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

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

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

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

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

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!)

TABLE 7-1 Cash Flows for Container-Loading Pier ($ millions) Year 0 1 2 3 4 5 6 7 8 9 10 Cash flow ($40) 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 17 1 2 3 4 5 6 7 8 9 10 7.5 17 40

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

Time value of Money: Compounding Compounding Example 10% interest rate, invest $1 End of year 1: $1 + (10% of $1) = $1 + .10 = $1.10 End of year 2: $1.10 + (10% of $1.10) = $1.20 +11 = $1.21

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 = $.909 + (10% of $.909)

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”

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

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.

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?

P? P = present value of the contract 0 1 2 3 4 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

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 = 2.855 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%

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

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 = $43.1925M + $6.562M P = $49.75M

$7.5M P = $49.75M at 10% $17M 1 2 3 4 5 6 7 8 9 10 Investment of $40M

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

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)

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

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

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

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

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

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