# CARNEGIE MELLON UNIVERSITY CIO INSTITUTE

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1 CARNEGIE MELLON UNIVERSITY CIO INSTITUTE CAPITAL BUDGETING BASICS Contact Information: Lynne Pastor

2 RELATED LEARNGING OBJECTIVES 7.2 LO 3: Compare and contrast the implications of commonly used metrics such as ROI, NPV, Internal or Modified Internal Rate of Return (IRR, MIRR) etc. This comparison should address not only the outputs of the metrics, but also the assumptions upon which the metrics are based. 7.2 LO 7: Justify the reason that the Clinger-Cohen Act requires a riskadjusted ROI before making an investment in IT. 7.4 LO 4: Discuss the role of forecasting in cost-benefit analysis. Include situations in which IT systems are making an investment in information that does not show up immediately in the ROI, but needs to be inserted into the ROI forecast. 1

3 INTERNAL RATE OF RETURN (IRR) INTERNAL RATE OF RETURN (IRR) The internal rate of return is the actual rate of return of an investment Incorporates the time value of money Represents the interest rate that matches the present value of the cost to the present value of the future benefits received Internal Rate of Return (IRR) is the actual rate of return that equates a dollar invested now with a dollar received in the future. IRR & NPV The future benefits can be in the form of a stream of payments over a period of time and/or a lump sum received in the future Represents the interest rate that results when the NPV is zero The present value of the costs must equal the present value of the benefits 2

4 IRR EXAMPLE Example: An investment of \$20,000 was made in a new project. Three years later the project was sold for \$50,000. What is the IRR on this investment? IRR SOLUTION Find the IRR by use of the nth root of (FV PV)-1. The IRR can also be found by use of a calculator using the following formula: IRR = (FV/PV)^(1/n) 1 IRR = (50,000/20,000)^(1/3) % IRR EXAMPLE SERIES OF CF A project requires an initial \$1,000,000 cash investment. The project will generate net cash flow of \$180,000 for the next 8 years. There is no value in the project assets at the end of the Eighth year. The company has a Weighted Average Cost of Capital (WACC) of 7%. Should the company take the project? 3

5 INTERNAL RATE OF RETURN Investment \$ (1,000,000) Cash Flow - Year 1 \$ 180,000 Cash Flow - Year 2 \$ 180,000 Cash Flow - Year 3 \$ 180,000 Cash Flow - Year 4 \$ 180,000 Cash Flow - Year 5 \$ 180,000 Cash Flow - Year 6 \$ 180,000 Cash Flow - Year 7 \$ 180,000 Cash Flow - Year 8 \$ 180,000 Internal Rate of Return 8.90% IRR is greater than 7% so go for it INTERNAL RATE OF RETURN Use the IRR function in Excel 8.9% > 7% Go for it! LIMITATIONS OF THE IRR IRR assumes that all cash flows are reinvested at the rate of return generated by the project. The IRR method may mislead mutually exclusive projects if they differ in size If the cash flows are unequal, calculating an IRR is best left to the IRR function in a spreadsheet like Excel 4

6 NET PRESENT VALUE (NPV) NET PRESENT VALUE (NPV) NPV incorporates the time value of money and discounts future returns and costs back to the present. PV of Annuity PV of a Lump Sum Pv of uneven cashflows The Discount rate is the interest rate that matches the cost of capital for an investment with its risk NET PRESENT VALUE NPV considers all of the current and future cash flows over the project s life. Where: NPV = Net present value of the investment PVB = Present value of the benefit PVC = Present value of the cost of the investment NPV = PVB - PVC 5

7 NPV EXAMPLE A project requires a \$1 million investment. Each year the Net Cash flow from the project is \$180,000 for 8 years. The Cost of Capital for a similar project would be 7%. Should the Company go ahead with the project? NET PRESENT VALUE Investment \$ (1,000,000) \$ (1,000,000) Cash Flow - Year 1 \$ 180,000 \$168, Cash Flow - Year 2 \$ 180,000 \$157, Cash Flow - Year 3 \$ 180,000 \$146, Cash Flow - Year 4 \$ 180,000 \$137, Cash Flow - Year 5 \$ 180,000 \$128, Cash Flow - Year 6 \$ 180,000 \$119, Cash Flow - Year 7 \$ 180,000 \$112, Cash Flow - Year 8 \$ 180,000 \$104, Net Present Value \$1,074,834 \$ 74, % NET PRESENT VALUE Use the NPV function in Excel \$1,074,834 - \$1,000,000 > \$0 Go for it! 6

8 INVESTMENT DECISION Internal Rate of Return (IRR) Higher is better Must exceed the firm s Weighted Average Cost of Capital Net Present Value (NPV) Higher is better Must be positive for acceptance 7

9 CAPITAL PLANNING MAKING THE DECISION The methods previously discussed are often used in making a capital budgeting decision. However, two other scenarios exist. Mutually Exclusive: Some investments are mutually exclusive because one is chosen and the others are automatically sacrificed or excluded. Capital Rationing: Capital rationing is a constraint placed on the amount of funds that can be invested in a given time period. CAPITAL ALLOCATION A department has \$10 million to invest in an IT program. It is determined that Project 1 has an IRR of 20% and Project 2 has an IRR of 15%. Project 1 requires a \$6 million investment. Project 2 requires a \$10 million investment. Which project should the department take? Depends on the Alternative Investment. CAPITAL ALLOCATION SOLUTION If the IRR of the alternative investment is 5% then take Project 2 even though it has a lower IRR. Project 1 = (60% x 20%) + (40% x 5%) Overall IRR for Project 1 is only 14% 8

