inputs, work program
tasks and outputs that form a natural whole, and can be considered as a separate
part of the overall activity.
Components may be identified on the basis of a number of possible variables,
including:
• Technical features (e.g. a health activity may have components focusing on
malaria control, diarrheal disease, and acute respiratory infections)
• Geographic locations (e.g. a census support activity focusing its capacity
building activities on different provinces or regions and at the national level)
• Beneficiaries (e.g. an HIV aids activity focusing on raising awareness among
schoolchildren, sex-workers, injecting drug users and health workers)
• Management/organizational structures (e.g. an agriculture activity divided into
extension, training, research and credit components to reflect the local structure of
the Department of Agriculture)
• Phasing of key tasks (e.g. a rural electrification activity which requires a
feasibility study, pilot testing, implementation and maintenance stages.
Identifying appropriate component ‘headings’ will thus depend on a number of
context-specific factors. Agreement on what the components should be is best
determined through a consultative process with key stakeholders.
Goal/Impact refers to the sectorial or national objectives which the activity is
designed to contribute to, eg increased incomes, improved nutritional status,
reduced crime. The goal helps set the macro-level context within which the
activity fits, and describes the long-term impact that the activity is expected to
contribute towards (but not by itself achieve).
Purpose: refers to what the activity itself is expected to achieve in terms of
sustainable development results, if the relevant assumptions of the activity
design are correct. It is the positive developmental change which the activity
would produce if it were completely successful (and the assumptions were fully
accurate). Examples might include increased agricultural production, higher
immunization coverage, clean water, or improved legal services.
Output/Intermediate Results: Where the activity is relatively large and has a
number of components (output/work program areas) it can be useful to give
each component an objective statement. These statements should help provide a
logical link between the outputs of that component and the overall
purpose/outcome.
Outputs: refer to the tangible products (goods and services) produced by
undertaking a series of tasks as part of the planned work of the activity. Examples
might include: irrigation systems or water supplies constructed, areas
planted/developed, children immunised, buildings or other infrastructure built,
policy guidelines produced, and staff effectively trained. The delivery of outputs
should be largely under activity management’s control.
Work program refers to the specific tasks to be undertaken as part of the planned
delivery of the activity to achieve the required outputs. Examples for a new
community water supply might include: establishing water users committee and
maintenance procedures, site preparation, collection of local materials, tank
construction and pipe laying, digging soak pits, and commissioning. However, the
Logframe matrix should not include too much detail on work program otherwise
it becomes too lengthy and potentially prescriptive. If detailed specification is
required, this should be presented separately in a work schedule/Gantt chart
format and not in the matrix itself.
Inputs refer to the resources required to undertake the work program and produce
the outputs, eg as personnel, equipment, and materials. However, inputs should
not be included in the matrix format.
Assumptions: Assumptions refer to assumptions made about conditions
which could affect the progress or success of the activity, but over which
activity managers may have no direct control, eg price changes, rainfall, land
reform policies, non-enforcement of supporting legislation. An assumption is
a positive statement of a condition that must be met in order for objectives to
be achieved. A risk is a negative statement of what might prevent objectives
being achieved.
Indicators: Indicators are measure of progress or lack of progress used to
assess progress towards meeting stated objectives. An indicator should
provide, where possible, a clearly defined unit of measurement and a target
detailing the quantity, quality and timing of expected results.
There are no absolute principles about what makes a good indicator of
physical achievement, however the SMART characteristics listed below
(Specific, Measurable, Attainable, Relevant, Timely) are useful.
Specific – Key indicators need to be specific and to relate to the conditions
the activity seeks to change. Cement delivered to a site is not a good
indicator of the number of houses constructed. Likewise seedlings distributed
from a nursery may not be a valid indicator of plants established. The
horizontal logic of the Logframe matrix helps to test these criteria.
Measurable – Quantifiable indicators are preferred because they are precise, can be
aggregated and allow further statistical analysis of the data. However, development
process indicators may be difficult to quantify, and qualitative indicators should also
be used.
Attainable – The indicator (or information) must be attainable at reasonable cost
using an appropriate collection method. Accurate and reliable information on such
things as household incomes and crop production from small-scale dry land farming
are, for example, notoriously difficult and expensive to actually collect.
Relevant – Indicators should be relevant to the management information needs of
the people who will use the data. Indicators must also be selected to meet the
management and informational needs of all partners to implementation. Field staff
may also need particular indicators that are of no relevance to senior managers, and
vice-versa. Information must be sorted, screened, aggregated and summarized in
different ways to meet different managers’ needs. (However, the Logframe matrix
itself should not attempt to contain this detail. Rather the detail should be
incorporated in the monitoring and evaluation framework, which is a key element of
the final activity design.)
Timely – Information on an indicator needs to be collected and reported at the right
time to influence many management decisions. Information about agricultural based
activities, for example, must often come within specific time periods if it is to be
used to influence events in the whole cropping and processing cycle.
There is also no point choosing indicators that can only tell you at the end of an
activity whether you succeeded or failed in meeting certain objectives. They may
be lessons learned but the information comes too late for personnel to act on.
Where possible, indicators should incorporate elements of quantity, quality and
time. This is about setting targets for implementers to work towards and against
which progress can then be measured. As the saying goes, “what gets measured
gets managed”.

Means of verification: Means of verification should clearly specify the expected

source of the information we need to collect. We need to consider how the
information will be collected (method), who will be responsible, and the
frequency with which the information should be provided.
There are 3 major steps in conducting an LFA, each with a set of activities to be
carried out as outlined below: situation analysis, analysis of strategies and
project planning matrix. What follows is an introduction to the three steps to
understand the general principles in undertaking an LFA.
The following questions should be asked and answered:
• How should the information be collected, eg sample surveys, administrative
records, national statistics (as in the census), workshops or focus groups,
observation,
 • What source is most appropriate? eg Who should be interviewed? Does the
Bureau of Statistics already collect the required information? Is the source
reliable?
• Who should do it? eg extension staff, supervisors, an independent team?
• When and how often should the information be collected, analyzed and
reported? eg monthly, annually, according to seasonal cropping cycles?
• What formats are required to record the data being collected?

If-then causality
Constructing the Project Description in the matrix involves a detailed breakdown
of the chain of causality in the project design (and the associated means-ends
relationships).
• if inputs are provided and activities are undertaken, then outputs will be
produced
• if outputs are produced, then purpose will be achieved
• if purpose is achieved, this should then contribute to the overall goal.
Each level thus provides the rationale for the next level down: the goal helps
justify the purpose, the purpose the component objectives, and so on down the
hierarchy.
Any activity is subject to influence by factors that are difficult to predict and
over which no-one has direct control.
The fourth column of the matrix is used to highlight assumptions about the
external conditions that need to be fulfilled if the vertical logic of the activity
description is to hold true. It is also used to highlight key assumptions about the
relationships between, and respective inputs of, the partners to activity
implementation.
The relationship between assumptions and the activity description is shown in
Figure below.

Figure 5 Relationship between assumptions and objectives

Only if these assumptions are met will the next level of objectives be achieved.
Assumptions are thus part of the vertical logic.
 Situation Analysis:
Analysis on:
(1) Stakeholder Analysis
(2) Problem Analysis
(3) Objective Analysis

Prior to beginning work on activity design and the construction of a Logframe

matrix it is important to undertake a structured analysis of the existing situation.
LFA incorporates four main analytical elements to help guide this process
• problem analysis
• stakeholder analysis
• objectives analysis, and
• selection of a preferred implementation strategy.

Each element is described further below,

Remember that effective development planning should be approached as an

iterative process, not as a linear set of prescribed steps.
 For example, while stakeholder analysis is presented in these Guidelines as
coming after problem analysis, in practice, stakeholder analysis is ongoing
throughout the design process, and does not neatly fit in to any one step. These
Guidelines should not be seen as prescribing a formulaic approach to activity
design.
The process of applying the analytical tools of LFA in a participatory manner is
as important as its products. This is particularly so in the context of
development activities, where ownership of the idea by implementing partners
is often critical to the success of implementation and to the sustainability of
benefits. Effective coordination and cooperation (including teamwork) is
critical.
Ideally, the main analytical tools should be applied in a workshop setting with
key stakeholders, so that the initial LFA analysis and the initial findings are
developed truly jointly. However, it needs to be recognized that there will be a
range of design studies where consultations with counterparts may be
extensive, but do not extend to joint design analysis in a workshop setting.
In these circumstances, the design team may need to itself apply the main
principles and practices of the LFA to information and input provided by
counterparts and stakeholders.
In these cases, the emerging conclusions of the team's analysis need to be
iteratively checked against the knowledge and understanding of our partners
through successive consultations.
The situation of the proposed project or program needs to be analyzed.
Answers to the following questions are needed:
Ø What are the general areas of concern, or themes, that the project will focus
on?
Ø What is the project aiming to achieve?
Ø At what spatial levels will the project focus, in terms of subject (broad/macro
to specific/micro) and or geography (local to global)?
Ø What political, socio-economic, technological and biophysical environment
will the project operate within?
Ø Who are the major stakeholders?
Ø How will stakeholders be involved in the process of design, implementation,
monitoring, evaluation and reporting?
Ø Who is working on the issues already? What are they doing?
Ø What is the niche of the project?
Ø Who will implement the project?
Ø What is the intended duration of the project?
Ø What is the anticipated level of funding?
Ø Who will fund the project?

