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Using Payback, ROI, NPV, and EVA
Budgeting and financial evaluation have always been, at least for most people, the most onerous parts of implementing a new technology. Unfortunately, planning and forecasting for projects involving new technology invariably involves a certain amount of black magic and there are risks everywhere: Will the product perform as expected? What does the vendor do if the product fails to perform adequately? What recourse is there if the product performs, but performs poorly? With tried-and-true products and solutions, the risk of poor product performance is minimized. With early adoption of new technologies, the risks are amplified.A primary function of risk assessment and risk management is evaluating the impact of a technology solution on the firm's bottom line, and for new technologies, the importance of financial evaluation and value-case analysis is even more critical.Just as choosing the right technology solution is critical for meeting business requirements, choosing the right methodology for valuing the project is equally important. It is also important for the methods used to match those used by the rest of the firm. For example, if a project is measured by a hurdle rate (or a required rate of return) that differs from the overall hurdle rate for the rest of the firm, the project can be viewed as a success by its stakeholders, whereas the rest of the business might consider it a failure.This chapter looks at four of the most common methods of evaluating the financial success of a project and the advantages and disadvantages of each one.NoteA critical aspect of the following methods is that each is customarily used to justify new capital investments based on revenue-facing environments. Each metric measures the financial benefit (or negative impact) of an investment based either on increased cash flows (revenue enhancements) or cost avoidance (expense reductions). Wherever possible, I highlight the functionality of these tools to evaluate their effectiveness in the context of IT projects that might or might not directly impact revenue. For the sake of simplicity, cost avoidance benefits are treated the same as revenue enhancements.
Payback Method
The payback method is commonly used in many businesses to evaluate capital purchases of relatively insignificant amounts.. The primary reason for its popularity is its ease of use. You could perform the payback method of analysis on a cocktail napkin or even in your head, as demonstrated in the following example.The Goodrich Ice Cream Factory wants to decrease lines and increase revenue at one of its satellite stores during long summer nights. They want to add a second cash register to do this. A new cash register costs $2500. The management team at Goodrich estimates (based on sophisticated regression analysis and complex weather-forecasting models) that adding the second cash register can increase revenues by $1000 in June, $2000 in July, and $1000 in August. The cash register investment then reaches full payback three quarters of the way through July. This purchase is easily justified using the payback method.The payback method is just that simple. Its simplicity, however, comes at a cost. Imagine what happens when the management team at Goodrich uses this methodology to justify the capital costs of building a new ice cream plant. The payback method, because it does not account for the time value of money, is not the appropriate tool to use.Using the payback method to evaluate large capital investments has two significant drawbacks. Both drawbacks involve time.The primary concern with using payback for large investments is that it is designed to measure the impact of an investment over short time horizons, such as with the cash register investment in which payback is accomplished in terms of months. When measuring the payback for building a new plant, the time horizons are longer and payback might not occur for a number of years. When the time horizons for a project are drawn out over a long period of time, the time value of money must be taken into account. The payback method lacks this capability.The second issue with using payback analysis is obvious if you consider what happens after payback is reached. What if the labor to operate the new cash register and associated costs, such as power and maintenance, are significant? What if the cash flows for the months following payback are negative? You cannot capture the subsequent impact of the investment after payback is reached.At a basic level, the failure of the payback method to take into consideration business-critical requirements makes it an unsatisfactory choice for justifying large IT purchases, such as storage networks.NoteThe payback method is especially difficult to use for projects that are not directly revenue-enhancing. For example, it is awkward to use the payback method to justify the purchase of a new backup infrastructure because, as with projects designed to increase operational efficiencies, the financial benefits (cash inflows or cost avoidances) of a new backup infrastructure are often difficult to quantify.