10 RETURN ON INVESTMENT (ROI) AND PAYBACK WHY ROI? Easy to understand Traditional metric WHY NOT ROI Focus on financial benefits only Does not consider future benefits Cannot consider intangible assets May benefit outside of business unit Benefits may take longer to materialize in IT projects Need to supplement financial information with qualitative benefits 9

11 TRADITIONAL ROI Average annual net benefit/ Initial costs Results in the most conservative number Ignores the time value of money CUMULATIVE ROI (CROI) Total net benefits/ Initial costs Total net benefits over useful life then divide by the initial cost. Generally results in the highest value relative to other ROI Misleading Aggregates several years of returns instead of considering them annually Ignores the time-value of money May be significantly exaggerate when benefits come later in the useful life of the project 10

12 DISCOUNTED ROI Discount Rate is Risk Adjusted PV of net benefits/ Initial costs Must choose a discount that reflects the opportunity cost of investing in the project Less than 1 (100%) means No PAYBACK PERIOD How long it takes to recapture Upfront Investment Shorter is better =Investment/Annual Savings Tiebreaker if NPV and IRR of different projects are very close Use discounted Cashflows 11

13 ECONOMIC VALUE ADDED ECONOMIC VALUE ADDED EVA equals the net operating profit minus any applicable capital charges The Economic Value Added (EVA) is a measure of surplus value created on an investment. EVA VS OTHER METHODS Standard accounting methods treat capital as if it were available for free Debt has interest expense Equity requires a return for the investor EVA FORMULA Net Operating Profit After Taxes (Capital x Cost of Capital) (Return on Capital - Cost of Capital) (Capital Invested in Project) Use value of benefits (cashflows) in place of NOPAT 12

14 ANOTHER VARIATION ROI = Net Income after Tax/Total Assets EVA % = ROI Cost of Capital EVA VS. NPV & IRR EVA is a measure of dollar surplus value Generally, not the percentage difference in returns Closest in both theory and calculation to the net present value of a project in capital budgeting As opposed to the IRR USE OF EVA CFO Research: 33% of finance managers uses EVA to help make technology investment decisions. 15% percent use EVA as their primary finance metric for evaluating IT projects Keeps everyone focused on wringing the most benefit out of the capital asset base 13

15 OUTSOURCING AND EVA EVA increase when investment capital assets are low Low Capital Assets generally lowers Operating Costs EVA therefore often supports Outsourcing LESSON EVA allows R&D expenses to be treated as a capital expense and allocated over the time the benefits are realized Goal: Don t waste Capital!!! LIMITATIONS OF EVA AND IT Projects don t have an individual NOPAT IT EVA calculations use Net Benefits Gross Benefits Annual Costs Difficult to quantify benefits from IT investments 14

16 ROI EXAMPLE IT Investment \$50,000 Value of Benefits net of Expenses \$ 8,000 Cost of Capital 12% EVA = Net Benefits - (Cost x COC) = \$8000 (\$50,000 x 12%) = \$2,000 USE OF ALTERNATIVE CALCULATION IT Investment: \$50,000 Value of Benefits net of Expenses: \$8,000 Cost of Capital : 12% ROI = Net Benefits/Cost \$8,000/ \$50,000 = 16% EVA Alternative: (ROI - COC) 16% - 12% = 4% 4% x \$50,000 = \$8,000 15

17 COST-BENEFIT ANALYSIS BENEFIT-COST RATIO Used often in Government Another way to evaluate Projects PV Cash Inflows PV Cash Outflow Pretty much the same as Profitability Index (PI) when PI is using Cash Flows as Benefits BCR EXAMPLE A company has to choose between two projects. One requires continuing investment and one requires a single upfront investment both with different cash inflows Inflows 1 Outflows 1 Inflows 2 Outflows 2 Year Year Year Year Year Year Year \$13.19 \$10.53 \$13.37 \$10.00 COC 20% 20% BCR

18 PROFITABILITY INDEX, OR PI The profitability index is the ratio of the present value of the benefits to the present value of the costs. PI = PV of Benefits/PV of Costs PI = 1,074,834/1,000,000 =1.074 CAVEAT Always remember to consider Capacity when making decision on which projects to choose. Excess capacity may indicate that you should take on projects you might not otherwise. RUN-AWAY PROJECTS 55% NO risk management 38% SOME risk management 7% DIDN T KNOW if they did or not* *KPMG Study 17

19 COST VS. BENEFIT Risk Management is an Investment Reduces the impact of possible unfavorable results The costs should not outweigh the benefits EXPECTED MONETARY VALUE Use EMV to evaluate risks to assess range of possible project outcomes Estimate Probability risk factor Impact of each factor Multiply probability and cost of associated risk event EXPECTED MONETARY VALUE Project 1 has an NPV of \$200,000. The likelihood of success is 20%. The cost of failure of the project is loss of the original investment of \$5,000 The alternative Project 2 has a 10% chance of success with an NPV of \$1,000,000. The cost of failure is the cost of the original investment of \$100,000. Which project do you choose? 18

20 EXPECTED MONETARY VALUE Project 1 \$200,000 profits x 0.2 = \$40,000 \$5,000 loss x 0.8 = (\$4,000) EMV = \$40,000 + (\$4,000) = \$36,000 Project 2 \$1,000,000 profit x 0.1 = \$100,000 \$100,000 loss x 0.9 = (\$90,000) EMV = \$100,000 +(\$90,000) = \$10,000 Choose Project 1 19

21 We hope you have found this session beneficial. Please note that the course material is for educational purposes only and is not intended to be used without the course presentation. The preceding information is not intended to be legal or business advice. Please consult competent professionals when implementing any of the techniques and methods discussed in this presentation. 20

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