535handout_5

535handout_5 - IS/PM 535 Handout #5 Information Technology...

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1 IS/PM 535 Handout #5 Information Technology Investment: Decision-Making Methodology by Marc J. Schniederjans, Jamie L. Hamaker and Ashlyn M. Schniederjans World Scientific Publishing Co © 2004. Extracted text from chapter 5 for instructional use. Chapter 5: Other Financial Methodologies What is Present Value Analysis Methodology? Present value analysis methodology is a traditional capital budgeting technique in which today's value of future cash flows of an investment are compared to the cost of the investment. According to a recent survey by Deloitte & Touche, out of 200 Chief Information Officers on how they measure the value of their IT investments, 29 percent said discounted cash flow were used (IT Value, 2003). Today's value of future cash flows is referred to as the present value (PV) of the investment. In general, if the present value of an investment is greater than the cost of the investment then it should be undertaken because it will add value to the organization. Present value analysis is based on the basic assumption that a dollar today is worth more than receiving a dollar tomorrow because it can be invested and begin accruing interest immediately. Typically, present value analysis is used in situations where cash flows may be easily determined which tends to be when cash flows are due to a cost reduction or cost avoidance. Present value analysis may be used to evaluate an independent investment individually or to select among a set of mutually exclusive investments. Present value is calculated as: where C 1 C n are the expected cash flows for n time periods, and r is the "discount rate." The discount rate , also called the opportunity cost of capital , is the rate that could be earned by investing in securities of comparable risk to that of the investment. The discount rate may be thought of as the expected return forgone by investing in the technology rather than in an equally risky investment in the capital market. An accurate estimate of the discount rate is necessary because this rate affects acceptance and rejection of individual investments. A Payroll IT Investment Problem To illustrate this methodology, let’s look at an example. Suppose you are charged with the task of deciding whether or not to invest in a payroll system. A payroll system is a transaction processing system which will likely lead to a cost reduction for an organization. A new payroll system will cost $100,000 and the expected cost savings will be $40,000 per time period for the next four time periods. Financial management recommends a discount rate of 10% for this project. Should the organization invest? Present value is today's value of future cash flows and the calculation for this payroll system is as follows:
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2 The present value of the investment is $126,794.62, which is larger than the initial cost of the investment of $100,000. The investment is worth more to the organization than it costs so the organization should purchase the payroll system (assuming that the
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535handout_5 - IS/PM 535 Handout #5 Information Technology...

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