Key Terms: Net Present Value, Net Present Value Discount Rate, weighted average cost of capital, time value of money, inflation.
In 1950, the median value of a home in the United Sates was $44,600. By 2000, this value rose to $119,600. During that time, population increased, but so did inventory, to the point that today there are more houses than people who can afford to buy them. What can explain this - inflation, rising wages, a housing bubble? In reality, the historical increase in prices over time is due to a combination of complex economic factors. However, this bit of history does illustrate an important fact: the value of a dollar changes over time and in general, the value of a dollar today is greater than it will be in the future. This phenomenon is sometimes referred to as the time value of money.
When businesses evaluate the economic benefit of an investment that provides returns over time, it is important to understand the value of those returns in terms of the value of a dollar today. If I implement a solution that saves me $200,000 a year in operating expenses, but costs $1,000,000 to deploy, it will take me five years to save $1,000,000. Five years from now, however, that $1,000,000 won’t have the purchasing power that it does today and meanwhile, I might have invested $1,000,000 in the stock market and made a greater return over the same five years. Which brings us to the second important point: it costs money to spend money, because money has an opportunity cost and a cost of risk. This is often referred to as the cost of capital.
A related concept in investing is the uncertainty principle. No, this has nothing to do with Heisenburg or electrons. What we mean by uncertainty (or certainty) is simply, “What is the risk that I will see the projected return on investment?” In making investment decisions, commonly the investment is made in the near-term and benefits come later. If I spend a dollar today in exchange for the promise of a dollar next year, I am trading certainty (my dollar is absolutely gone) for uncertainty (maybe I will see a return on that dollar next year, or maybe not). So I need compensation for the uncertainty I am accepting. The greater my perception of future risk, the more compensation I will want. The uncertainty factor drives me to discount the value of these future returns, because I want to see that I still generate positive returns after factoring the cost of risk that I will realize these returns into the cost of my investment.
When I make an investment, I want to know that (a) my return over time will be a profit in terms of the value of a dollar today (the time that I make the investment, not the time that I realize the return),(b) that I have a reasonable chance of meeting or beating the return I would make on another investment of the same amount.
The calculated value of the future returns of an investment that takes into consideration the time value of money is called the net present value (NPV) of the investment. Essentially, the net present value calculation applies a compounding discount to the returns you receive on an investment by an average rate to demonstrate the effect market pressures, like inflation and missed opportunity cost, have on the value of your investment. This discount rate is sometimes called the weighted average cost of capital. A higher net present value discount rate results in a lower return, representing a higher average cost of capital over the time frame under consideration. Many organizations have a specific NPV discount rate they use to evaluate certain kinds of investments. It is a good idea to ask your customer if their organization uses a standard rate and to use that rate in your calculations.
In general, a net present value that is greater than zero represents a positive return on investment, an NPV less than zero means the returns gained did not cover the original investment and an NPV of exactly zero represents a break even scenario.
NPV is used to inform a lot of other commonly used financial metrics. ROI is based on the net present value of the returns of an investment divided by the original investment. Payback period is the amount of time that will elapse between a capital outlay and the point at which the NPV of the return of that investment equals zero. Internal rate of return actually projects the NPV discount rate that would be required to make a proposed investment break even over the timeframe under consideration, all other variables being equal. Because NPV is so intertwined with these metrics, it is important to understand and be able to deliver the NPV of any proposed investment if you want to gain the mindshare of a financial decision maker.
Wednesday, April 16, 2014
Wednesday, April 9, 2014
What these metrics mean and why they are important
Key Terms: Total Cost of Ownership (TCO), Return on Investment (ROI)
When CIOs and other like-minded executives consider the financial impact of a new technology investment, they overwhelmingly look to two metrics: total cost of ownership (TCO) and return on investment (ROI). Although these two terms are sometimes thrown together, they are actually measures of two very different things and which metric is preferable depends on the parameters of your decision.
First of all, let’s clear up the definition of these terms.