5.1 Problem analysis and the problem tree

5.1.1 Overview
Development Activities are usually proposed as a response to addressing
development situations, and overcoming identified development problems in
those situations. Problem analysis involves identifying what the main problems
are and establishing the cause and effect relationships which result in, and flow
from, these problems.
The key purpose of this analysis is to try and ensure that ‘root causes’ are
identified and subsequently addressed in the activity design, not just the
symptoms of the problem(s). A clear and comprehensive problem analysis
provides a sound foundation on which to develop a set of relevant and focused
activity objectives.
One main tool used in problem analysis is the ‘problem tree’, a simplified
example of which is shown in Figure below. This example presents the causal
structure of problems impacting on poor budget execution by the national
Government of a developing country, and therefore the inadequate delivery of
key public services.
Important points to note about using the problem tree tool are:
• There are two main approaches that can be used to help give focus to the
problem analysis, namely: (i) the ‘focal problem’ method, whereby development
problems (or constraints) are brainstormed by the group, a core or focal problem is
identified, and the cause and effect analysis then pivots around the focal problem;
or (ii) the ‘objectives oriented’ method, whereby a broad/high level development
objective is specified at the start of the analysis, and constraints to achieving this
objective are then brainstormed, analyzed and sorted in to a cause and effect logic.
Both approaches are equally valid, and which to use is largely up to individual
preference and circumstances.
• Ideally, problem analysis should be undertaken as a group learning activity
involving stakeholders who can contribute relevant technical and local knowledge.
A workshop environment (involving groups of up to 25 carefully selected
participants) is an appropriate forum for developing problem trees, analyzing the
results, and then proposing solutions.
• As noted, however, some design teams will need to apply the LFA - and its tools,
including problem analysis - outside a workshop setting, based on information and
feedback provided by counterparts and stakeholders in some other way.
• It may be appropriate to undertake a number of separate problem analysis
exercises with different stakeholder groups, to help determine different
perspectives and how priorities vary.
• The process is as important as the product where a workshop is possible, the
exercise should be presented as a learning experience for all those involved,
and as an opportunity for different views and interests to be presented and
discussed. However, one should not necessarily expect full consensus among
stakeholders on what the priority problems are or what the causality of these
problems is.
• It is important to recognize that - however produced - the product (the
problem tree diagram) should provide a simplified but nevertheless robust
version of reality. If it is too complicated, it is likely to be less useful in
providing direction to subsequent steps in the analysis.
5.1.2 Preparatory steps
Before starting work on preparing a problem tree
• Clarify the scope of the investigation or analysis. If you are participating in an
activity preparation mission, others (perhaps including other donors) will have
already identified (at least to some extent) the main development situation they
are concerned with, or opportunities they have seen. Understanding this will
help you focus and structure the direction of the analysis. You will not want, or
be able, to deal with a limitless range of problems. This information should
thus help you to identify either an appropriate objective, or focal problem,
to help give focus to the problem tree analysis.
• Inform yourself further. Collect and review existing background information
on the main issue(s) of concern and/or on the geographic area(s) you will be
working in. Are you clear what the main issues are, or are likely to be?
• Identify the relevant stakeholder group(s). Who needs to be involved to ensure
the workshop group (and/or design team) is well informed and can help to
analyze and discuss the main issues that the analysis will focus on? For
example, if you are looking at a health and sanitation problem which may
require a water supply as part of the solution, make sure that you have available
to join you a water supply engineer and an environmental health officer (among
others). Also, be sure to involve community representatives that you believe
would be willing and able to contribute to this kind of exercise. A representative
and technically competent reference group is required to help effectively
identify, analyze and organize ideas. Participants need to be informed to be
useful and productive. They should know why they are doing the analysis, what
the process involves and what information they are expected to contribute.

5.1.3 Conduct the analysis

For a workshop situation, cards, marker pens, wall space for display and some
means of sticking and moving cards on the display area are essential to
undertaking this exercise successfully.
 Once a workshop group is generally happy with the main elements of the problem
tree, move on to investigating and documenting possible solutions through using
stakeholder analysis, the objective tree, alternatives analysis and finally the LFM
itself. Remember that planning is an iterative process and that elements of both
problem analysis and stakeholder analysis will need to be revisited on an ongoing
basis as new information and ideas come to light.

Steps in conducting problem tree analysis:

A. Identifying and listing the main problems
• Explain the purpose of the exercise and the context within which it is taking place,
eg preparation of a primary health care activity. Explain the problem tree method
and the input expected from the participants. Provide some examples of the cause
and effect relationship before starting, emphasizing the importance of identifying
root causes.
• Using contributions from the group, list all the negative statements about the
situation you are analyzing. This can be undertaken as a brainstorming session.
• Print each problem statement in clear language on a card and display this on some
suitable wall space.
B: identifying core problems
• Through discussions, identify a consensus core problem - the one(s) which
appear to be linked to most negative statements.
• Print a precise definition of the core problem on a card (if the existing
statement requires further clarification).
• Display the card on a wall (or on the floor) so that the whole group can clearly
see it.
C: Identifying cause and effect
• Begin to distribute the negative statement cards according to whether they are
‘causes’, i.e. leading to the core problem, or ‘effects’, ie resulting from the core
problem. Do this until all causes are below the core problem and all effects are
above the core problem. At any stage in the exercise, those statements that are
considered to be unclear should either be more clearly specified or discarded.
Problems that are clear but very general in nature and which affect not only this
issue but would apply to almost any development problem can be treated as
‘overall constraints’ and moved to the side of the main problem tree. This helps
keep the core problem tree focused and manageable. You can be guided in this
by considering whether or not the problem is likely to be one which can be
addressed by an activity based solution. If not, it is a constraint.
• Then the guiding questioning for further structuring the statements into a
problem tree becomes “What leads to that?” Choose any negative statement
printed as a problem on the cards and ask: “What leads to that?” Then select
from the cards the most likely cause of the problem, and place it below the
chosen statement.
• If there are two or more causes combining to produce an effect, place them
side by side below the resulting effect.

• After you have placed the card or cards for each relationship, pause to review.
Then ask the group if there are more causes leading to that problem.
• Similarly you must ask if there are any more effects resulting from that
problem.
• If there are multiple effects resulting from a cause, place them side by side
and above the cause(s).
D: Checking the logic
• At each stage you should invite participants to move the cards, i.e. to suggest
or hypothesize other relationships.
• When you have placed all cards, review the structure to ensure that related
streams of cause and effect are close to each other on the problem diagram.
• Choose one of the cards at the top line of your Problem Tree, then work back
through the diagram according to the guiding question: “What leads to, or
causes, that?” in order to check the logic or completeness of your cause-effect
structure.
E: Drafting the problem tree diagram
• Then draw in vertical links to show cause-effect relationships, and horizontal
links to show joint causes and combined effects; and
• Copy your diagram onto a sheet of paper and distribute it for further comment
and variations within an appropriate time period.

5.2 Stakeholder analysis

Having identified the main problems and the cause and effect relationship
between them, it is then important to give further consideration to who these
problems actually impact on most, and what the roles and interests of
different stakeholders might be in addressing the problems and reaching
solutions.
 On some occasions it may be advisable to undertake the stakeholder analysis
(or an initial stakeholder analysis) before embarking on the problem analysis.

For example, if it is likely that there are strong competing interests within or
between stakeholder groups that may influence their input into the analysis of
the development problem, then this should be known beforehand so that the
problem analysis can ensure such divergent views and interests are
appropriately ‘captured’ and factored into the analysis.

The main purposes of stakeholder analysis are to:

 Understand the interests of different groups, and their capacities to address

identified problems, and
 Design activities that appropriately address institutional capacity, distributional
and social issues.

Stakeholder analysis is about asking the questions: “Whose problem” and, if an

activity is then designed: “Who will benefit?” Stakeholder analysis is thus an
essential element of both poverty and gender analysis.
Stakeholder analysis also helps to determine who needs
to change the way they operate/work in order to address
problems and thus achieve desired objectives.

The main steps in stakeholder analysis include

• Identifying the principal stakeholders (these can be at

various levels, eg local, regional, national)
• Investigating their roles, interests, relative power and
capacity to participate
• Identifying the extent of cooperation or conflict in the
relationship between stakeholders, and
• Interpreting the findings of the analysis and defining
how this should be incorporated into activity design.
 In using the LFA approach, the stakeholder analysis is an
analysis of the problems, fears, interests, expectations,
restrictions and potentials of all:
 Important groups
 Organizations and institutions
 Other projects and
 Individuals who may have an influence on a situation/(intended)
project or are themselves affected by it. Those analyzed in detail
should be limited to those who are perceived to:
• be able to contribute to questions to be answered
• be important with regard to decisions to be taken.

They should constantly be referred to in developing the LFA. Key

questions to ask in preparation for developing the logframe are:

Ø Who will be involved in the logframe development?

Ø Where will the development be conducted?
Ø Who will facilitate the development of the logframe?
Ø What background materials, papers and expertise may be
needed?
When looking at who the stakeholders are, it is useful to
distinguish between the ‘target group’ and the ‘final
beneficiaries’.

Stakeholders: Individuals or institutions that may

directly or indirectly, positively or negatively be affected by
or affect an Activity

Beneficiaries: Are those who benefit in whatever way

from the implementation of the Activity.

Target group(s): The group/entity who will be directly

positively affected by the Activity at the Activity Outcome
level. This may include the staff from partner organizations.

