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Business Case Analysis: A Remedy for the Common Mistake Presented by: Michelle Amorese BAE Systems [email protected] Authored by: Michelle Amorese & Marc Rose MCR Federal, LLC [email protected] "The views expressed herein reflect the personal views of the author(s) and do not purport the views or positions of the Federal Aviation Administration or any other component of the Federal Government." Developed under the FAA SETA II Contract 1 Key Factors in Business Case Analysis Cost Estimate Benefits Estimate Risk Assessment/Inclusion Schedule Assessment Today’s Focus: Cost and Benefits Estimates We will assume that both risk mitigation and schedule risk mitigation have been included in the cost estimate. 2 Business Case Metrics There are three metrics used in the FAA-Air Traffic Organization that are based upon cost and benefit estimates to determine the Return on Investment (ROI) Net Present Value Payback Period Benefit/Cost Ratio The Common Mistake… …not accounting for statistics in Business Case Metrics We will focus on the Benefit/Cost Ratio Metric 3 Benefit/Cost Ratio What is it? The present value benefits of an investment divided by the present value initial cost of the investment. What does this mean? Describes if the benefits are greater than the costs in present day values. Ideal To obtain a Benefit/Cost Ratio (B/C Ratio) greater than 1.0. 4 Statistical Risk To complete a cost or benefits estimate, an analyst should account for uncertainty by adding some statistical risk. By adding this risk, a probability distribution becomes associated with its respective cost or benefits estimate where: A 80% probability for cost = 80% confidence A 20% probability for benefits = 80% confidence Hence we arrive at our 80% confident cost and benefits estimates used to determine the business case metrics. These estimates are utilized to calculate Benefit/Cost Ratio…… 5 The Common Mistake… Present Value Distributions Confidence Level 0% 5% 10% . . . 80% 85% 90% 95% 100% Total PV Benefits Total PV Costs $2,341.68 $148.59 $2,162.36 $184.26 $2,075.47 $242.84 . . . . . . $629.04 $623.24 $552.58 $766.19 $419.13 $940.13 $332.94 $1,147.99 $248.14 $1,330.55 Simple Mathematical B/C Calculation PV Benefits/PV Costs 15.76 11.74 8.55 . . . 1.01 0.72 0.45 0.29 0.19 Statistically Derived B/C Distribution Confidence Level 0% 5% 10% . . . 80% 85% 90% 95% 100% PV Benefits/PV Costs 2.81 1.76 1.63 . . . 1.22 1.18 1.13 1.05 0.70 By using simple mathematics on statistical entities, an analyst may over or under estimate the metric measurement Monte Carlo simulation was utilized for this example. 6 The Resolution Avoid using simple mathematics when integrating statistical entities Economic measurements must be generated through statistical methods to accurately determine business case metrics 7 The Result By statistically integrating estimates to obtain business case metric measurements, we can… Avoid Misguided Investment Decisions 8 Questions / Feedback… What are your common practices? Comments and questions 9 Back Up -> 10 Net Present Value What is it? The net present value (NPV) of an investment is the present (discounted) value of future benefits minus the present value of the investment and any associated future cash outflows. What does this mean? It's the net result of a multiyear investment expressed in today's dollars. Ideal To obtain a positive NPV. 11 Payback Period What is it? An investment's payback period in years is equal to the net investment amount divided by the average annual cash flow from the investment. What does this mean? How long will it take to get my money back? Ideal For there to be a reasonable length of time until a positive NPV is achieved. 12