A Comparison of Approaches to Investment Analysis

John Favaro

Proc. Fourth International Conference on Software Reuse, 1996,

IEEE Computer Press, p. 136-145

Software reuse economics

• Three kinds of activities:– Reuse metrics

• the measurement of reuse-related characteristics of software

– Cost estimation• the estimation of cost and benefits associated with

reusable software development

– Reuse investment analysis• the evaluation of investment decisions

The investment analysis

• Is in the domain of the financial corporate analyst• Different perspective from the software engineer

– reuse is only one alternative for investment– is concerned with the best way to allocate capital and human

resources

• There is always an alternative to reuse investment– equivalent investment in the capital market that provides some

yearly rate of return– reuse-oriented investment should be compared with this

• Capital investments are analysed with respect to periods of time, and the same approach should be used for reuse investment analysis

Cost estimation and cash flow

• Cost estimation = cash flow analysis• Estimation of cost/benefit • Candidate reuse projects has potential cash flows

– positive (e.g.. savings by avoiding work)– negative (e.g.. work to generalize a component)

• Techniques for quantifying economic benefits are emerging.• Cash flows are forecast over a suitable time horizon• Time period must be neutral estimate, not a desired

characteristic • Cash flow analysis is an activity prior to investment analysis

Comparison of approaches

• Desirable characteristics– depend as much as possible only on forecast cash flow

– have a quantifiable acceptance rule to guide the investment decision

– suitable for comparing and ranking candidate projects

– be able to deal with arbitrarily large or small projects

– be able to handle projects of arbitrarily long or short duration

Net present value

• PV = Present Value

• PV = Ct / (1 + kt)t

• Ct : future cash flow in period t

• kt : discount rate in period t

• NPV = Net Present Value• add the initial investment as a negative value

• NPV = C0 + PV

NPV characteristics

• Acceptance rule is based on the value of NPV– positive : accept

• Permits realistic comparison with alternative capital investment possibilities

• Does not depend on arbitrary factors (e.g.. managers instincts)

• Values are additive, can be ranked, and are sensitive to scale

• Large and small alternative can be compared and combined

Payback

• The time or number of uses required to recover the cost of an investment

• The payoff threshold value:– N0 = E / (1-b)

– E = relative cost of developing a component for reuse

– b = relative cost of integrating the component

– N0 = number of times a component must be used before its cost is recovered

Payback characteristics

• Acceptance is based on cost recovery within a cut-off date

• Intuitively appealing but problematic– cut-off date is arbitrarily and subjective

– payback is not sensitive to patterns of cash flow

– problem of scale: the true value (long term) is not taken into account

– choice of cut-off period affects whether short or long lived projects are accepted, tends to penalize forward looking reuse programs

• Ad-hoc approach useful for communicating the result of an investment analysis

Average return on book value

• Software as a capital asset• An amortization schedule for the investment for

reusable work products is agreed upon (deducted as appropriate from future cash flows from those work products)

• The book rate of return (of an investment) is calculated by:– dividing the avg. profits from predicted cash flows by

the avg. net book value of the investment

Avg. return on book valuecharacteristics

• Acceptance rule is based on the book rate of return meet some target set by the analyst e.g..– companies current book rate of return

– of the industry as a whole

• The approach is entirely insensitive to a variable cash flow pattern

• The calculation is depending on the choice of amortization schedule

• Choice of target book rate is arbitrary and subjective

• Not satisfactory approach

Internal rate of return

• A way of defining the rate of return of a long lived asset

• IRR is related to NPV– IRR is the discount rate which makes NPV

equal to zero

• C0 = Ct / (1 + IRR)t

IRR characteristics

• Acceptance rule:– accept a project if its IRR is greater than the

opportunity costs of the project

• Can be used to produce results equivalent to NPV • Proper use of IRR is more difficult• Can be undermined by certain patterns of cash

flow in a project• Exhibits problems with respect to the scale of

projects

Profitability Index

• Examines the ratio of benefits to costs

• Conceptually closest to NPV

• Numerous variations– ROI (return of investment)– Q (Quality of investment)– CDCF (Cumulative discounted cash flow)

• Values are note additive

Summary / conclusion

• Table on page 143 of the article