It is important to see stakeholder analysis as part of the

iterative process of activity planning.
As both problems and potential activity objectives are analyzed in more detail,
the stakeholder analysis should be reviewed and updated to account for the new
information which comes to light.
A: SWOT analysis
SWOT analysis (strengths, weaknesses, opportunities and threats) is used to
analyze the internal strengths and weaknesses of an organization and the
external opportunities and threats that it faces. It can be used either as a tool for
general analysis, or to look at how an organization might address a specific
problem or challenge.
The quality of information derived from using this tool depends (as ever) on
who is involved and how the process is managed – it basically just provides a
structure and focus for discussion.
SWOT is undertaken in three main stages, namely
1. Ideas are generated about the internal strengths and weaknesses of a group or
organization, and the external opportunities and threats
2. The situation is analysed by looking for ways in which the
group/organisation’s strengths can be built on to overcome identified
weaknesses, and opportunities can be taken to minimize threats, and
3. A strategy for making improvements is formulated (and then subsequently
developed using a number of additional analytical planning tools).
An example of a SWOT matrix, (analyzing the capacity of an organization to
deliver effective staff training) is shown in Figure B3 below:
SWOT matrix
Strengths Weaknesses
Senior management commitment to HRD No comprehensive training strategy in place
Suitable infrastructure available Lack of appropriate written policy and
Reasonable budget allocation for training criteria for selection of trainees
Cadre of trained trainers and training Budget allocation processes not linked to
managers available in-house analysis of priorities/needs
No defined and structured process for
training needs analysis and training course
design

Opportunities Threats
Increasing pressure from public and from National fiscal outlook not promising – threat
politicians to address police service training of budget cuts
needs Risk of growing institutional corruption
Public Service Training Institute starting to Country commitment to regional and
offer broader range of generic management international peacekeeping are stretching
skills training overall resources
Regional interest in joint/collaborative
security issues resulting in increased sharing
of resources for training
B: Venn diagrams
Venn Diagrams are created to analyse and illustrate the nature of relationships
between key stakeholder groups. The size of the circle used can help indicate the
relative power/influence of each group/organization, while the spatial separation
is used to indicate the relative strength or weakness of the working
relationship/interaction between different groups/organizations. Venn diagrams
are commonly used as a participatory planning tool with target groups, to help
them profile their concept of such relationships. An example of a Venn Diagram
is shown in Figure B4.

Figure: Venn Diagram

Venn diagram of stakeholder relationships in the ‘justice sector’ – from a
community perspective
community
Public sector

Traditional
Police elders

Village courts
Judiciary
Preliminary analysis indicates that: Community consider themselves close to
Village Elders and to village courts, but distant from ‘official’ justice
organisations. Police are viewed as distant but powerful, and closely linked to
the judiciary and public prosecutor. The ombudsman is particularly distant and
seen to be aligned with other “official” interests.
5.3 Analysis of objectives
Objective trees should be prepared after the problem tree has been completed
and an initial stakeholder analysis has been undertaken.
In its simplest form, the objective tree uses exactly the same structure as
the problem tree, but with the problem statements (negatives) turned into
objective statements (positives). However, the results of the stakeholder
analysis may have helped to give better focus to priority problems and not all of
the original problem statements may therefore need to be translated into
objective statements.
While the problem tree shows the cause and effect relationship between
problems, the objective tree shows the means - end relationship between
objectives (i.e. the means by which desired ends – or results – will be
achieved). This leads directly into developing the activity’s narrative
description in the LFM.
Once the negative statements from the problem tree have been re-worded to
positive statements, you should then check
• are the statements clear and unambiguous?
• are the links between each statement logical and reasonable? (Will the
achievement of one help support the attainment of another that is above it in the
hierarchy?)
• is there a need to add any other positive actions and/or statements? More detail
may be required.
• are the positive actions at one level sufficient to lead to the result above?
• do the risks to achieving the objectives and also having sustainable outcomes
appear to be manageable?
• is the overall structure simple and clear? Simplify if possible or necessary.

Once these main points have been checked, the proposed objective tree structure
can be circulated for further comment and feedback.
The problem tree is transformed into an objectives tree by restating the problems as
objectives. The objectives tree can be viewed as the positive mirror image of the
problem tree. It is usually necessary to reorder the position of objectives as you
develop the tree. The objectives tree can also be considered as an 'ends - means'
diagram. The top of the tree is the end that is desired and the lower levels are the
means to achieving the end.
Example:
5.4 Analysis of alternative strategies

During the process of analyzing the problems, stakeholder issues and

developing a draft objective tree, views on the potential merits or difficulties
and risks associated with different possible interventions should have been
developed and discussed. These options then need to be further scrutinized to
help firm up the likely scope of the activity before more detailed design takes
place.
The type of questions that might need to be asked (and answered) could include
• should all of the identified problems and/or objectives be tackled, or a selected
few?
• what is the combination of interventions that are most likely to bring about the
desired results and promote sustainability of benefits?
• what are the likely capital and recurrent cost implications of different possible
interventions, and what can be realistically afforded?
• which strategy will best support participation by both women and men?
• which strategy will most effectively support institutional strengthening
objectives? and
• how can negative environmental impacts be best mitigated?
 To assess alternative interventions in a workshop setting, it is useful to identify and
agree on a number of assessment criteria against which alternative interventions can
be ranked or scored. Criteria that may be used to help make a broad assessment of
different intervention options could include the expected
• benefits to target groups – level of benefits, equity and participation
• sustainability of the benefits
• ability to repair and maintain assets post-activity
• total cost and recurrent cost implications
• financial and economic viability
• technical feasibility
• contribution to institutional strengthening and management capacity building
• environmental impact, and
• compatibility of activity with sector or program priorities.
An activity design should demonstrate that the main alternative options have been
assessed and considered. There is always more than one way to solve a
development problem. The aim is to find the best way.
However, it is important to emphasize again that activity planning is not a linear
process. One does not move mechanistically from one step to the next, always in a
forward direction.
Example:
5.5 Link to the Logframe matrix

The figure of the objective tree shows how the objective tree can be used to start
framing the objectives hierarchy in the first column of the Logframe matrix.
Objectives at the top of the tree should help frame goal and purpose statements,
while further down the tree component objective and output statements can be
identified. However, it should not be expected that the objective tree can be
transposed directly, without further adjustment, into the hierarchy of the activity
description in the matrix. Further adjustment and refinement of statements is
usually required and checking of the ‘means-ends’ logic should be ongoing as
the matrix is developed.
The logframe matrix is developed from the strategy analysis by filling in the
columns of the matrix as shown below. The goals, purpose, outputs/results and
inputs/activities are transposed from the strategy tree to the columns and rows in
the matrix.
The PPM (Project planning matrix) provides a one-page summary of:

Ø Why a project is carried out (= who/what will benefit ?)

Ø What the project is expected to achieve (= utilisation of services)
 Ø How the project is going to achieve its outputs/results (= measures executed)
Ø Which external factors are crucial for the success of the Project (= risks and
frame conditions)
Ø How we can assess the success (= indicators)
Ø Where we will find the data required to assess the success (= means of
verification).
A Fiji Police Training Project is used as an example.
 Assignment:
analyze a situation in any Rwandan sector of your choice
and find out the core problem that you want to solve and
the causes of that core problem (other sub problems),
present the problem tree and the objective tree, and lastly
present the summary of your project in a logical
framework matrix
 Chapter 4: TIME AND COST MANAGEMENT

I. Time Management
1. Activity List
This is a complete list of project activities, detailing all the work
packages according to their respective actions.
Activities are the necessary stages for the completion of a project. They
are performed on a sequence determined by the project characteristics.
The activities may occur sequentially or simultaneously.
The main types of activities are described in the following text:
 Executive activities or tasks:
These are the activities directly related to the course of action within the
project. Examples of executive activities:
 Packing computers
 Cleaning the land
 Typing a purchase report
 Reviewing an article
 Milestones or deliverables:
The milestone represents an event or condition that marks the execution of a group of
activities related to each other, or the completion of a project phase. It serves also to
identify the work package deliverables and has no duration. It is also referred to as
stages or gates. Examples of milestones:
 Roof ready (delivery)
 Product tests performed
 Third installment paid

 Summary activities, summary tasks, or work packages:

These are activities that comprise other activities, called sub activities. They represent
sets of activities that encompass the duration, dates, and costs of the activities
belonging to them. They may also be called work packages.
Examples of summary activities:
 Planning phase
 Building the house foundation
 Drawing the product prototype
 Design phase
2. Gantt Chart

A Gantt chart is a very popular graphical representation of schedules. The chart

uses horizontal bars, placed within a timescale. The relative bar lengths determine
the activity duration. Sometimes the Gantt chart includes lines connecting the
individual bars, reflecting the relationship among tasks.

The main advantages of the Gantt chart are the following:

- Easy to understand
- Delays are easily viewed
- Well-defined timescale

Its main disadvantages are the following:

- Not adequate for projects with a large number of tasks
- Dependencies are difficult to view
- Vague description of how the project reacts to scope changes

The Gantt chart is the standard display in most of the project management
software.
3. Network Diagram

A network diagram is a graphic representation of the interrelationship

among project activities (Figure below).
In the past, it was sometimes known as PERT (program evaluation and
review technique) chart. The network diagram highlights the
interrelationship among activities in the global project.

The advantages of a network diagram are the following:

- Easy to understand
- Well-defined interdependency among activities

The disadvantages of a network diagram are the following:

- Presents too long reports
- Does not display a visual relationship among activity durations
- Difficult to handle (too much paper)
4. Milestones Chart

The Milestones chart is a representation of the main project deliverables within a

schedule (Figure below).

It is an extremely condensed report with high management value.

II. Cost Management

1 Project Task Budget

The project budget can be represented by the sum of the fixed cost plus the
cost of the resources of each project activity. Budgets are the financial
attributions of the resources necessary to complete the project, usually
expressed in currency units (see Table below).
2: NETWORK SCHEDULING AND THE PERT METHOD

I. The network scheduling

Gantt charts indicate the general sequence of work tasks, but they do not explicitly
show the relationships among tasks, nor the impact of delaying tasks or of shifting
resources. Planning and scheduling methods using networks do not have this
inadequacy. They clearly show interdependencies among activities and enable
planning and scheduling functions to be performed separately. Alternative plans can
be analyzed and, afterwards, they can be scheduled according to the availability of
resources.
This chapter addresses the topic of project network development and describe the
most widely used network based approaches to project planning, the precedence
diagramming method (PDM), the program evaluation and review technique
(PERT), and the critical path method (CPM).

1. Logical diagrams and networks

The simplest kind of network, called a logic diagram, shows the major elements of a
group of tasks and their logical relationship. It clearly exposes those tasks that
must be completed before others can be started; this is called the “precedence.”
Example:
This figure is a logic diagram for “getting up in the morning and getting dressed”
(for a male). The boxes represent tasks (or activities) and the arrows connecting
them show the order in which they should occur (e.g., put on shirt before tie, put on
pants and socks before shoes, etc.).

