Financial Analysis Tools
 

The analysis that you receive is only as accurate as the input information, so keep in mind that your assumptions are very important (garbage-in, garbage-out).  For some assumptions such as increased production as a result of increased morale and job satisfaction, you will have to make an educated assumption of the dollar cost impact to your organization as intangible benefits are difficult to measure accurately.  This is true when evaluating any project or capital investment decision.  Below are a number of different valuation techniques that you can use to determine the value of a software package.  If you are a bit overwhelmed because you are not a “numbers person”, then feel free to contact us with your assumptions and we will perform the calculations for you.  Along with the valuation techniques below are a few pros and cons of each method.  Some methods are better than others, and you may only be interested in performing one type of analysis.  The various techniques below are intended to help you determine the ROI of a software project.  The bottom line is that an investment is worth undertaking if it creates value for the organization.

Net Present Value (NPV)

In simple terms, NPV is the difference between an investment’s market value and its costs.  The “P” in NPV means that we will derive a single dollar value for the investment today even though the life of the project may span many years.  We begin by estimating the future cash flows that the new software will produce.  For purposes of these calculations, any cost saving or incremental revenues to the organization as a result of purchasing the software are considered  “inflows” and are positive numbers.  All costs are considered “outflows” and are negative numbers.  The hypothetical example below assumes that the lifecycle of the software is 10 years.  Numeric cost savings assumptions were made as well.

Once your cash flows projections are laid out by year (initial cost of the software is at time zero, or today and cash inflows and outflows start at the end of year 1), we need to discount all of those future cash flow estimates so that we can get a value today of all future cash flows.  This process is also referred to as discounted cash flow (DCF) valuation.  To discount the cash flows, we must determine a discount rate, otherwise known as a required rate of return.  For simplicity’s sake, let’s presume that we would be happy with a 15% return, so 15% will be our discount rate.  We will discount each future cash flow (years 1-10 in our example) so that we get a value for each cash flow today.  Keeping in mind the concept that a dollar today is worth more than a dollar tomorrow, cash flows further out will be discounted more heavily than those that occur earlier.  Each cash flow is discounted back to today’s dollar terms using the formula below where r = discount rate and n = year. 

As you can see, the $195,000 amount in year one is worth considerable more in today’s dollar terms than the same $195,000 amount 10 years out.  Since our initial investment amount occurs today (when we pay for the software), we do not discount that amount because it is already in today’s dollar terms.  If we sum the initial cost (-$100,000) and all of the discounted cash flows, we get a NPV of $844,307.  Interpreting the NPV result is very simple.  Your accept/reject decision is based on whether the NVP amount is positive or negative.  In this case, our NPV is positive, so we should go ahead with the software purchase because it will provide a return to the organization above our required 15%. 

Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV of a project equal zero.  The IRR provides us with a single rate of return that summarizes the merits of the project.  For our example above, when you set the NVP to zero, the IRR is 193%, which is well above our required rate.  This tells us that we should undertake the project.  Just one quick word of caution about IRR calculations, they work for conventional project cash flows, meaning that the first cash flow (initial investment at time zero) is negative and all of the remaining cash flows are positive.  If the cash flows are not conventional, then you will have multiple rates of return where the NPV is zero.  In the case of non-conventional cash flows, use the NPV method only.  If the cash flows for multiple projects are conventional, then the IRR method is a great way to compare projects because you can talk in terms of rates of return instead of dollar amounts (NPV).    

Payback Period

The payback period is the amount of time needed for an investment to generate cash flows to recover its initial costs.  This concept is widely understood and used, particularly when evaluating IT projects.  If we look at our sample above from the NPV section, we see that at the end of year one, we have $195,000 in cash flow which is greater than the initial cost of the software (-$100,000).  This means that the payback period occurs at some point during the first year (100,000/195,000 = .51 years or just over 6 months).

The payback period method has some serious shortcomings though.  It is calculated by simply adding up the future cash flows.  There is no discounting of cash flows, so the time value of money is ignored.  Without discounting the future cash flows, your project will look much more attractive than it really is.  Not only will the project look more attractive, but since there is no required rate of return used, the risk level of the project is never captured. This means that a very risky project is treated the same as a low risk project.  The biggest shortcoming with the payback method is that there is no economic rationale for determining the correct cutoff period.  An arbitrary cutoff period must be chosen, so you need to decide whether 2 years is acceptable, or 4 years, or 5, etc.  The payback period also tends to bias the user toward short term investments as it ignores cash flows beyond the cutoff.  A project that takes a few years to get up to speed and then creates phenomenal returns would be rejected strictly on its cash flow profile. 