TCO or total cost of ownership is a measure of cost. This includes the capital cost to purchase equipment, deploy it, configure it or integrate it with other systems, and the operational costs (sometimes referred to as the run-rate) to operate and administer the equipment over a given period of time. Time is a key component of TCO, as most operating costs are ongoing; therefore, the longer the timeframe, the higher the TCO. If you think of a car as a metaphor for an IT investment, the TCO for your vehicle would certainly consider the price you paid for the car at the dealership, but it would also include the ongoing costs of ownership, like insurance, gas, and maintenance for as long as you owned the car. In the IT world, these ongoing operational costs can sometimes far outweigh the initial capital cost of a technology solution.
Return on investment is a measure of benefit from a capital investment. ROI is depicted as a percentage. ROI looks at the total capital cost of an investment and calculates the value returned by that investment over a given time period. Time is a key component in calculating ROI in two ways. Like TCO, an ROI result will change over time as ongoing benefits (like a reduction in operating costs) continue to accrue. The timing of investment is also critical to an accurate ROI calculation. In most scenarios where ROI is an effective metric, an upfront capital investment is offset by some kind of ongoing operational benefit to create a positive cash flow. To generate a positive ROI, the positive cash flow generated by the benefits of that investment must outweigh the initial cost of the investment.
To calculate ROI, you need to model the outbound cash flows (costs) and inbound cash flows (benefits) associated with a particular investment. Any accurate ROI calculation should consider all costs associated with an investment, therefore, an ROI analysis must start with the TCO of the proposed solution. You must also model benefits of the investment which you will weigh against the cost. These benefits can be savings over an existing cost, additional profit generated from new revenue streams enabled by the technology, or any other benefit that can be quantified as currency.
So, which metric is better? The answer is different depending on your customer’s decision point.
TCO is a useful metric for comparing a proposed solution to the TCO of another similar solution. It is especially useful it comparisons of competitive solutions that may provide similar functionality to the business, but in different ways. Considering the capabilities offered by two competing technologies to be equal, a lower TCO is a better TCO. TCO is a useful metric for the IT buyer who is asking, “Which new technology should I invest in?”
ROI is often used to compare a proposed IT investment against an existing solution. In this type of scenario, the proposed technology generally promises to deliver the same functionality as the existing environment, but in a more efficient manner or with lower overhead costs. ROI can also be used, however, to demonstrate the benefit of new business capabilities that are not supported by the existing technology. ROI is a useful metric for an IT buyer who is asking “Should I invest in a new technology at all?”
Wednesday, April 2, 2014
There are also times when a business case is not the right tool to use. Here are some examples:
1. When the proposal is relatively small.
If your proposed solution costs less than one million dollars, a business case is probably overkill. Most opportunities that Mainstay works on are upwards of ten million dollars.
2. When the decision is being made in the next 30 days.
A competently prepared business case takes at least 45 days to complete, usually longer. If you don’t have the time to do the job right, you’re better off not doing it at all.
3. When the key data holders are opposed to you, your company or your solution.
Unfortunately, Mainstay has had experience working with customers who were strongly opposed to the solution being offered. In these conditions, data is withheld, delayed and sometimes intentionally falsified.
This forces the business case to be developed using extrapolated data. The case can then be attacked by the opposing players, claiming it to be inaccurate.
Without at least one influential person on your side, developing a good case and getting an open-minded hearing of it is unlikely. Be warned: a business case presented in this situation can actually hurt your cause.
4. When the data is unlikely to be available.
If the customer tells you that cost information is not available, be cautious about offering a business case. Examples include customers that have recently done large acquisitions; decentralized multinational corporations; customers with outsourcers who will not be participating in the business case; customers who are under significant external pressures such as government audits, criminal investigations and the like.
Customers with a major presence outside the US and Europe will always have trouble getting good data. Most countries in Asia, Africa and South America require local ownership and control of foreign subsidiaries. This means there is no centralized accounting or purchasing. As a result, data can be very fragmented. Mainstay has done dozens of studies involving Asian and South American locations and has almost never gotten good data.
5. When the true objection is not financial.
Beware of the customer who tells you the problem is budget approvals when it’s really something else. You may spend months and money to create a good business case and still not get an order. Only offer a business case when you are certain there are no technical or cultural issues blocking your deal.
In Mainstay’s experience, business cases are too often overlooked as a way to make a big deal happen - and too often thrown into the breach as a last-gasp effort to save a lost cause. A business case is a great tool for closing business. But it needs to be used at the right time.