Chapter 14

Evaluating AIS Investments

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Learning Objectives

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• LO#1 Articulate similarities and differences between major IT initiatives and other capital investments

• LO#2 Explain the major steps in the economic justification of an IT initiative

• LO#3 Explain potential benefits of IT initiatives and how to evaluate them

• LO#4 Assess potential costs of IT initiatives and how to evaluate them

• LO#5 Describe potential risks of IT initiatives and corresponding risk mitigation techniques

• LO#6 Apply capital budgeting techniques to assess the value of an IT initiative

Large IT Projects Require Economic Justification

• Worldwide IT spending forecast to exceed $4 trillion by 2015 (according to the Gartner Group in January 2013)

• IT projects require large amounts of capital and capital is limited

• Selecting one project often means foregoing others• IT projects often involve changes in business processes

that will affect substantial portions of the organization• Capital budgeting techniques provide a systematic

approach to evaluating investments; yet, many organizations find it difficult to evaluate IT projects using traditional techniques.

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LO# 1

Business Case for IT Initiatives

Should answer these questions:1. Why are doing this project?2. How does it address key business issues?3. How much will it cost and how long will it take?4. What is the return on investment and payback period?5. What are the risks of doing the project?6. What are the risks of not doing the project?7. What are the alternatives?8. How will success be measured?

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LO# 2

The Economic Justification Process

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LO# 2

Assessing Business Requirements

• Refer to information on the balanced scorecard in Chapter 13

• IT initiatives should reduce one or more gaps between the firm’s current and desired performance levels as indicated by the firm’s strategy map

• IT alone is usually not sufficient to achieve important changes

• Consider other enabling changes that in conjunction with the technology will accomplish substantial business change

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LO# 2

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LO# 2

Examples of Complementary Changes

• Training employees • Redefining job descriptions• Reconfiguring tasks• Offering incentives to make changes• Others?

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LO# 2

Estimating Benefits

1. Revenue enhancement—creating new sales opportunities

2. Revenue protection—protecting existing revenue streams

3. Cost savings—opportunities to modify business processes to reduce low value-added or manually intensive activities, to improve capabilities to manage assets to increase efficiencies, or to reduce errors

4. Cost avoidance—opportunities to modify business processes to avoid cost increases in the future

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LO# 3

Estimating Relevant Costs

• Acquisition Costs– Direct costs to acquire and implement

• Hardware• Software• Networking• Development• Project Management• Consulting• Training

– Indirect costs of the disruption to current operations

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LO# 4

Estimating Relevant Costs

• Operating Costs– Direct costs necessary to operate, maintain, and administer the

technology• Hardware replacements• Software upgrades• Maintenance contracts• Help desk support • Ongoing training• Administration • Decommissioning

– Indirect costs of user downtime and lost productivity, such as time spent on self-training, peer support, end user data management

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LO# 4

Assessing Risks

• Alignment risk—the solution is not aligned with the strategy of the firm.

• Solution risk—the solution will not generate projected benefits.• Financial risk—the solution will not deliver expected financial

performance.• Project risk—the project will not be completed on time within

budget.• Change risk—the firm or part of the firm will not be able to

change.• Technological risk—the technology will not deliver expected

benefits.

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LO# 5

Identifying Risk Mitigation Techniques

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IT Initiative Risks Risk Mitigation Examples

Alignment Risk Use the Balanced Scorecard Framework (Chapter 13) to assess the link to strategy

Solution Risk Use sensitivity analysis to consider likely alternative benefit levels

Financial Risk Interview other users of similar IT; follow a structured Balanced Scorecard Management Process (Chapter 13)

Project Risk Assure active top management support for the projectChange Risk Conduct training and create employee incentives for

successful use of the new ITTechnological Risk

Require hardware and software vendors to demonstrate that their systems can meet requirements

LO# 5

Combining Benefits, Costs, and Risks

• Fully understand the financial implications of the investment– Determine the relevant time frame for costs and

benefits– Select appropriate discount rates to apply– Prepare capital budgeting financial metrics – Assess the sensitivity of results to the assumptions

• Select the best alternative and summarize the reasons for that choice

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LO# 2

Capital Budgeting Financial Metrics

• Payback period and breakeven analysis—both compare the costs with benefits of an IT project. The breakeven point is where the total value of benefits equals that of total costs. The payback is the number of periods needed to recover the project’s initial investment.

• Payback Period = Initial Investment/Increased cash flow per period

• Assume an IT project is expected to cost $20,000 up front, and it will provide net benefits that average $16,000 per year for the next 3 years.

• Payback Period = $20,000/$16,000 = 1.25 years.14-15

LO# 2

Capital Budgeting Financial Metrics

• Net present value• Sum of the present value present value of all cash

inflows minus the sum of the present value of all cash outflows. Each cash outflow/inflow is discounted to its present value.

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Present Value = CFt/(1 + r)t

Where:CF = cash flow for period t, andr = discount rate (typically the firm’s weighted average cost of capital).

LO# 2

Capital Budgeting Financial Metrics

• Internal rate of return (IRR)• Discount rate that makes the project’s net present value

equal to zero• financial calculators and spreadsheet software, such as

Microsoft EXCEL, Microsoft Excel, use an iterative technique for calculating IRR. Starting with guess, they cycle through the calculations until the result is accurate.

• The IRR and NPV functions are related in that if you use the IRR as the discount rate (r) in calculating NPV, your NPV is zero

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LO# 2

Capital Budgeting Financial Metrics

• Accounting rate of return (ARR)• The average annual income from the IT initiative

divided by the initial investment cost

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ARR = (average annual income from IT initiative) /(total IT initiative investment cost)

LO# 2

Strengths and Weaknesses of Financial Metrics

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Financial Metric Strength WeaknessPayback Period Easy to calculate and understand.

Widely used. Ignores the time value of money as well as both costs and benefits occurring after the payback period.

Accounting Rate of Return

Relates estimates to standard accounting ratios using accrual accounting. Shows impact on operating income.

Also ignores the time value of money. Assumes cash flows in all periods are similar.

Net Present Value Considers the time value of money. Incorporates cash flows over the life of the IT initiative. Compares the dollar value of the benefits from an IT initiative to the initial investment.

Larger projects tend to have larger net present values. Does not show rate of return on investment. Sensitive to discount rate applied.

Internal Rate of Return

Considers the time value of money. Incorporates cash flows over the life of the IT initiative. Computes the unique rate of return for the initiative. Not sensitive to a selected discount rate.

Fails to consider the size of the project. Sensitive to timing of the cash flows.

LO# 2

Example

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Discount rate 10%

Project 1 Year 0 Year 1 Year 2 Year 3 Total AverageBenefits $20,000 $20,000 $30,000 $70,000 $23,333Costs $20,000 $7,500 $7,500 $7,500 $42,500 $10,625Cash Flow -$20,000 $12,500 $12,500 $22,500 $27,500 $15,833Payback 1.26NPV $16,908 IRR 52%

Note that total cash flow is equal but NPV and IRR are not, due to time value of money. Try it in EXCEL using the NPV and IRR functions!

LO# 2

Test Sensitivity to Changes in Assumptions

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LO# 2

Prepare the Value Proposition

• Assemble the analysis for each alternative IT initiative and recommend the preferred alternatives.

• Focus on these five questions:1. The change and technology proposed2. The anticipated benefits (related to the firm’s critical

success factors)3. The group(s) within the firm that will benefit4. The timing of the benefits5. The likelihood of achieving those benefits as planned

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LO# 2