Return on Investment
ROI analysis is well received across all industries and as such, ROI analysis is commonly used to justify investments in IT hardware and software. The ROI ratio is understood as the following:ROI = (Sum of all Returns) (Sum of all Investments) / (Sum of all Investments)NoteAlthough it is generally assumed that period returns are annualized, ROI horizons can be shortened or lengthened to fit the timeframe of the project as needed. Such flexibility can lead to abuses of ROI analysis.Here is an example of the common usage of ROI to justify a project. The management team at Goodrich Ice Cream Factory wants to implement a data warehouse to analyze taste trends in the process of marketing new flavors. The team sends out a request for information (RFI) to several vendors and selects a product. The product purchase and implementation costs are estimated (based on the vendor's proposal) at $750,000. The IT infrastructure at Goodrich also needs to be upgraded to support the data warehouse, and the team is required to purchase multiple disk frames to store over 20 terabytes (TB) of customer preference data in a storage area network. New servers, new disks, and installation services for the data warehouse project (the code name of the project is Waterfront) cost an additional $750,000.The management team believes, based on data from the vendor, that the Waterfront project will increase total revenues by $1,500,000 in the first full year after the implementation (year one), and $250,000 in the two subsequent years. Not only does this project look good in terms of the payback method (payback occurs in the first year), but the ROI is also a decent 33.33 percent. Table 3-1 shows the projected cash flows for Waterfront.
| Year 0 | ($1500) |
| Year 1 | $1500 |
| Year 2 | $250 |
| Year 3 | $250 |
| Year 0 | ($1500) |
| Year 1 | $1500 |
| Year 2 | $-1000 + 250 |
| Year 3 | $-500 + 250 |
Net Present Value
NPV is a way of projecting the financial worth of a project over time. Firms use NPV to roll back the value of anticipated cash flows from the future to the present day. NPV helps managers and planners understand the impact of choosing to do a certain project based on projected cash flows while presenting the project in the black and white terms of positive or negative: If the NPV is negative, the project is a non-starter. Likewise, if the NPV is positive, the project creates value for the firm.The key feature of NPV is that it builds its projected cash flows based on a discount rate or required rate of return. Most often the rate of return is the firm's cost of capital. Alternatively, the discount rate might be an accepted hurdle rate. The most commonly used discount rate for NPV analysis is the weighted average cost-of-capital (WACC), a blended valuation of the firm's cost of debt, the firm's cost of equity, and the firm's corporate tax advantages.NoteAlthough an in-depth discussion of capital structure valuation is out of the scope of this book, a brief explanation of cost of capital can help explain the role of the rate of return in NPV analysis.The firm's cost of capital is the portion of one dollar of investment by a firm that belongs to the firm's shareholders and creditors. Companies of similar size and in related industries might have a comparable cost of capital; however, each firm's cost of capital is unique and exclusive to that firm.WACC is the most commonly used method to measure cost of capital and is the rate of return typically used in NPV analysis. The formula for WACC is as follows:Total WACC = (Cost of Equity * Percentage Equity) + (Cost of Debt * Percentage Debt) * (1 Tax Rate)After the rate of return is determined, the cash flows are then discounted over the life of the project based on the required rate of return.NPV is fairly simple despite the intimidating formula. Because NPV is not "napkin math," the preferred method of calculating NPV is to use a spreadsheet or a business calculator. The formula for NPV is:
For example, if a new disk system that cost $5,000 is expected to increase performance for an online transactional system, resulting in cash inflows over $2500 over three years, and the firm's WACC is 12 percent, the NPV is calculated as:
The NPV for this project is negative; therefore, the company should not do the project.Let us perform NPV analysis on the Goodrich Waterfront project for a final example. Year 0 of the project sees a total capital outlay of $1,500,000 and subsequent cash inflows of $1,500,000, $250,000, and $250,000 in years one, two, and three, respectively. The revised cash flows for years two and three are negative, however, after including the outrageous licensing and maintenance charges.The required rate of return for Goodrich is ten percent. The net present value of the Waterfront project is calculated as follows:
