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SRT510
Business Case
Studies
Evaluating Financial
Investment in IT
“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
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
 Calculate a “figure of merit” A for this
investment
 Compare A 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
7.5
17
1
40
2
3
4
5
6
7
8
9
10
Eg: Container Loading Pier
First, “back of the envelope”:
 Payback?
year 6 (accum ben – accum costs is > 0)
 (7.5M*6 – 40M) = 45M – 40M = 5M
 In
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)

Discounting
 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 (appendix A of
text), 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
 The company’s “opportunity cost of capital”

If a company must raise cash (by selling
securities):
 Rate

of return expected by buyers of the securities
The buyers’ “opportunity cost of capital”
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 Appendix A:
• 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 %
BeginningEnd-of
of-Period Interest at
-Period
Year Principal
15%
Principal
1
$5,710,000 $856,500 $6,566,500
2
4,566,500
684,975
5,251,475
3
3,251,475
487,721
3,739,196
4
1,739,196
260,879
2,000,075
Withdrawal
$2,000,000
2,000,000
2,000,000
2,000,000
Note: The $75 remaining in the account after the last withdrawal is due to
round-off error in the present value tables.
Back To the Pier Example

Calculate P, over 10yrs using 10%
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
$7.5M
P = $49.75M at 10%
$17M
1
2
Investment of $40M
3
4
5
6
7
8
9
10
Net Present Value (NPV)
NPV = Present Value of Cash Inflows
Present Value of
Cash Outflows
NPV for Pier =
$49.75M - $40M = $9.75M
NPV Rule of Thumb

NPV > 0
 Accept

NPV < 0
 Reject

the investment!
the investment!
NPV = 0
 Investment
is marginal (does not create or
destroy wealth)
Benefit:Cost Ratio (BCR)
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
Discount Rate
NPV ($ millions)
10%
12%
$9.75
5.44
IRR = 15%
18%
-4.48
FIGURE 7-2 NPV of Container Pier at Different Discount
Rates
NPV ($ millions)
50
40
30
20
IRR
10
0
-10
-20
0
4
8
12
16
Discount rate (%)
20
24
IRR of Pier Container

If the $40M was invested at 15% with
appropriate cash flows withdrawn at the
end of each year ($7.5M for the first 9
years, then $17M for the 10th), the amount
in the account at the end of the 10th year
would be approx. $14.8M
 See
page 252 of the text
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

Other Considerations
Depreciation
 Shared resources
 Excess capacity
 Sunk costs

Selecting a Figure of Merit

When investments are independent and
the decision is simply to accept/reject:
 NPV,

When investments are mutually exclusive
 Use

BCR, IRR are equally satisfactory
NPV
Independent, Under Capital Rationing

interested in payoff per $ invested
 Use BCR
TABLE 7A-2 Four Independent Investment Opportunities
under Capital Rationing (Capital budget =$200,000)
Investment
A
Initial
Cost
NPV at BCR at
12%
12%
$200,000 $10,000
IRR
1.05
14.4%
B
120,000
8,000
1.07
15.1
C
50,000
6,000
1.12
17.6
D
80,000
6,000
1.08
15.5
Investment budget = $200K; take bundle giving highest NPV: Rank by BCR
(gives “benefit per dollar”) and work down the list until the 200K is used up
FIGURE 7A-2 Capital Budgeting Decision Tree
Use NPV, IRR, or BCR
Rank by NPV
Mutually exclusive
Rank by NPV over
common investment
horizon
No fractional
projects
Accept bundle
of investments
with highest NPV
Accept bundle of
investments with
highest NPV over
common horizon
Accept bundle
of investments
with highest NPV
Rank by BCR