Before activities can be included in a network, their relationships to each other must
be known; in general, this involves knowing for each activity:
• What activities are its predecessors?
• What activities are its successors?
• What activities can be done at the same time as it?
Every activity, except the first one, has predecessors, which are activities that must
be completed ahead of it. In the figure above, for example, “put on shirt” is a
predecessor for “put on tie.” Similarly, every activity except the last has successors,
activities that cannot begin until the current activity is completed. “Put on tie” is a
successor of “put on shirt,” which is a successor of “put on underwear,” and so on.
However, to construct a network it is really only necessary to identify each
activity’s immediate predecessors, those activities that immediately precede it. For
example, although “wake up” and “get undressed” are both predecessors for “take
shower,” only “get undressed” is the immediate predecessor and need be identified.
Given the information in, for example, the previous table it is easy to construct
the network in the previous figure by starting with the first activity (the one with
no immediate predecessors), then linking activities one by one to their respective
immediate predecessors.

Once you have constructed the network you can easily see which activities are
sequential and which are parallel.
Two activities that have a predecessor-successor relationship are sequential
activities one follows the other. For example, “take shower,” “put on
underwear,” and “put on shirt” are sequential activities because they occur in that
order, one after another.
Two or more independent activities that can be performed at the same time
are parallel activities. For instance, “put on shirt,” “put on pants,” “dry, brush
hair,” and “put on socks” are parallel because they can be done in any order or
(though difficult in this case) all at the same time.

The immediate predecessors for a task should be determined during the

WBS analysis. Relationships are then checked for completeness and logical
consistency when the project network is constructed.
2. The critical path

How are networks used in project planning? The major use of

networks is for scheduling, determining how long the project
will take (the expected project duration) and when each
activity should be scheduled.
The expected project duration, Te, is determined by finding
the longest path through the network. A “path” is any route
comprised of one or more arrows (activities) connected in
sequence. The longest path from the origin node to the
terminal node is called the critical path; this gives the
expected project duration.

These concepts are illustrated in the following example. The

firm of Kelly, Apple baum, Nuzzo, and Earl, Assoc. (KANE) is
working on the Robotics Self-Budgeting (ROSEBUD) project.
Table below lists the project activities and Figure below
shows the network. The first phase in the project is systems
design (Activity J). After that, simultaneously (a) the robotics
hardware is procured, assembled, and installed (M-V-Y), and
Table: Activities for the ROSEBUD project.
The first activity J (system design) takes 6 weeks. Notice in Figure below that after J
has been completed; both the “hardware activities” and “software activities” can
begin.
It will take 4 + 6 + 8 = 18 weeks to do the hardware activities (Path M-V-Y), and 2
+ 8 = 10 weeks to do the software activities (Path L-Q). Because Activity J takes 6
weeks, hardware will be ready for Activity W (system test) in 6 + 18 = 24 weeks,
and the software will be ready in 6 + 10 = 16 weeks. However, because both the
hardware and the software activities must be finished before Activity W (system
test) can begin, the earliest Activity W can begin is in 24 weeks. Two weeks later,
after both Activity W and Activity X (user test) are completed, the ROSEBUD
project will be completed. Thus, the project duration is Te = 24 + 1 + 1 = 26 weeks.
Notice that there are two paths from the origin node to the terminal node. The
shorter path J-L-Q-W-X is 18 weeks long; the longer path J-M-V-Y-W-X is 26
weeks long. In general, the longest path gives the duration of the project. This is
called the critical path, and the activities that comprise it are called critical
activities. The path is “critical” in the sense that, should it be necessary to reduce
the project completion time, the reduction would have to be made by shortening
activities on the critical path. Shortening any activity on the critical path by 1 week
would have the effect of reducing the project duration by 1 week.
In contrast, shortening activities not on the critical path, L or Q, would have no
effect on project duration. If either activity is reduced by 1 week, then the software
activities will be completed in week 15 instead of week 16. However, this would not
change the project duration because Activity W still has to wait for completion of
hardware activities, which is not until after week 24.
The critical path is important for another reason: A delay in any activities along the
critical path will result in a delay in the completion of the project. Should any
critical activities be delayed by 1 week the project completion will be delayed by 1
week.
Notice, however, that noncritical activities L and Q can be delayed somewhat
without delaying the project. In fact, together they can be delayed up to 8 weeks.
This is because they will be completed in week 16, which is 8 weeks earlier than the
hardware.
Thus, although the software can be ready at the end of week 16, it is okay if it is not
ready until the end of week 24.
As a further example, look at the network in Figure below. This network has
four paths leading from origin to termination:
a. H-J-P-Y-Z
b. H-J-K-V-X-Y-Z
c. H-J-M-R-V-X-Y-Z
d. H-J-L-Q-T-Z
The lengths of the four paths are, respectively: 35, 42, 47, and 32; the critical path is
c, the longest, and Te is 47.

II. PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT)

The PERT is a network method for project planning. PERT was developed for
application in projects where there is uncertainty associated with the nature and
duration of activities. It originated in the late 1950s during the U.S. Navy’s Polaris
Missile System program. In complex research and development programs there are
questions about the kind of research to be done, how long it will take, what
stages of development are necessary, and how fast they can be completed
largely because of the uncertainty about the exact nature of the final outcomes.
Such projects are contracted as new developments unfold and before problems in
technology, materials, and processes can be identified and resolved.
Thus, the duration of the project is uncertain, and there is considerable risk that the
project will overrun the target completion time.
To accelerate the Polaris program a special operations research team was formed in
1958 with representatives from the Navy’s Special Projects Office, the consulting
firm of Booz, Allen, and Hamilton, and the prime contractor Lockheed Missile
Systems. As a way of handling uncertainties in the estimating activity times, the
team developed PERT.
1.Three Time Estimates

PERT addresses uncertainty in the duration by using three time estimates,

optimistic, most likely, and pessimistic. These estimates then are used to calculate
the “expected time” for an activity. The range between the estimates provides a
measure of variability, which permits statistical inferences to be made about the
likelihood of project events happening at particular times.

As seen in the figure below the optimistic time, a, is the minimum time an activity
could take, the situation where everything goes well; there should be little hope of
finishing earlier. A normal level of effort is assumed with no extra shifts or
personnel. The most likely time, m, is the normal time to complete the job. It is the
time that would occur most frequently if the activity could be repeated. Finally, the
pessimistic time, b, is the maximum time an activity could take. the situation
where bad luck is encountered at every step. The pessimistic time includes likely
internal problems in development or fabrication, but not environmental snags such
as strikes, power shortages, bankruptcy, fire, or natural disasters. The three
estimates are obtained from the people most knowledgeable about difficulties
likely to be encountered and about the potential variability in time, expert
estimators or those who will actually perform or manage the activity.
The three estimates are related in the form of a Beta
probability distribution with parameters a and b as the end
points, and m the modal, or most frequent, value. The PERT
originators chose the Beta distribution because it is unimodal,
has finite end points, and is not necessarily symmetrical,
properties that seem desirable for a distribution of activity
times.
Based on this distribution, the mean or expected time, te, and
the variance, V, of each activity are computed with the three
time estimates using the following formulas:
The expected time, te, represents the point on the
distribution in the previous figure above where there is a
50-50 chance that the activity will be completed earlier or
later than it. In figure above:
The larger V, the less reliable te, and the higher the likelihood that the
activity will be completed much earlier or much later than te.
This simply reflects that the farther apart a and b, the more dispersed the
distribution and the greater the chance that the actual time will be significantly
different from the expected time, te. In a “standard job” estimates of a and b are
close to each other, V is small, and te is more reliable.

2. Probability of Finishing by a Target Completion Date

The expected time, te, is used in the same way as the estimated activity duration
time was used in the networks. Because statistically the expected time of a
sequence of independent activities is the sum of their individual expected times,
the expected duration of the project, Te, is the sum of the expected activity times
along the critical path:
where te are expected times of the activities on the critical path. In PERT, the project
duration is not considered a single point estimate but an estimate subject to uncertainty
owing to the uncertainties of the activity times along the critical path. Because the project
duration Te is computed as the sum of average activity times along the critical path, it
follows that Te is an average time. Thus, the project duration can be thought of as a
probability distribution with an average of Te. So the probability of completing the project
prior to Te is 50 percent, and the probability of completing it later than Te is 50 percent.
The variation in the project duration distribution is computed as the sum of the variances of
the activity durations along the critical path:

where V are variances of activities on the critical path.

These concepts are illustrated in the network in the figure below.
The distribution of project durations is approximated using the familiar bell shaped, normal
distribution.
Given this assumption, the probability of meeting any target project completion date Ts
that does not coincide with the expected date Te can be determined.
As examples, consider two questions about the project shown in the figure:
(1) What is the probability of completing the project in 27 days?
(2) What is the latest likely date by which the project will be completed (on which
date do we have 95% of chance of finishing the project) ? Both questions can be
answered by determining the number of standard deviations that separate Ts from
Te. The formula for the calculation is:

To answer the first question, use Ts = 27 because the question asks the probability
of finishing within a target completion date of 27 days. From the network, the
expected project duration, Te, is computed as 29 days. Therefore
The probability of completing the project within 27 days is equal to the area under
the normal curve to the left of z = -0.82. Referring to statistic table and interpolation
(see statistic first year management) and interpolating, the probability is 0.207, or
about 21 percent. (P (z < - 0.82) = P (z>0.82) because the curve of Gauss is
symmetric. Therefore, this probability can be transformed into: 1 – P(z <0.82). 1 –
0.7939 = 0.207 = 21%.( Read book: Bernard Grais, statistic methods, 3rd edition,
2000, page 110)
The first thing to do is to calculate the te and V for each activities. The V of each
path will equal to the sum of te and V of activities constituting the path.

*critical path
*near critical paths
To answer the second question, suppose we rephrase it to ask: At what date is there
a 95 percent probability that the project will have been completed? Again, using the
table and interpolating, a probability of 0.95 is seen to have a z value of
approximately 1.645. As before, we calculate:
In other words, it is “highly likely” (95 percent probable) that the project will be
completed within 33 days.

