1. Evaluating Financial Investment in IT Projects
Present Value Analysis
Note: examples are from Analysis for Financial Management, Robert C. Higgins, 8th Edition, McGraw-Hill

2. “Back of the Envelope” methods
Payback period
Return on Investment %
When to use?
Limitations?

3. Strategic Planning
Investment/Performance planning process for an organization
What do we need to invest in, in the next quarter/year, and what benefits can we expecting in return?
Involves “capital budgeting” – the financial evaluation of investment proposals

4. Discounted Cash Flow Relevant when Includes
A company contemplates an action entailing costs/benefits that extend beyond the current year
Includes
Analyzing equipment acquisitions or sales
Choosing among competing technologies

5. Financial Evaluation
Estimate the relevant cash flows (benefit $ and cost $)
Calculate a “figure of merit” for this investment
Compare the figure of merit to an acceptance criterion

6. Challenges? Estimating relevant cash flows
E.g. depreciation, financing costs, shared resources, etc.
Many important costs/benefits cannot be measured in $ so must be evaluated qualitatively (evaluating $ is simpler!)

7. TABLE 7-1 Cash Flows for Container-Loading Pier ($ millions)
Year
Cash flow ($40)
7.5 17 40

8. Eg: Container Loading Pier
First, “back of the envelope”:
Payback?
In year 6 (accum ben – accum costs is > 0)
(7.5M*6 – 40M) = 45M – 40M = 5M

9. Time value of Money: Compounding
Compounding Example
10% interest rate, invest $1
End of year 1:
$1 + (10% of $1) = $ = $1.10
End of year 2:
$ (10% of $1.10) = $ = $1.21

10. Time Value of Money: Discounting (present value)
Finding the present value of a future sum
Example
10% return; Promised $1 in one year—what would you have to invest today?
.909
i.e. $1 = $ (10% of $.909)

11. Calculating Present Value
Use present value tables calculators, spreadsheet.
Present Value Table
Shows the present value of $1 to be received at the end of any number of periods from 1 to 50, at interest rates ranging from 1% to 50%
In present value “interest rate” often called “discount rate”

12. What is the “discount rate”?
If a company already has cash “in hand”:
The rate of return available on similar risk investments
If a company must raise cash (by selling securities):
Rate of return expected by buyers of the securities

13. Discount Rate & Risk
Discount rate is often adjusted to reflect risk in an investment’s cash flow
If an investment is higher risk, a “risk premium” is often added to the discount rate to compensate for the risk (e.g. that the investment will not meet projected cash flows). This means that the discount rate for a higher risk investment will typically be higher.

14. Example: Baseball Catcher
New, young catcher signed to a contract promising $2M a year for 4 years.
What is the contract worth today assuming the catcher has a similar risk investment opportunity yielding 15% per year?

15. P?
P = present value of the contract
Using Present Value Tables:
Must find P at 15% of each individual payment
P = (.870 x $2M) + (.756 x $2M) + (.658 x $2M) + (.572 x $2m)
P = $5,710,000

16. Example: Baseball Catcher cont’d
Much simpler approach:
This amount happens to be an annuity (same $ every year) so we can use the present value annuity table (appendix B).
P = x $2M = $5,710,000
P = $5,710,000 means that:
$5,710,000 today is equivalent to the future cash flows of $2M per year for 4 years at 15%

17. $5,710,000 Today is Equivalent to $2 million a Year for 4 Years When the Interest Rate is 15 %

18. Back To the Pier Example
Calculate P, over 10yrs using 10%
$7.5M for 9 yrs – an annuity
$7.5M + $9.5M = $17M for the 10th year
P = (5.759 x $7.5M) + (.386 x $17M)
P = $ M + $6.562M
P = $49.75M

19. $7.5M
P = $49.75M at 10%
$17M
Investment of $40M

20. Net Present Value (NPV)
Present Value of Cash Inflows
Present Value of Cash Outflows
NPV = -
NPV for Pier =
$49.75M - $40M = $9.75M

21. NPV Rule of Thumb NPV > 0 NPV < 0 NPV = 0 Accept the investment!
Reject the investment!
NPV = 0
Investment is marginal (does not create or destroy wealth)

22. Benefit:Cost Ratio (BCR)
(present value of cash inflows) /
(present value of cash outflows)
BCR for Pier = $49.75M / $40M = 1.24

23. BCR Rule of Thumb BCR > 1, attractive investment
BCR < 1, unattractive investment
BCR = 1, marginal

24. Internal Rate of Return (IRR)
IRR is the discount rate at which an investment’s NPV is zero
Often tricky with the tables; calculator or computer are easier
The IRR is equivalent to the interest rate on a bank account that would yield the same $ as the investment being considered

25. TABLE 7-2 NPV of Container Pier at Different Discount Rates

26. FIGURE 7-2 NPV of Container Pier at Different Discount Rates
IRR

27. IRR Rule of Thumb If K% is the “opportunity cost of capital)
IRR > K, accept the investment
IRR < K, reject the investment
IRR = K, the investment is marginal