ROI Analysis for E-Biz ProjectsClass 6: IT Investment & ROI

Mark Jeffrey, Northwestern University Case Summary by: June Shin

* FYI, blue parts are my own personal additions.

Main Takeaways

IRR rather than ROI:

- ROI does not include the time value of money and is about PV

- IRR includes the time value of money and is about NPV

PV and NPV clearly depend onDiscount Rate (Cost of Capital or WACC)

Assumptions on Uncertainties and Risksare pivotal parts of the ROI Analysis

Assumptions on Revenue and Cost Factors are to be put into Sensitivity Analysis

An E-Biz or IT PJT (A) vs. Base Case (B): A – B = Incremental Cash Flow, and IRR & NPV are calculated from the cash flow

Sensitivity Analysis: because we use assumptions rather than facts in the analysis, conducting sensitivity analysis is meaningful. Estimate and compare the best case, worst case, and most likely case scenarios on the purpose of decision-making

Projected ROI (IRR) is Just Oneof the many Business Value Criteria, because of uncertainty, risk, and any other factorssuch as leader’s will, executive’s experience, and political issues

Unquantifiable factors - Option Value or Soft Benefit - should be considered

More in-depth Summary (including case discussion)

What is the ROI & ROI Analysis?

  • ROI is a project’s net output ((cost savings + new revenue) – total project costs) / total project costs
  • ROI represents PV(Present Value), IRR represents NPV(Net Present Value of money)
  • Generally, the scope of ROI Analysis includes IRR analysis
  • Financial Projection (Modeling) Analysis, Business Valuation Analysis, Feasibility Study, or ROI(IRR) Analysis are all the same terminology
  • For ROI Analysis, considering uncertainties and risks can significantly improve the chance of successful investment decisions
  • Many IT companies think of ROI as important criteria when making investment decision, but actually it is only one category on their scorecards

The Information Paradox

  • Information Paradox (Productivity Paradox): “there is no correlation between IT investments themselves and firm productivity”
  • Investing in IT is on average a positive ROI activity, but the benefits of IT investments are difficult to measure and risk factors can significantly impact the actual ROI realized

Review of Basic Finance

  • Time Value of Money, NPV:“when it comes to the IRR calculation, today’s $100 is bigger than tomorrow’s $100”
  • Discount Rate, Cost of Capital:“the Cost of Capital implies a particular firm’s financial risk, and accordingly company A’s cost of capital may be different from company B’s. And, cost of capital in industry C may be different from that in industry D”
  • IRR (Internal Rate of Return) is the discount rate at which the NPV of the project is zero
  • Positive NPV or greater-than-WACC IRR means that a project can be profitable and is worthwhile to go
  • Payback Period: time taken for a project to recover its initial investment (payback period for a typical e-business project can be in the range of 6 months to 2 years)

Calculating ROI for an (E-Business) Project

Before entering the first step, we should establish general and common assumptions - inflation rate, WACC, growth rate for the population, etc. After that, we should establish with-the-project assumptions, so-called, Cost and Revenue factors sensitively affecting the project’s profitability and ROI. These factors are also to be used as input parametersin the Sensitivity Analysis. In case of B&K Distributors, tier migration, channel migration, order size, and penetration are the inputparameters for the revenue side. Upfront cost and annual ongoing cost,including HR and marketing, are the input parameters for the cost side. And, the projection period is also to be considered a variable.

  • Step1 (Base Case Projection) : calculate the base case revenue and costs expected if the business continues as it is now and does not implement a new project
  • Step 2(Project Case Projection) : calculate the net cash flows with the new proposed project, including total revenue, cost savings, and all costs of the project
  • Step 3(Incremental Cash Flow) : the base case cash flows are subtracted from the projected cash flows with the new project
  • Step 4 (ROI) : the IRR, NPV, and Payback Period are then calculated from the incremental cash flows
  • Step 5 : go to Sensitivity Analysis

The challenge is to accurately incorporate the business drivers in the base case and all of the project costs, potential cost savings, and potential revenue benefits in the new project’s cash flow.

To build vs. to buy decision for a new project is very important. Namely, the cost of outsourcing the system, versus keeping it in house, may also be considered. In case of buying and maintaining systems or equipments as the company’s fixed assets, depreciation and its expense are to be calculated into the cash flow, and ROI should be different.

Accurately quantifying all of the benefits of an e-business or IT system is the most challenging part of any ROI analysis. The analysis therefore typically does not include unquantifiable soft benefits. This means that the ROI calculated will potentially be less than the realized ROI including soft benefits.

Uncertainties, Risk, and Sensitivity Analysis

  • The major uncertainties will come from the business assumptions and the risks of the technology project
  • It is practically impossible that the assumptions will indeed be exactly correct
  • The calculated ROI is only a point estimate
  • In this context, it will be good to estimate the Best, the Worst, and the Most Likely case for each of the major assumptions and compare each case. This stage is called Sensitivity Analysis by scenario. For the B&K case, the penetration rate and the projection period were two most sensitive variables in the Analysis
  • If there is a wide variation of the best and worst case IRRs, this is an indicator that there is significant risk in the project
  • However, the sensitivity analysis has the limitation that one can vary at most two parameters simultaneously. When simulating multiple parameters simultaneously and continuously, we can use the Monte Carlo Analysis iterating the calculations and being defined by standard distribution

Executive Insights

Intangible values

  • IRR or NPV does not take into account management flexibility
  • Option Value is one of the important factors to consider when it comes to investment decision-making. If an IT project is the one to make additional, relevant projects possible, the project has an option value
  • Soft Benefit also should be considered. Unquantifiably added values like customer satisfaction can be a soft benefit

IT Investments w/ Strategy

  • The process of managing the portfolio of technology investments of a firm is called IT Portfolio Management, which includes strategy of the firm, the risk, and ROI
  • The IT portfolio management process gives executive managers a framework for optimal investment decision-making
  • ROI analysis is only one component of a technology investment decision
  • Important is that e-business and IT investments should be linked with the corporate strategy. The IT objectives for the firm must support the key business objectives (KBOs) derived from the corporate strategy in order to optimize the value of the portfolio of IT managements

Beyond ROI

  • Building the ROI model on sound assumptions and developing a risk management strategy can significantly impact the actual ROI
  • The ROI should be measured even after the project is complete, because this after action review enables feedback to the entire IT portfolio management process
  • For big-size projects, the whole project needs to be broken down into phases, where each phase is defined by ROI. This approach reduces the risk of the e-business investment and makes the project self-funding

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