5. Time-Cost Relationship

The critical path method assumes that the estimated completion time for a
project can be shortened by applying additional resources; labor,
equipment, capital to particular key activities. It assumes that the time to
perform any project activity is variable, depending on the amount of effort or
resources applied to it.
Unless stated otherwise, any given activity is assumed to be performed at a
normal (usual and customary) work pace. This is the “normal” point shown in
the figure below.
Associated with this pace is the normal time, Tn—how long the activity will
take under normal work conditions. Also associated with the normal pace is the
normal cost, Cn, the price of doing the activity in the normal time. (Usually the
normal pace is assumed to be the most efficient and thus least costly pace.
Extending the activity beyond the normal pace will not produce any additional
savings and might well increase the cost.)
To reduce the time to complete the activity, more resources are applied in the form
of additional personnel and overtime. As more resources are applied, the duration
is shortened, but the cost rises. When the maximum effort is applied so that the
activity can be completed in the shortest possible time, the activity is said to be
crashed. The crash condition represents not only the shortest activity duration, but
the greatest cost as well.
This is the “crash” point shown in the figure below
Figure: Time-cost relationship for an activity.
The cost slope is given by:

= - $3/week

As illustrated in the figure above, the time-cost of completing an activity under

normal conditions and crash conditions theoretically defines two extreme points.
The line connecting these points, called the cost slope, represents the time-cost
relationship, or marginal trade-off of cost-to-time for the activity. Every activity
has its own unique time-cost relationship.
The relationship can be linear, curvilinear (concave or convex), or a step
function. Because the shape of the actual time-cost relationship is often not
known, a simple linear relationship is assumed. Given this assumption, the
formula for the cost slope is where Cc and Cn are the crash and normal costs,
respectively, and Tc and Tn are the crash and normal times for the same activity.
The cost slope shows by how much the cost of the job would change if activities
were sped up or slowed down. In general, the steepness of the cost slope
increases as an activity is accelerated.
Using the formula, the cost slope for the activity in the figure above is $3K per
week.

Thus, for each week the activity duration is reduced (sped up) from the normal
time of 8 weeks, the additional cost will be $3K. Completing the activity 1 week
earlier (in 7 weeks) would increase the cost of the activity from the normal cost
of $9K to the “sped up” cost of $9K + $3K = $12K; completing it another week
earlier (in 6 weeks) would increase the cost to $12K + $3K = $15K; completing
it yet another week earlier (in 5 weeks) would increase the cost to $18K.
According to the figure above, this last step puts the activity at the crash point,
the shortest possible completion time for the activity.

6: Reducing Project Duration

The cost-slope concept can be used to determine the most efficient way of
shortening a project. The figure below illustrates this with a simple example.
Start with the preliminary project schedule by assuming a normal pace for all
activities: therefore, the project in the figure can be completed in 22 weeks at an
expense of $52K. Suppose we want to shorten the project duration. Recall that the
project duration is the length of the critical path. Because the critical path A-D-G is
the longest path (22 weeks), the way to shorten the project is to simply shorten any
critical activities— A, D, or G. Reducing an activity increases its cost, but because the
reduction can be made anywhere on the critical path, the cost increase is minimized by
selecting the activity with the smallest cost slope. Thus, Activity A would be selected
because it has the smallest cost slope. Reducing A by 1 week shortens the project
duration to 21 weeks and adds $2K (the cost slope of A) to the project cost, bringing
the project cost up to $52K + $2K = $54K.
This step does not change the critical path so, if need be, an additional week can be cut
from A to give a project duration of 20 weeks for a cost of $54K + $2K = $56K.
With this second step, the nature of the problem has changed. As the top network in
the figure below shows, all of the slack on Path B-E-G has been used up, so the
network now has two critical paths: A-D-G and B-E-G. Any further reduction in
project duration must be made by shortening both paths because shortening just one
would leave the other at 20 weeks. The least costly way to reduce the project to 19
weeks is to reduce both A and E by 1 week, as shown in the bottom network in the
figure below. The additional cost is $2K for A and $2K for E, so the resulting project
cost would increase to $56K + $2K + $2K = $60K. This last step reduces A to 6
weeks, its crash time, so no further reductions can be made to A.
 Chapter 5: FEASIBILITY STUDY OF A PROJECT

I. MEASUREMENT OF THE VALUE OF NON MERCHANT GOODS AND

SERVICES

The measure of utility or satisfaction produced by a project seems to be simple and

easy when the production is sold on a given price: the produced quantities or sold
quantities are multiplied by the foreseen prices and we obtain the measure of goods
or services value produced by the project. The following formula gives the social
value of the goods or service:
Value of goods or service = number of produced unities x unit value of the goods or
service.
Valorization of non merchant goods and services by the community that produced
them

For products which cannot be sold directly to the consumers, it is possible to

estimate the price, or the measure of the value that a community can attribute to a
certain quantity of a social goods or service. This process is somehow complex but
provides prices socially as significant as market prices.
 The basic theory of “socially determined prices” can be expressed in
abstract terms at a national level throughout a political process. In this
course, we will use a new approach that is used by international NGO for
measuring the value of non merchant
Let us suppose a village which wants to improve the situation of the
population in three types of “social goods”:

1. one or several schools which will allow alphabetization of children, may

be also of adults
2. a network of hospital which will allow the improvement of the
population health
3. water wells (puits d´eau) which will provide a use quantity of available
water, of good quality et more closer to the village than the current well

Through the following stapes, this village can arrive to determine the prices
which will allow measuring the “social satisfaction” regarding the budget
of the project.
 stage 1 : choice of products and definition of unities of goods

For each social sector chosen by the community, (health, education, drinkable water),
the village must begin by defining produced unities: for example: one year of school for
children, a certain quantity of water per family and per day, a child vaccinated against
diseases that affect children, or one medical consulting for a pregnant woman, etc.
By discussing with the population, it is possible in a community, to determine quantities
of each social goods the population likes or prefers to obtain.

stage 2 : rank the different products

Once the types and quantities of goods have been defined, one can ask to the population
to rank the preferences, it means to range the different products according to their
preferences. Of course, this process is complex, but with a dialogue and discussion with
the population by asking them clear and precise questions, it is again possible, by
asking them for example to vote, that the population rank their preferences.
Afterward, the preferences can be weighted. The objective here is to ask the community
for how much it prefers one product to another one. A very simple way is to begin by
most desired product and to see afterward; to what extent the first product is preferred
to the second one, etc.
Let us suppose that after discussing with the population, the village has defined
three products: one year of schooling for a child, 50 liter of water per family and
per day, one medical consulting for pregnant woman at the hospital, with the
weighting given bellow. A higher weighting means that the product is highly
desired by the population.

This table shows that through a democratic process, the village has ranked the
different products. The drinkable water is 2 times preferred than the children
schooling, and the later is 2 times preferred than the medical consulting.
Stage 3: The sum of the weighting and expression of the weighting in terms of percentages.

To easy the future calculations, we will express the weights in percentage, by comparing each to
the total. The following table is then obtained:

To estimate the return of the project, we will assume first of all that the
production of the project will not change the value that the population
attributes to the goods produced by the project. It means that the value
of a product will not change if for example it is produced in a huge
quantity.
- stage 4: estimation of the production of the project (in quantity)

Let us suppose that there are several possible combinations of the project, each combination
can produce a certain quantity of each type of product. One can have for example a project 1
that produces 100 units of water (X), its means 2 wells, 200 school units, etc. the following
table gives the different possibilities of production.
Number of unites produced (X, Y, Z) by the project n°....

The table gives also an estimation of the investment cost of each project.

Stage 5 : estimation of social utilities (satisfaction) that each project can produce

After estimating the producible quantities, one can now estimate the social value
that each project can produce by multiplying the number of units of each product by
its social value (its weight) estimated in the following table:
One can see that that greatest collective satisfaction of utility is given by the
project n° 2 and n°3. However, to select the best project, one must not only
calculate the satisfaction produced by the project but also the cost at which
the utility or satisfaction is produced.

stage 6: comparison (ratio) of utilities (advantages) and costs, i,e, return

By calculating the ratio between the utilities generated by each project and
its cost, one can obtain the following ratios:
One can see that, basing on return (ration Utilities (advantage)/cost), the project
n°1 has the highest return, followed by the project n°3 and by the project n°2.

- stage 7: Value of the weighs in terms of monetary units

If we agree that the village has limited means, either because its revenues are
limited or because the working time the peasant can allocate to the project (work
group) is limited, or the combination of the 2 reasons, we will see that this limit
will allow giving a monetary value to each weight.
Let us assume that the village possesses only a budget of $15000 to be affected to
projects.
 With this amount the project will decide to carry out the project n°1 and n°3 which
offer the highest return according to the budget. In other words, taking account the
budget constraint, the village will reach the highest satisfaction per spent $ by
carrying out the two projects.
One can also notice that the total satisfaction of the projects n°1 and n°3 equals to
121.45+214.2 = 335.65 points of collective value. It means that, the peasants are
ready to spend $ 15000 for reaching a global satisfaction at which they give a value
of 335.65 points. In other words each value point equals (is worth) for the village
(15000/335.65) = 44.69$

II. PROFITABILITY ASSESSMENT OF INVESTMENT PROJECTS

DEMAND ESTIMATE
Introduction

It is of vital importance for any firm to have an understanding of the demand for its
products. Demand relationships determine revenues and indirectly affect output and
costs; they thus have a fundamental impact on profits. An understanding of demand
is also relevant for planning purposes, involving production, transportation,
inventory, sales, marketing and finance functions.
The identification of factors affecting demand and the precise effects that these
have is therefore a core element in managerial economics.

3.2 Definition and representation

3.2.1 Meaning of demand

Unfortunately the word ‘demand’ can be used in a variety of senses, which often
causes misunderstanding and errors of analysis. We can talk about demand
curves, schedules, functions, equations, relationships or points.