NPV analysis, by taking into account the time value of money and the firm's required rate of return, provides a much more realistic view of the financial impact of the project. Because the NPV is negative, the $1,500,000 invested in Waterfront would actually lose the firm money. The Waterfront project can be seen for what it is: a significant capital outlay that destroys more value than it creates.NoteNote that for IT-related projects, NPV analysis is typically carried out over three years to match the depreciation schedule and the useful life of the assets involved. For larger projects (such as constructing a new building) or for purchases of other assets with lengthy depreciation schedules (such as real estate), longer time horizons are used.There are a number of reasons NPV is not widely used to measure IT projects. Many people are unfamiliar with NPV or tend to have the misperception that it is hard to use and the required rate of return is not often freely available. The primary reason NPV is not widely used to measure IT projects, however, is that projected cash flows for non-revenue impacting environments are difficult to estimate. Storage networking projects, however, are ideally suited for NPV analysis because of the tangible benefits mentioned earlier: primarily increased utilization, and, if the cost of downtime is measurable, increased availability. These expense reduction and cost avoidance benefits can be treated as cash inflows over the life of the project.Economic Value Added
[1]EVA is a method of valuing a company's economic profit versus accounting profits, as recorded in SEC filings. Economic profit is the creation of shareholder value, whereas accounting profits might or might not reflect economic value or profit. Accounting profits are inflated by credit and tax advantages that do not include the firm's cost of capital (and can be manipulated with malicious intent).Like Six Sigma, which aims to decrease error rates and increase productivity across the whole enterprise, or Total Quality Management (TQM), which has similar aims, EVA analysis does encompass the performance of the whole firm. EVA is not, however, strictly a performance management trend. EVA analysis picks up financial measurement where ROI and NPV leave off by factoring in the cost of purchasing and using capital and by measuring the performance of all projects, products, and divisions of the firm using the same benchmark rate.Drucker states quite plainly that, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources."[2]Because EVA analysis is typically used to measure the value of the firm's output, the formal equation for EVA analysis uses something called NOPAT (net operating profit after taxes):EVA = Net Operating Profit After Taxes (Capital * Cost of Capital)Because the IT department typically does not sell a product or a service on the open market or pay taxes separately from the firm as a whole, you need to modify the EVA equation to apply EVA to internal infrastructure projects.NoteEven a department that uses a chargeback mechanism for its goods and services needs to modify the EVA measurement because an internal department typically does not operate at a profit.To use EVA to measure the impact of an IT project, the operating profit or net inflows have to be measured in terms of cost avoidances and cost savings. As with NPV analysis, the net benefits from the project, primarily increased utilization, still require a dollar value. The revised calculation looks like this:Revised EVA = Net Benefits (Capital * Cost of Capital)Net benefits are the sum total of all cash inflows, cost avoidances, and cost reductions related to the project. The capital charge in the equation is the obvious capital expenditure associated with the project. New hardware, new software, new datacenterany costs that cannot be expensed and must be depreciated need to be included here.For an example, let us apply EVA to the Goodrich cash register example:EVA = Net Benefits (Capital * Cost of Capital)EVA = $4000 ($2500 * 10.0 percent)EVA = $3750The economic profit of investing in the new cash register is actually only $3750, not $4000. Note that the economic profit (the EVA) from investing in the cash register is less than the accounting profit. EVA analysis presents the investment in terms of value added to the shareholders.Metrics, such as ROI, can be refined to account for EVA.The ROI for the cash register investment is 60 percent($4000 $2500) / $2500. The EVA-adjusted ROI for the cash register project is calculated as follows:EVA-Adjusted ROI = ($3750 $2500) / $2500ROI = 50.00 percentLet us apply EVA to the Waterfront project. (Note that the cash flows here are treated as one-time events).The Waterfront project has capital outlays of $1,500,000 and increased revenue streams of $1,500,000 in the first year, and $750,000 and $250,000 in each of the two subsequent years:EVA = Net Benefits (Capital * Cost of Capital)EVA = $-1,000,000 ($1,500,000 * 10.0 percent)EVA = $1,150,000You do not need to calculate the EVA-adjusted ROI: The EVA of the Waterfront project is, as expected, a negative number, which indicates that Goodrich would destroy economic value by investing in Waterfront.EVA is most beneficial when used across the entire firm. An EVA firm is capable of more accurately measuring the impact of all of its investments on shareholder value. EVA analysis can be used, however, to measure the value of individual projects and, when used together with ROI and NPV, EVA provides another level of accountability for capital investments.This chapter uses these metrics to build four simple value cases. Selecting the appropriate metric for value case analysis is up to the firm's finance or management teams. The following examples, however, use each of the three metrics appropriate for measuring the impact of large projects (ROI, NPV, EVA). The use of multiple metrics often helps present a stronger case for management.