With all of the shortcomings of the payback period method, it is easy to see why you should put very little weight on the analysis results other than as a very general guide when looking at two fairly comparable projects.  If payback period is a valuation metric that your organization tends to look at, you can and should perform a discounted payback period analysis where you determine your discount rate and discount the future cash flows before performing the payback analysis.  This would eliminate the some of the shortcomings mentioned above, but very few individuals ever perform such an analysis in practice. Use the discounted payback method only as a quick and dirty valuation method to value a project on the “back of an envelope” and as just another valuation metric in conjunction with the others mentioned here.  Do not base your accept/reject decision upon it.

Profitability Index (PI) or Benefit/Cost Ratio

The PI is the present value of future cash flows divided by the initial investment.  The present value of future cash flows is another term for discounted cash flows calculated exactly as shown in the NPV section.  The PI would be larger than 1 for positive NPV projects and less than 1 for negative NPV projects.  For our example above the PI would be 9.44.  The PI measures “bang for the buck”.  It tells us that for each dollar invested, the organization receives $9.44 in value.  The PI and the IRR valuation methods are obviously very similar to the NPV method.  They just present the results in a different fashion.  An attractive NPV project will also look attractive on an IRR or PI basis and vice versa.  IRR and PI allow you compare multiple projects on a level playing field.  Just be careful, because it might make more sense for your organization to pursue a high NPV project even though it carries a lower IRR and PI than another comparable project.  Earning a 500% return on a $10,000 project might not add much value to your organization, whereas earning 22% on a $5 million project would add considerable value.

Return on Investment (ROI)

ROI and the financial tools above are designed to help you build a business case to support your technology decision by evaluating the real impact to your corporation's bottom line.  ROI and other financial analyses should not be your only evaluation criteria though.  For example, a higher ROI project might not have a very intuitive GUI.  If most of your end users are not very tech-savvy, then they might not adopt the system.  This type of event might be impossible to predict.  If you cannot accurately reflect that dynamic in your assumptions, then you might invest hundreds of thousand of dollars into a system that users refuse to use.  Non-quantitative input is required here and should be equally as important to your decision making process as the financial analysis.

Be careful when talking about ROI as many people tend to talk about ROI without including time horizons.  Every time you use ROI as a comparison of two or more projects make sure you are comparing “apples to apples” meaning that the ROI figures being compared are for equal time-frames. 

So what is ROI?  If you try to look up the definition or ask someone, you will get a variety of different answers.  For our purposes, ROI is a return ratio that compares the net benefits of a project, verses its total costs. As such, the ROI calculation represents the relative value of the project's cumulative net benefits (benefits less costs) over the analysis period, divided by the project's cumulative total costs, expressed as a percentage. 
In our example from Figure 1.0 above, we find that our return is 844% over the life of the project.  Whenever anyone talks in ROI terms, they are speaking an on annual basis, so our 844% return has an ROI of 84% per year over a ten year period.  If we were to perform the same ROI analysis on the first three years only, we would see a total return of 329% or an ROI of 110% per year over the first three years.  It makes sense that our ROI is higher for a shorter time frame because discounting has less of an impact on cash flows in the early years.  The important thing is the time frame.  If you compare a project with a three year life cycle with another project that has a five year life cycle, make sure you compare 3-year ROIs but do not forget to consider the 5-yer ROI as well, otherwise you will be discounting to zero the benefits of those final two years.  This is why time frames are important to know when comparing ROIs for decision making purposes.

Use the above financial valuation techniques to calculate an ROI for your proposed software projects.  The analyses will force you to think about how the software will impact your organization and consequently will guide you so that you make the right software decisions for your organization with confidence.  Ultimately, you must weigh financial returns against many other factors such as risk, timing, platform issues, user acceptability, competitive issues, feasibility considerations, etc., but you cannot build your business case without a solid financial analysis.

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