When economists use the single word ‘demand’ they are referring to the
relationship that is frequently called the demand curve. In this sense, demand
refers to the quantities that people are or would be willing to buy at different
prices during a given time period, assuming that other factors affecting these
quantities remain the same.
 It is worth noting that this definition incorporates three important concepts:
- It involves three parameters – price, quantity and time
- It refers to quantities in the plural, therefore a whole relationship, not a single
quantity
- It involves the ceteris paribus (other things being equal) assumption, which is a
very common one in making statements in economics.

Example:
Demand table
3.2.2 Tables, graphs and equations
a. Tables
These are the simplest method of representation. An example of a demand table or
schedule faced by a retailer is given above. The table shows the general ‘law of
demand’, that less is demanded at higher prices. It should be noted that the original
statement above relating to a quantity demanded is included in the table as one of
the five pairs of values. Although they are simple to understand the main problem
with tables is that they are not very useful for analytical purposes.
b. Graphs

These are much more useful for analysis, and indeed most analysis in introductory
microeconomics involves the use of graphs. A graph relating to the above demand
schedule is shown in Figure above. It can be seen that the demand relationship in
this case is both inverse and linear. At this stage both of these characteristics are
assumed, but later on both of these assumptions will have to be examined. Again the
difference between the concepts of demand and quantity demanded is illustrated:
the former relates to the whole demand curve whereas the latter relates to a single
point on the curve.
Although graphical analysis is very useful in economics its main disadvantage is
that it essentially involves a two-dimensional framework. Thus it is mainly limited
to examining two-variable relationships. Demand relationships often involve many
variables and although the effects of these can be shown on a graph, they are
difficult to measure.

c. Equations
These are the most useful method of representation for analytical purposes since
they explicitly show the effects of all the variables affecting quantity demanded, in a
concise form that at the same time reveals important information regarding the
nature of the relationship.
Taking the demand curve in Figure above, we can estimate the equation relating to it in
various ways. The general form of the demand function in terms of price and quantity
demanded is:
Taking the demand curve in Figure above, we can estimate the equation relating to it in
various ways. The general form of the demand function in terms of price and quantity
demanded is:
Q = f(P)
This is the most general way of describing the relationship since it does not involve
any specific mathematical form. It can obviously be expanded by including any
number of variables that might affect quantity demanded on the right hand side of the
equation, for example:
Q = f(P; A; Y; Ps; . . . )
where A represents advertising expenditure, Y represents average income of the market
and Ps represents the price of a substitute product.
In the two-variable case the demand function can be expressed in a linear form:
Q = a + bP
a and b are coefficients, represents . Again any two pairs of values can be used to
establish that b=-2. For example, if the first two pairs of values are taken,
b=-20/10=-2. Then any pair of values can be used, substituting the value of b, to
calculate the value of a.
If the first pair of values is taken the following expression is obtained:

120 = a -2(30)
Thus a=180 and the demand equation can now be written:
Q =180 - 2P
The advantage of this approach is that the value of b can more easily be
interpreted as a slope coefficient. The value of a in turn can be interpreted as an
intercept.

a and b have economic interpretations. The value of a represents the maximum

sales that will occur if the price is zero.
While this interpretation obviously has limited practical application, the
interpretation of b is of much greater practical importance. It represents the
marginal effect of price on quantity demanded. This means that for every unit
the price rises, the quantity demanded will rise by b units. In the context of the
demand equation the value of b will normally be negative. This interpretation
can be extended to multiple-variable equations; each coefficient of a variable
represents the marginal effect of that variable on quantity demanded. Thus in
the equation:
Q = a + bP + cY
the value of c represents the marginal effect of Y (income) on Q.
Demand estimation

1. Introduction
In the previous section it was generally assumed that the demand function for a
firm or market was known; in practice it has to be estimated from empirical data,
and that is the subject of this chapter. When we speak of estimation there are a
number of stages involved in this process. Some of these stages may be omitted
in the simpler methods of estimation, like the first two described in the next
section. However, with a statistical study, or econometric analysis

2. Methods
There are a variety of ways that can be used to estimate demand, each of which
has certain advantages and disadvantages.

2.1 Consumer surveys

Firms can obtain information regarding their demand functions by using
interviews and questionnaires, asking questions about buying habits, motives and
intentions. These can be quick on-the-street interviews, or in-depth ones.
They might ask, for example, how much more petrol respondents would buy if its
price were reduced by 15 pence per liter, or which brand of several possibilities
they prefer. These methods have certain drawbacks:

1. Validity: consumers often find it difficult to answer hypothetical questions, and

sometimes they will deliberately mislead the interviewer to give the answer they
think the interviewer wants.

2. Reliability: it is difficult to collect precise quantitative data by such means.

3. Sample bias: Those responding to questions may not be typical consumers.

In spite of these problems, there are advantages of surveys:

1. They give up-to-date information reflecting the current business environment

2. Much useful information can be obtained that would be difficult to uncover in
other ways; for example, if consumers are ignorant of the relative prices of
different brands, it may be concluded that they are not sensitive to price changes.
Firms can also establish product characteristics that are important to the buyer, and
priorities. Methods such as multidimensional scaling can be used to give rating
scores on product characteristics.
3.2 Statistical models

In practice we can very rarely specify an economic relationship exactly. Models y

their nature involves simplifications; in the demand situation we cannot hope to
include all the relevant variables on the right hand side of the equation, for a
number of reasons:

1. We may not know from a theoretical viewpoint what variables are relevant in
affecting the demand for a particular product.
2. The information may not be available, or impossible to obtain. An example might
be the marketing expenditures of rival firms.
3. It may be too costly to obtain the relevant information. For example, it might be
possible to obtain information relating to the income of customers, but it would take
too much time (and may not be reliable).

What about the source of data?

There are many sources of data available, but in general the following are the most
important in demand estimation, and indeed in most of managerial economics.
1. Records of firms. Sales, marketing and accounting departments keep records
of many of the key variables of interest. Such data are normally up to date.
2. Commercial and private agencies. These include consulting firms, market
research firms and banks. In addition, a firm may want to commission one of
these agencies to carry out a particular study, but it would have to consider the
cost involved compared with using freely available data.
3. Official sources. These include government departments and agencies, and
international agencies like the EU, OECD (organization for economics
cooperation and development), WTO (world trade organization) and the various
UN agencies. Such data tend to be more macroeconomic in nature, although
there are also many industry studies.

Presentation of data

a. Tables

The most basic method of presenting demand data is in the form of a table, as
seen in the previous chapter. To begin with, we will take a two-variable study,
involving just quantity (sales) and current price, to simplify the analysis. In
reality this is only justified if either:
no other variables affect sales (highly unlikely), or
other variables do affect sales but remain constant (still fairly unlikely).
The main advantage of limiting the study to two variables is that such
relationships can easily be shown graphically.
Consider the example in Table below, relating to a cross-section study of seven
firms.

Demand table
 4.5 Simple regression
4.5.1 The OLS method

Simple regression means two-variable regression. The method of least squares

means finding the line that minimizes the sum of the squares of the differences
between the observed values of the dependent variable and the fitted values
from the line. This is easier to follow in terms of mathematical symbols
combined with a graph.
The equation to be estimated is written as follows:

The technique for solving for the values of a and b as follows:

4.5.2 Application of OLS

The OLS procedure is normally performed on a computer using a software package like
SPSS or STATA. The data are entered, the relevant commands are given and the values
of a and b are then displayed
Example:

Thus Y = 64-8x or Y= 64 – 8(X – 17) = 64 – 8X + 136 = 200 – 8X

Therefore we can write the regression line as:
Y = 200 – 8X
We can now express the demand equation in terms of sales and price as:
Q = 200 – 8P
The value of b is particularly important in the equation; as seen previously it
represents the marginal effect of price on quantity. Thus the demand equation can be
interpreted as saying that for every £1 the price rises the quantity sold will fall by
eight units.

Goodness of fit

Whereas regression analysis examines the type of relationship between variables,

correlation analysis examines the strength of the relationship, or goodness of fit.
The correlation is used for that respect.
The correlation coefficient (r) measures the degree of linear association between
variables. It should be noted that correlation says nothing about causation.
The formula for calculating the correlation coefficient can be expressed in a number
of ways, but probably the most common is:
Forecasting
Forecasting means estimating a specific value of a variable, as opposed to
estimating a whole relationship. The method used for the forecasting is the
regression analysis. In this case a value (or values) of the independent variable(s)
is given, or estimated in turn, and these values are substituted into the appropriate
demand equation.
Suppose we have the following equation:
Q = 200 – 8P
If we want a forecast for a firm charging a price of £18 we obtain a sales value of
56 units.

Multiple regression
It was highly unlikely that in a demand relationship there would only be one
factor affecting sales, or that other factors would remain constant. We therefore
have to consider the multiple regression model in order to analyze more complex
but more realistic situations. This section will focus on the differences between
the multiple regression (MR) and simple regression (SR) models. Since the MR
model is unlimited in terms of the number of independent or explanatory
variables that it can include, we must also consider how to determine which
variables to include in the model in any particular situation.
We already know that if a simple regression model produces a low R2 this is an
indication that other factors should be explicitly included in the analysis, thereby
involving a multiple regression model. The population regression function
therefore assumes the linear form:

Where are regression coefficients representing the marginal effects

of different independent variables.

The model is presented as follows:

The hypothesis here is that sales might on past price and current price.
The regression equation is:

Thus we can see the effects of both current price and past price. The
interpretation is that for every £1 the current price rises, sales will fall by 3.89
units, assuming no change in the past price. Also it can be seen that for every
£1increase in past price, current sales will be 6.394 units lower, assuming
current price stays the same.

