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Tuesday, August 7, 2012

Financial Prioritization - Ways to evaluate a cash flow stream?

Financial analysis of themes helps in prioritization because for most organizations the bottom line is the amount of money earned or saved. It is usually sufficient to forecast revenue and operational efficiencies for the next two years. One can always look ahead, however, if necessary.

A good way of modeling the return from a theme is to consider the revenue it will generate from new customers, from current customers buying more copies or additional services, from customers who might have otherwise gone to a competitive product, and from any operational efficiencies it will provide.

Money earned or spent today is worth more than the money earned or spent in future. To compare a current amount with a future amount, the future amount is discounted back into a current amount. The current amount is the amount that could be deposited in a bank or into some other relatively safe investment and that would grow to the future amount by the future time.

What are four ways to evaluate a cash flow stream?

The four good ways to evaluate a cash flow stream are:
- Net present value (NPV) : 
Using this method to prioritize themes has the advantages of being easy to calculate and easy to understand. The primary disadvantage of NPV is that comparing the values of two different cash flow streams can be misleading.

- Internal rate or return (IRR) or Return on Investment :
It provides a way of expressing the return on a project in percentage terms. IRR is the measure of how quickly the money invested in a project will increase in value. Usually, IRR is not used in isloation.
There are couple of disadvantages of IRR. First, The calculation is hard to do by hand, the result may be more subject to distrust be some. Second, IRR cannot be calculated in all situations.

- Payback Period : 
NPV looks at a cash flow stream as a single, present value amount. IRR looks at a cash flow stream as an interest rate. Payback period looks at cash flow stream as amount of time required to earn Back the initial investment.
Two primary advantages of payback period is when comparing and prioritizing themes. First, calculations and interpretations are straight. Second, it measures amount and duration of finacial risk taken on by the organization.
First disadvantage to payback period is that it fails to take into account the time value for money. Second disadvantage is that it is not a measure of the profitability of a project or theme.

- Discounted payback period :
To remedy the first drawback of payback period, simply apply the appropriate discount factor to each item in the cash flow stream

By calculating these values for each theme, the product owner and team can make intelligent decisions about the relative priorities of the themes.

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