As we approach the fourth quarter, many application development managers are beginning to plan for 2005 projects. The first step in this process is soliciting input from business and IT partners to generate a list of potential project candidates. In most organisations, there is a never-ending reservoir of new ideas for generating value for the organisation.
This usually leads to a wealth of project requests, of which executives will only approve a few.
Which has good ROI?
Determining a project's return on investment can be a daunting task. This process usually considers financial investment and operational costs vs. expected revenues. A key consideration is the analysis of cash flow for the project over time.
There are many formulas to do this, but the most common one is the Net Present Value (NPV) calculation. NPV is the value of future free cash flows discounted back to the present by applying a percentage discount rate. If NPV is positive, then the project will return value. If the NPV is negative, then the project will result in a financial loss.
Project scrubbing
The process of reducing the project wish list begins by performing enough analysis of each candidate to answer at least the following two fundamental questions:
Free cash flow is total income minus all outlays to create that income. The discount rate is based on the company's cost of capital and varies depending on risk. Calculating the cost of capital for an organisation is a complex analysis of the organisation's current financial situation, which includes such factors as available funds (i.e., cash), capital commitments, operational costs, overall assets, and outstanding debts.
The corporation's finance department determines this calculation, but it usually approximates the percent of return the organisation could receive on long-term investments at no risk (e.g., Federal Reserve Notes). Most organisations add a certain value to this rate to determine the organisation's "desired rate of return" for the project investment, or the desired internal rate of return (IRR).
Then, organisations adjust the rate for risk. Organisations need to consider business and financial risk (both of which raise the discount rate). Business risk includes factors such as technology fit, likelihood of adverse future events, market acceptance, competition, and project complexity. Financial risk includes items such as debt vs. equity financing, shareholder commitments, and prevailing interest rates. The following example illustrates these processes.
VoIP example
Consider a new emerging technology project to do voice over IP within your organisation. Your company's finance department determines a minimum discount rate of return of 10 percent. Your organisation's executive committee determines that all projects must return a rate of at least 5 percent above the discount rate. (This is mainly due to a prevailing interest rate of 3.5 percent.)
The organisation's good financial year allows available equity (i.e., zero debt financing) to fund most project expenses. Additionally, you decide that this project has significant business risks due to the introduction of a new and significant technology. Therefore, you calculate the project discount rate as follows:
Rate = 15 percent (desired rate of return) + 10 percent (due to high business risk) + 3 percent (due to low financial risk), or 28 percent >
Next, you calculate that the initial investment is $100K. You calculate a net cash inflow of $20K for each year and do a calculation for five years.
By using 28 percent as the discount rate and the formula for NPV--NPV = - initial investment + summation of periods 1 thru n of (net cash flow in year i/(1+discount rate) to the ith power), or $640.12--here's the equation you would use:
NPV = -$50,000 + ($20,000/(1+.28)E1) + ($20,000/(1+.28)E2) +($20,000/(1+.28)E3) +($20,000/(1+.28)E4) +($20,000/(1+.28)E5)
This project will return a positive return (albeit a very low one) over five years.
But should your organisation pursue this project?
Based on the NPV alone, this project appears to be on the border. If risk increases, the project could easily become a monetary loser. Your company's decision would ultimately need to consider other non-tangible values in the project returns.
biography
Scott Withrow has more than 20 years of IT experience, including IT management, Web development management, and internal consulting application analysis.
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