FEASIBILITY ANALYSIS OF A PROJECT

The economic feasibility consists in three types of analysis: marketing study,
technical study and financial study.
The marketing feasibility study

The aim of this market analysis is to make sure there is a true market for the
project product or a service. The aim of this study is to conduct three kinds of
estimates:
- Estimate total demand
- Estimated total supply
- Estimate market gap

Example:
Total market = 500000 units
Total supply = 300000 units
Market gap = 200000 units
Project product = 100000 units
Market share of the project = 1000/2000 = 50%
Suppose that the increase rate of the demand is 10%
The market gap can be estimated as follows:

The share of the project of the market gap can be calculated as follows:
 Technical Feasibility Study

The Technical Feasibility Study assesses the details of how you will deliver a
product or service (i.e., materials, labor, transportation, where your business will be
located, technology needed, etc.). Think of the technical feasibility study as the
logistical or tactical plan of how your business will produce, store, deliver, and track
its products or services.
A technical feasibility study is an excellent tool for trouble-shooting and long-term
planning. In some regards it serves as a flow chart of how your products and
services evolve and move through your business to physically reach your market.
You do not have to include specific financial information in the technical portion of
your feasibility study, but all information in this component must support your
financial data represented elsewhere. Basic things that most businesses need to
include in their technical feasibility study include:
• Materials
• Labor
• Transportation or Shipping
• Physical Location
• Technology
The technical component serves as the written explanation of financial data
because it offers you a place to include detailed information about why an
expense has been projected high or low, or why it is even necessary. It
demonstrates to potential investors and lenders (and in some cases, potential
clients) that you have thought about the long-term needs your business will
have as it grows.

For example:

- Land: 200 000

- Buildings: 2 600 000
- Machinery: 10 000 000
- Other fixed assets: 2 500 000
- Raw materials & parts: 50 000 units (planned production), raw materials &
parts costs per unit: 300. Total costs of raw materials & parts = 15 000
000
Financial feasibility study of projects

Cash Flow Estimation for Capital Budgeting

Fancy formulas for ranking capital projects have little meaning unless the cash
flow data going into them are correct. In this section, we shall explore principles
for project cash flow estimation. These principles are also broadly applicable to
operating cash budgets. Cash budgets different from typical operating budgets
that focus on profit and loss.

2.1: Capital budgeting ground rules

Capital budgeting decisions are based on cash flows, not accounting income.
This overriding principle informs decision making throughout the process of
developing a cash flow model. The other overriding principle is to understand
that, like finance, capital budgeting is about shaping the future. It is a forward-
looking process, and little weight is given to anything that happened prior to the
date budgeting decisions are being made. These principles give rise to a number
of rules about cash flow estimation.
1. Incremental cash flows: Only incremental cash flows are relevant. Cash that
will flow into or out of the company whether or not the project is undertaken is
irrelevant.
2. Sunk costs: Expenditures made prior to the capital budgeting decision, also
called sunk costs, are never included in the decision-making process or in the
estimation of cash flows. Sunk costs are the result of past actions and cannot be
changed. However, sunk costs may reduce future costs. For example, if a project
can be built on a foundation that already exists, it will indirectly affect the capital
budgeting decision by lowering future costs.

3. Shipping and installation: Shipping and installation costs should be included

in capital budgeting costs.
4. Cash net of tax: Cash flows should be considered net of tax. For example, if
$50,000 per year of operating profit is expected, and the company is in the 30%
bracket, the relevant cash flow from the operating profit is $35,000 ($50,000 less
$15,000 of taxes).

5. Working capital: Most projects require changes in working capital. If a new

manufacturing plant is being brought online, arguably that will increase sales,
which will require more accounts receivable and inventory.
Some of that will be financed through increased accounts payable and payroll
accruals. So the net change in working capital is the relevant cash flow item to
budget. When the project winds down, accounts receivable will be collected, and
inventory sold and not replaced. The net working capital should be recovered.
Recovery of this working capital is also relevant for a capital budget.

6. Salvage: If plant or equipment purchased for the capital project can be sold at
the end of the project, the salvage value of that plant and equipment should be
counted as a cash inflow. Gain or loss on sale of salvage has tax consequences
that must be netted against proceeds. Selling costs should also be considered in
net cash flows as, for example, when real estate is sold through a broker.

8. Net cash flows: In some years, there will be cash outflows for plant,
equipment, upgrades, restoration of land, and so forth at the same time that there
are cash inflows from operations, salvage, or recovery of working capital. Cash
inflows and cash outflows for any given year should be netted to a single number
for the year.

9. Impact on other projects: Another factor to consider is whether sales from

this new project are going to cannibalize existing sales or, on the other hand,
enhance existing sales.
It may be difficult to quantify the incremental cash flow impact on other projects,
but such a potential impact should always be on a checklist of cash flow
estimation issues. If it is determined that the proposed project will affect cash
flow in other projects, the net affect of that cash flow should be recognized.

Projected Cash Flows

Virtually every capital project has three phases.

1. Investment cash flows: Investment outlays are expenditures needed to get the
project up and running. This includes plant and equipment, as well as increases
in net working capital for accounts receivable, inventory, and training payroll.

2. Operating cash flows: Operating cash flows are cash flows over the life of
the project.
3. Terminal cash flows: Terminal cash flows include the salvage value of plant
and equipment at the end of a project, as well as recovery of working capital.

Example:
Parker Packaging estimates it can double sales if it purchases and installs a new box-
making machine. The cost of the machine is $200,000, shipping and installation costs
are $40,000. Accounts receivable and inventory combined will double from $100,000
to $200,000 as the result of increased sales. The machine has a life expectancy of six
years and a salvage value of $20,000. After-tax profits attributable to the machine will
be $70,000 per year. Year 6 inflows are the result of operating cash inflows of
$110,000 plus the terminal cash flow of $120,000, for a total of $230,000.

Parker Packaging Cash Flow Estimates for New Box-Making Machine

Investment Outflows
1. Machine purchase and installation ($200,000 + $40,000) $240,000
2. Increase in working capital ($200,000 - $100,000) $100,000
Total initial investment $340,000
Operating Cash Flows
1. Operating profits $ 70,000
2. Depreciation ($240,000/6) $ 40,000
Total operating cash flows $110,000
Terminal Cash Flows
1. Salvage value of machine $ 20,000
2. Recovery of working capital $100,000
Total terminal cash flows $120,000
Relevant cash flows are
Year 0 Outflow $340,000
Year 1 Inflow $110,000
Year 2 Inflow $110,000
Year 3 Inflow $110,000
Year 4 Inflow $110,000
Year 5 Inflow $110,000
Year 6 Inflow $230,000

1. METHODS FOR EVALUATING CAPITAL PROJECTS

There are five basic methods for evaluating capital projects. Companies often use
two or more methods to rank projects as a reasonableness check on their analysis.
The methods are as follows:
1. Payback method: This involves determination of the amount of time it will take
to recover an investment.
2. Discounted payback method: Cash flows are discounted, then the amount of
time necessary to recover an investment in present dollars is computed.
3. Net present value (NPV): This is the present value of the cash inflows less the
present value of the cash outflows (investments).

4. Internal rate of return (IRR): This is the yield on a project. It is defined as the
discount rate that will make the net present value equal to zero.

1. Payback methods

If all cash inflows were the same in every period, one could simply divide cash
inflows by cash outflows. However, with uneven cash flows, one must subtract
inflows from outflows year by year until the final year. In the final year, divide the
residue of the outflow amount by the last inflow.
Example
A project costs $100,000 in year 0, and CF $30,000 in year 1, $50,000 in year 2,
and $70,000 in year 3. Subtracting $30,000 and $50,000 from $100,000 for years 1
and 2 leaves a residue of $20,000. The residue of the $20,000 cash outflow
(investment) /$70,000 cash inflow in year 3 = 0.286. Taken together, the payback is
2 years = 0.286 year or 2.286 years.
Partial year payback = Residue of initial investment/ Year’s cash inflow =
$20,000/$70,000 = 0.286 year
The following formula can be used:
PB= A+
A is the last period with a negative cumulative flow
/B/ Is the absolute value of cumulative cash flow at the end of the period A
C is the total of cash flow during the period after A

When using the payback method, projects with the shortest payback rank ahead of
projects with longer paybacks. Since payback provides information on how quickly
investments are recovered, it addresses liquidity and cash flow issues, both of which are
extremely important to small businesses.
While the payback method is simple and widely used, it has two major flaws: (1) it
doesn’t consider the time value of money, and (2) it tends to favor projects with
near-term payback, compared to a project that has a greater payback over the long
run.

Consider two projects, A and B. Both require an investment of $100,000. Cash inflows
for project A are $50,000 for three years, at which time the project ends. Cash inflows
for project B are $40,000 for eight years. The payback method will rank project A ahead
of project B, even though project B will generate more cash over its lifetime.
Format for computing payback:
2. Discounted payback method

The discounted payback method is similar to the payback method

except that all future cash inflows and outflows are discounted back to
the present. Discounted payback is a method for determining how
long it will take for the project to pay for itself in present dollars.
Example

A project costs $100,000 in year 0. Cash inflows are Y1 = $30,000, Y2 =$50,000,

Y3 = $70,000, where year 0 is the present, and Y1, Y2, and Y3 are the inflows in
one, two, and three years, respectively. Assume a discount rate of 12%. The table
below provides a format for computing discounted payback. Projects with the
shortest discounted payback ranked highest. This method has an advantage over
the simple payback method because it considers the time value of money.
Since it provides information on how quickly investments are recovered, it
addresses liquidity and cash flow issues. However, it still suffers from one of the
payback method’s shortcomings. It doesn’t consider the value of cash generated
beyond the payback date. Let’s look at projects A and B in more detail (see Figure
below).

Both require a $100,000 investment, and A pays $50,000 for three years, whereas
B pays $40,000 for eight years. For purposes of this example, assume a discount
rate of 10%.

Format for computing Discounted Payback

Residue/inflow in year 3 = 33342/49822 = 0.669
Payback = 2 years + 0.669 = 2.669 years
Analysis of the impact of cash generated beyond the discounted payback period

PV=FV(1/(1+r)n
FV= PV(1+r)n
Project B generates far more cash over its lifetime than project A, even though
project A ranks higher than project B in both the payback and discounted payback
method. Fortunately, there is a method that considers the present value of the cash
generated over the life of a project. It is the net present value method.

