Any business project is based on understanding its efficiency from perspective of its being in demand and profitability. However, currently there is no single formula for calculation of efficiency for HR project systems.
For many company CEOs, return on investment into HR technologies is not the major criteria for making decisions related to project implementation. The efficiency of systems is more often estimated from the perspective of increasing the performance. At the same time, in international practice there are several different methodological approaches used for evaluation of implemented HR projects. Some of these approaches are briefly described below.
Discounting and cash flow
First, it must be said that all financial methods are based on discounting principle. The point of discounting is to bring future cash flows to present time. Whereas it is quite clear that a dollar today and a dollar in a year’s time de facto represent absolutely different monetary values, while we regard them according to their face value. The cost of money change over time. A dollar in a year’s time will cost 90-95 cents in today’s money. The point of discounting is to bring the dollar to be received in a year’s time to the present value of money, so as our calculation contained actual information, using which we can reason our point of view to financial management of the company. In addition, it must be noted that when we have an HR project, there are expense flows and income flows, and the discount rate must be applied to both. Traditional discount calculation is presented in Pv formula.
Pv = P/(1 + r)t
where Pv — present sum, P — unreconciled sum, r — discount rate, t — time when the sum is expected.
To determine the discount rate the following method should be used. First, the weighted average capital cost must be determined (the calculation of weighted average capital cost is given in WACC formula).
WACC = Re (E/V) + Rd (D/V) (1 – Tc)
where WACC — weighted average capital cost, Re — rate of return on equity, Rd — rate of return on debt, E — market value of equity, D — market value of debt, V — aggregated value of debt and equity (V = E + D), Tc — profit tax rate.
Secondly, the discount rate itself is determined. To determine the discount rate we recommend to use CAPM (Capital assets pricing model). In this model the discount rate is determined as risk-free rate of return multiplied by difference between weighted average and risk-free rate of return taken with elasticity coefficient (Re formula).
Re = Rf + K (Rm – Rf)
where Re — discount rate, Rm — weighted average market rate of return, Rf — risk-free rate of return, К — elasticity coefficient of return to the market.
The last thing we use in financial methods of investment assessment in HR is cash flow. There are many practices used to determine cash flows. Typically, by cash flow we mean so-called gross cash flow (GCF), which is defined as a sum of profits and non-cash revenue. However, for our purpose it is inconvenient, and in calculations of feasibility study for investments into HR project it is recommended to use so called free cash flow (FCF) or net cash flow (NCF). Its point lies in bringing the cash flow to such form, which can be correctly applied to calculation of financial return.
NCF = GCF + NWC (net working capital) + Inv (turning investments into noncurrent assets). GCF = Net profit + Non-cash revenue
Primary financial methods used for determination of investments into HR:
- ROI (Return on Investment)
- NPV (Net present value)
- IRR (Internal rate of return)
- Payback period
ROI (Return on Investment)
Rate of return on investment into human capital is assessed according to formula:
HCROI = Revenue – (Expenses – [Pay + Benefits]) / (Pay + Benefits)
NPV (Net Present Value)
Unlike ROI indicator, the NPV method is used for forecast evaluation. Thus, this model, largely, is a strategic rather than operating tool.
NPV is determined according to traditional discounting formula.
NPV = NCF1/(1 + Re) + ….. + NCFi/(1 + Re)i
where NCFi — net cash flow at i-th planning interval, Re — discount rate (in decimal format).
Net present value demonstrates whether we will have economic profit or not. It is clear that financial methods must be applied only with all others. Accordingly, NPV enables us to make project-related decision. When the resulting NPV indicator is above zero, it means that everything is all right, and the project will bring some (present) money. It replies to one of the main questions — how much future receipts will justify today’s expenses on HR project. All future receipts are reconciled according to today’s value exactly because the decision has to be made today. NPV demonstrates whether we should at all think about such a project. When NPV is below zero, it means that there will not be economic profit from the project; we should reject it and invest money into another project or deposit them.
The major disadvantage of NPV method (yet other financial methods also possess this disadvantage) is its insufficient flexibility, which is a requirement for managers under conditions of uncertainty. The method of NPV calculation implies making only one decision at the very beginning on the basis of forecast data. NPV formula does not include risk analysis. Therefore, after favourable NPV there must follow a stage with HR project risk analysis. Then later, matching the dimensions of risks, we can make a decision whether to launch or reject a project. Besides, NPV is very good for justification of accepting one project. When there is a need to justify the choice between two or three projects, NPV fits poorly, requires adjustments, joining projects within common budget, thus enabling the comparison of budgets.
IRR (Internal Rate of Return)
This indicator is often used to justify investments as an alternative to NPV.
IRR defines the interest rate from project implementation, and then compares this rate with the rate of return taking into account the risks. When calculated return exceeds the return subjected to risks, the investments make sense. IRR determines the upper limit of the acceptable range for the bank interest rate. To make project-related decision we need to know the hurdle rate, which defines the minimal profit rate on investment. When IRR is higher than hurdle rate, the project is considered worthy of notice.
Unlike NPV, IRR is an absolute indicator, which enables not just to make decisions regarding particular projects but also compare projects with different financing levels and completely different budgets.
Basic difference of IRR calculation from NPV calculation lies in the fact that at initial stage estimation does not require determination of the discount rate, only cash flows during the project life cycle and the amount of investments are taken into consideration.
This method works well when the project anticipates only one-time investments, uses single discount rate, and when following initial investments all periods result in positive cash flows.
Effectively, this is a payback analysis based on maximal return on investments approved in the company. Let’s assume that in the company it equals to 30 months. We invest 300 thousand dollars with annual rate of return of 100 thousand dollars. In this case, the payback period of three years exceeds the maximal payback period established in the company.
The point of Payback period method is very simple and clear; it is focused on liquidity more than on other indicators. One can say that a method is “adjusted” in relation to uncertainty of the later cash flows (as it does not take those into account). These characteristics can be attributed to advantages. Then there are only disadvantages, which are much more numerous and more solid. Among main shortcomings: requirement for temporary cut-off point, and neglecting cash flows that a project will bring after the payback period. One of the most serious method disadvantages, according to definition, is that it neglects temporary value of money. The prospective cash flows are not discounted and used “as is”.
Every described method has its advantages and shortcomings. Thus, only when we make a calculation of several indicators, we get full understanding of project funds, profit and economic benefit we can obtain from HR project.
Net present value (NPV) takes into account the cost of money but does not include project risks. Besides, this is an absolute indicator (money), which does not allow us comparing projects with different financing. IRR indicator eliminates these disadvantages. Yet, the internal rate of return (IRR) does not take into account the capital cost and, unfortunately, does not have simple economic evaluation (e.g. similar to NVP). This indicator is more complex. Finally, the payback period does not include temporary value of funds.
It is easy to note that NPV and IRR indicators complement each other, and therefore, the majority of companies use them only in combination. Payback period indicator is used more rarely.
Translation into English and editing – Nellya Dyshlovaya
Target-setting: Target vs. Objective