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F28SD2 Software Design Monica Farrow EM G30 monica@macs.hw.ac.ukmonica@macs.hw.ac.uk Material available on Vision Cost/benefit analysis Accounting methods

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01/13/09Lecture 10 20062 Accounting methods Assuming that both benefits and costs can be identified and evaluated, how do we compare them to determine project feasibility? Typical cases include comparing costs of alternatives (assuming equal benefits) or comparing various payment options: Payback Analysis: how long it will take (usually, in years) to pay back the project, and accrued costs: Return on Investment Analysis: compares the lifetime profitability of alternative solutions. Net Present Value Analysis: determines the profitability of the new project in terms of today's dollar values.

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01/13/09Lecture 10 20063 Discount rates A pound today is (usually!) worth more than a pound tomorrow Inflation – things will cost more Investment – we lose a year’s interest The pound values used in this type of analysis should be normalized to refer to current year pound values. For this, we need a number, the discount rate. This measures the opportunity cost of investing money in other projects, rather than the information system development one. What else could you do with the money? This number is company- and industry-specific.

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01/13/09Lecture 10 20064 Discount rates To calculate the ‘present value’ of £1 in n years time, i.e., the real pound value given the discount rate i, we use the formula Present value in n years = 1/(1 + i) n For example, if the discount rate is 12%, then Present Value (1) = 1/(1 + 0.12) 1 = 0.893 Present Value (2) = 1/(1 + 0.12) 2 = 0.797

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01/13/09Lecture 10 20065 Present value table Year 0Year 1Year 2Year 3Year 4 Present value (rate 0.12%) 10.8930.7970.7120.636

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01/13/09Lecture 10 20066 Payback Analysis - costs How long will it take (usually, in years) to pay back the project, and accrued costs? Basically, we need to compute Total costs (initial + incremental) - Yearly return (or savings) but it must be done with present values.

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01/13/09Lecture 10 20067 Payback Analysis - costs Year 0Year 1Year 2Year 3Year 4Year 5Year 6 Dev. Costs-418000 Operating costs -15045-16000-17000-18000-19000-20000 Present value 10.8930.7970.7120.636 Time-adj costs -418040-13435-12752-12104-11448-10773-10140 Cumulative costs -418040-431475-444227-456331-467779-478552 -488692 Estimated lifetime cumulative costs

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01/13/09Lecture 10 20068 Payback Analysis - benefits Year 0 Year 1Year 2Year 3Year 4Year 5Year 6 Benefits0150000160,00017000180001900020000 Present value 00.8930.7970.7120.6360.5670.0.507 Time-adj benefits 0133950135490135280133560130410126750 Cumulative benefits 0133950269440404720538280668690 795440 Estimated lifetime cumulative benefits

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01/13/09Lecture 10 20069 Payback Analysis - net Year 0Year 1Year 2Year 3Year 4Year 5Year 6 Cumulative costs -418040-431475-444227-456331-467779-478552-488692 00.8930.7970.7120.6360.5670.0.507 Cumulative benefits 0133950269440404720538280668690795440 Cumulative lifetime costs + benefits -418040-297525-174787-5161170510190138306748

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01/13/09Lecture 10 200610 Break even after about 3.5 years

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01/13/09Lecture 10 200611 Computing the payback period exactly Need to determine the time period when lifetime benefits will overtake the lifetime costs; This is the break-even point. Determining the fraction of a year when a payback actually occurs: (|beginningYear amount|)/ (endYear amount + |beginningYear amount|) For our last example, 51,611 / (70,501 + 51,611) = 0.42 Therefore, the payback period is 3.42 years Assuming costs and benefits spread evenly in year

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01/13/09Lecture 10 200612 Return on Investment analysis The ROI analysis technique compares the lifetime profitability of alternative solutions or projects. The ROI for a solution or project is a percentage rate that measures the relationship between the amount the business gets back from an investment and the amount invested.

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01/13/09Lecture 10 200613 Return on Investment analysis The ROI for a potential solution or project is calculated as follows: ROI = (Estimated lifetime benefits - Estimated lifetime costs) / Estimated lifetime costs

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01/13/09Lecture 10 200614 Return on Investment analysis For our example, Lifetime ROI = (795,440-488,692)/ 488,692= 62.76%, = 306,748 / 488,692 = 62.76% The solution offering the highest ROI is the best alternative.

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01/13/09Lecture 10 200615 Net Present Value The net present value is simply the profit or loss on your investment after n years After discounting all costs and benefits, subtract the sum of the discounted costs from the sum of the discounted benefits to determine the net present value. For our example = 795400 – 488692 = 306748 after 6 years

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01/13/09Lecture 10 200616 Net Present Value Using the net present value If it is positive, the investment is good. If negative, the investment is bad. When comparing multiple solutions or projects, the one with the highest positive net present value is the best investment.

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01/13/09Lecture 10 200617 Another NPV example (Cadle and Yeates 2001) Here the PV factor is only applied at the end

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01/13/09Lecture 10 200618 To Do Read chapter 9 from Systems Analysis and Design methods Available electronically on Vision Do examples which will be available by Thursday COME and bring your friends to the Tue lecture Guest speaker Lyle Barbour What are feasibility studies like in the real world?

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