3. NET PRESENT VALUE

Net present value (NPV) is the discounted value of cash inflows less discounted
cash outflows, as shown in below. Net present value is designed to determine
whether the project will increase or decrease shareholder wealth on a risk-adjusted
basis, and by how much.
NPV = PV (cash inflows) – PV (cash outflows)
Where NPV is the net present value and PV is the present value of the cash inflows
and outflows, respectively. When there is only one cash outflow at the beginning of
a project, which is typical for many projects, PV (cash outflows) simply equals
invested capital. However, where there are multiple cash outflows, each must be
discounted back to the present. Two examples of projects with cash outflows at the
end of their useful life are strip mines where the land must be reclaimed, and
nuclear power plants that must be decommissioned.
Example

A project has cash inflows of Y1 = $30,000, Y2 = $50,000, and Y3 = $70,000.

The project costs $100,000 in year 0. Assume a discount rate of 12%.

PV(K, n) = 1/(1+K)n
NPV = $30,000 x PV(12%, 1)
= $50,000 + PV(12%, 2)
= $70,000 + PV(12%, 3)
- 100,000
= $30,000 + 0.89286 + $50,000 x 0.79719
= $70,000 + 0.71178 _ $100,000
= $26,786 + $39,860 + $49,825 - $100,000
= $16,471
As a general rule, if the net present value is greater than zero, the project is
worth funding. The advantages of this method are that (1) it is fairly
straightforward; (2) unlike the payback and discounted payback methods,
it recognizes the value of cash inflows beyond the payback period; and (3) it
quantifies the risk-adjusted increase in shareholder wealth from the
The disadvantage is that it is difficult to compare NPV to any benchmark. For
example, suppose project A has an NPV of $10,000 and project B has an NPV of
$25,000. Which is the better project?
On the face of it, project B would seem better. However, suppose project A
required an investment of only $100,000, whereas project B required an
investment of $10 million. To make a sensible analysis of the two projects, one
would have to consider alternative uses of the incremental $9.9 million required
for project B. If alternative uses provide an NPV greater than the incremental
$15,000, project B would have to be rejected in favor of Project A and the other
alternative projects.

What does net present value depend on?

While net present value is obviously based on the amount and timing of cash
flows, it is worth examining how it varies with the discounting rate.
The higher the discounting rate, the more future cash flow is depreciated and,
therefore, the lower is the present value.
Net present value declines in inverse proportion to the discounting rate, thus
reflecting investor demand for a greater return (i.e., greater value attributed to
time).
Take the following example of an asset (e.g., a financial security or a capital
investment) whose market value is 2 and whose cash flows are as follows:

A 20% discounting rate would produce the following discounting factors:

As a result, the present value of this investment is about 2.4. As its market value is
2, its net present value is approximately 0.4.
If the discounting rate changes, the following values are obtained:
 Consider n= 3years

Which would then look like this graphically:

NET PRESENT VALUE AND THE DISCOUNT RATE
The present value and net present value of an asset vary in inverse proportion to the
discounting rate.

4. INTERNAL RATE OF RETURN (IRR)

Internal rate of return (IRR) is the discount rate at which a project will have a net
present value of zero. Internal rate of return is another name for the yield on funds
invested in a project. How does one compute IRR? Thinking about the problem for
a moment, it is a lot like a bond yield problem. This class of problems is generally
too complex to use tables. Some texts suggest that this class of problem is
impossible without a financial calculator or computer, and leave people to trial and
error. But we know we can do better. How? Consider how the following equation
can be rewritten to yield the equation for the internal rate of return,
NPV = PV(cash inflows) - PV(cash outflows)
We know that NPV = 0, so the equation becomes
0 = PV cash inflows - PV cash outflows
In most cases, there is one cash outflow at project inception.
So we can further rewrite the equation as
Cash outflow - PV(cash inflows)
We could substitute a range of test IRR values into the present value function for
cash inflows and generate a series of numbers, some higher than the cash outflow
(the investment) and some lower.
If we plotted the generated numbers on the y axis, and the corresponding test
IRRs on the x axis, we could graph a curve. If we found, on the y axis, the actual
cash outflow, and drew a horizontal line across to where it intersected the curve,
we could read down to the x axis to find the correct IRR. But that is still not as
efficient as we want it to be. So consider this computational alternative.
a. Select a test IRR and compute a test present value of a cash inflow.

b. From our bond problems, we know that if the test cash inflow is less than the
cash outflow (investment), our IRR is too high. The discount rate, our IRR, is
“sanding down” cash inflows too fast. If the test cash inflow is higher than the
cash outflow, IRR is too low.

c. Select another IRR using informed judgment, based on the first test
computation.

d. Interpolate using the two data points thus created to estimate the actual IRR.
Example

Consider a project with cash inflows of Y1 = $30,000, Y2 = $50,000, and Y3 =

$70,000. The project costs $100,000 in year 0. Having just computed the NPV for
this problem, we know that 12% is an insufficient discount rate to achieve an NPV
of zero. Ideally, a test discounted cash inflows would bracket the initial investment
of $100,000. Assume an IRR1 of 18% and compute a value test1.

test1 = $30,000 x PV(18%, 1) + $50,000 x PV(18%, 2) + $70,000 x PV(18%, 3)

= $30,000 x 0.84746 + $50,000 x 0.71818 + $70,000 x 0.60863
= $25,423.80 + $35,909.00 + $42,604.10
= $103,936.90

We see that IRR1 was insufficient to discount cash inflows down to the amount of
the cash outflows (investment), so we need to select a higher value for IRR2. If, on
the other hand, IRR1 had discounted the cash inflows to a value less than cash
outflows, IRR1 was too high, and we would have to select an IRR2 that is lower.
For this problem, however, we need a higher IRR2. Selecting 24% and applying it
to the facts of the case, we can compute a test2.
test2 = $30,000 x PV(24%, 1) + $50,000 x PV(24%, 2) + $70,000 x PV(24%, 3)
= $30,000 x 0.80645 + $50,000 x 0.65036 + $70,000 x 0.52449
= $24,193.50 + $32,518 + $36,714.30
= $93,425.80

This is less than the investment (cash outflow) of $100,000. Since test1 and test2
bracket the cash outflow, we can conclude we have bracketed the “actual” IRR.
However, suppose IRR2 yielded a test2 that was still greater than the investment. In
that case, we would know that we had to select a higher discount rate, perhaps 30%
or more until test1 and test2 bracket the investment.

Adapting the interpolation formula

Multiplying both sides by -1 and cross-multiplying by (IRR - 18%) and 6%,
respectively gives
(IRR - 18%) x $10,511.10 = $3,936.90 x 6%
Dividing both sides by $10,511.10 gives
IRR - 18% = ($3,936.90/$10,511.10) x 6%
IRR = 0.37455 x 6% + 18%
= 2.247% + 18% = 20.247%

Proof We can prove that 20.247% is a good estimate of the internal rate of return for
this project by plugging it back into the NPV equation. If the NPV is zero, we know
our IRR is correct because, by definition, IRR is the discount rate that makes NPV
equal to zero.

Since there are no tables for 20.247%, it would be impossible to perform this proof
without the present value formula we discussed above5, which is given by:

PV(K, n)= 1/(1 + K)n

Proof
NPV = $30,000/(1 + 20.247%) _ + $50,000/(1 + 20.247%) 2 + $70,000/(1 + 20.247)3
- $100,000
= $30,000/(1.20247) + $50,000/(1.20247)2 + $70,000/(1.20247)3 - $100,000
= $30,000/1.20247 + $50,000/1.44593+ $70,000/1.73869 - $100,000
= $24,948.65 + $34,579.82 + $40,260.20 - $100,000

Difference = $99,788.67 - $100,000= - 211.33

The variance in the solution is about 0.2% (-211.33/$100.000). Precision in

computing the internal rate of return can be improved further, if necessary, by (1)
using the present value formula to compute test1 and test2, and increase the number
of decimal points in the computation beyond that in the tables; (2) selecting IRR1
and IRR2 closer to the “actual” value of the internal rate of return, which we have
estimated fairly closely already. Recall that interpolation is based on a calculus trick
that says if points on a curve are fairly close, the slopes of the lines between them
are almost exactly equal.
By selecting IRR1 and IRR2 closer to the “actual” IRR, precision can be improved.
Internal rate of return calculations can be modeled on a spreadsheet, as can the
analysis of variance to determine whether the selected IRR1 and IRR2 were close
enough to the actual IRR to converge to an answer with the requisite amount of
precision.

Projects with the highest internal rate of return rank higher than projects with a
lower IRR. Projects with an IRR greater than the cost of capital should be
considered for funding. Those with an IRR equal to or less than the cost of capital
should not be considered.

The advantage of internal rate of return is that it is directly comparable to

competing uses of funds. IRR can be compared to the yield of stocks and bonds,
and to the yield of other projects. It can also be used to determine the optimal
capital budget by ranking projects in terms of their IRR and comparing them to
the marginal cost of capital. IRR can also provide an idea of the “cushion” in a
project. If, for example, a project has an IRR of 15% and the cost of capital is
12%, the cushion is 3%.
PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the
ratio of the present value of cash flows (PVCF) to the initial investment of the
project.

In this method, a project with a PI greater than 1 is accepted, but a project is

rejected when its PI is less than 1. Note that the PI method is closely related to
the NPV approach. In fact, if the net present value of a project is positive, the PI
will be greater than 1. On the other hand, if the net present value is negative, the
project will have a PI of less than 1. The same conclusion is reached, therefore,
whether the net present value or the PI is used. In other words, if the present
value of cash flows exceeds the initial investment, there is a positive net present
value and a PI greater than 1, indicating that the project is acceptable.

PI is also know as a benefit/cash ratio

Project L

Accept project if PI > 1.

Reject if PI < 1.0