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Evaluating Information Technology Investments
What systems to build?
Ken Peffers UNLV October 2004
Evaluation Timing
Ex Ante—before investments are committed
Ex Post—after committing resources
Actually evaluation can be made at any time.
During development
Before subsequent investments
Ex Ante Evaluation
Expected benefits/costs
Alignment with strategy
Feasibility
Risk
During Development
EvaluationAt the end of the feasibility study
At the end of the requirements analysis
When the prototype is developed
Six Roles for Evaluation in the Systems Life Cycle1
Ex AnteJustify funding for the project. Get the backing of decision makers by telling a credible story about value created by the project
During ImplementationConvince End users. Win over reluctant end users who weren’t included in the project justification. Adapt language to audience, e.g., not “enhance the firm’s competitive advantage,” but “get fewer irate customer calls.”
1Adapted from Keen, J.M. and B. Digrius, Making Technology Investments Profitable, John Wiley & Sons, 2003.
Six Roles for Evaluation in the Systems Life Cycle1
During Implementation Help control scope creep. Can be pointed to to help keep the project consistent with its originally approved objectives.Cheerleader. Can be pointed to when obstacles sap morale of the project team members. Keep team members motivated by pointing to their role in achieving value for the firm.Executive reminder. Helps keep the executive sponsor aware of the value of the project. Important when new executives come on board.
During operation.Track achieved value. Foundation for feedback loop for measuring value creation.
1Adapted from Keen, J.M. and B. Digrius, Making Technology Investments Profitable, John Wiley & Sons, 2003.
Ex Post Evaluation
Development success
Performance
Performance impacts
Benefits/costs
Profitability Methods of Evaluation
Payback
ROI
Discounted Cash Flow
Option Pricing
Payback
Payback (# of years) =
Investments/Average annual net benefit
Not justified by theory
Useful for small projects to demonstrate obvious value, i.e., very short payoff equivalent to high ROI
Return on Investment
Return on Investment =
Annual net benefit/Investment amount
Use not justified by theory
Convenient and easy to understand
May result in rejection of positive value projects
Problems with ROI
Short term projects with high ROI may be favored over longer term projects more important to the firm
ROI favors small investment, hence projects may be undercapitalized
Discounted Cash Flow (DCF)
where,NPV = Net Present ValueC = Investment at the start of the projectAt = Cash flow at tT = Project lifer = Risk-based discount rate for the project
Value maximization
Managers objective to maximize firm value
Value of the firm equals discounted value of all future cash flows
Firm Value Maximization
where,PV = Present Market ValueAt = Cash flow at tT = Firm lifer = Industry required rate of return
DCF Example
One period
C = 10,000
A1 = 6,000
r = 10%
= -10,000 + 6,000/1.1 = -4545.4
Contribution of NPV
Objective
Congruence with value maximization
Better than undiscounted cash flow, simple payback, ROI
Limitations
Estimates of revenues and costsmanipulated to justify projects already selected
Clemens: work through the decisions
Estimations of project risk
Second stage projects
Value of Managerial Flexibility
DCF method assumes 2nd stage projects are undertaken
Actually won’t be undertaken if value less than 0 at time of investment decision
The Value of an Option
In making an initial investment in IT the manager is purchasing an option to make a subsequent investment later if the value of the second stage project is positive
Estimating the model
Necessary to estimate B1, C1, var B1, var C1, corr BCEstimating variation. Intuitively: “there is approximately a 2/3 probability that the revenues (costs) will vary up or down by no more than X%)”Estimating the corr BC. Intuitively: “approximately X% of the variation in revenues is attributable to variations in the development costs. The remainder is attributable to other factors. The corr BC is the squareroot of X.”
Evaluating IS Investments: Clemens
Rank alternativesFind bases of comparison
Difficult to compute NPV
Rational, analytical decisions without precise estimates of NPV
Sensitivity analysis
Decision trees
Balance forms of risk (feasibility)
Clemens, cont
Actively manage riskStrategic necessitiesExecutive championship
Role of critical resourcesIf system to create advantage, it must exploit key resources, capabilities. Think ‘barriers to imitation’Sustainable competitive advantage rare. Think cooperation
Be mindful of the downsideVanishing status quoOptions
Relationship between Strategic and Finance Methods
Since expected value of investment in properly valued assets is zero, positive NPV indicates strategic advantage
If NPV>0 there should be a strategic reason
If investment results in strategic advantage, NPV will be positive
Use of finance based measures not uniformly avowed
Robson: Finance measures lead to “short term evaluations on a quantitative basis that favor risk aversion and cost lowering activities with the financial year as their natural horizon and so are inevitably inappropriate for the high risk long-term projects...”
Why?
Risk aversiondiscount rate too high
Cost lowering activitiesstrategic benefits not fully valued
Long term projectsdiscount rate too high
On the other hand
Technologically enthusiastic managers may over-invest in IT
Just because something can be done doesn’t mean that it should be done.
Successful innovations, projects, and products can be worth less than they cost
The middle course
Use a variety of evaluation methods, both quantitative and qualitative
Use qualitative methods to arrive at good estimates of value for quantitative methods
The middle course
Avoid unrealistically high discount ratesunrealistically conservative valuation of strategic benefits
They can damage the firm by biasing investments toward short term gains and cost reduction and may result in underinvestment in long term, innovative technology.
