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This chapter is from the book

Breakeven Time

To recap, conventional ROI analysis is about measuring the amount of the payback and the time in which is it achieved.

For example, a project that becomes profitable in 18 months is intuitively more compelling than a project that takes five years to become profitable. However, it may not be financially more compelling over the long term. It's possible that the return from the five-year project is significantly larger than the one from the 18-month project. Under these circumstances, how is it possible to decide if the five-year project is to be preferred over the 18-month project?

Clearly money has a time value. A piece of software that delivers $1 million in savings in one year is more interesting than a piece of software that delivers $1 million in savings in 20 years. So how do we compare the value of $1 million next year with $1 million in 20 years?

To some extent the value of future cash can be measured by discounting it against an assumed interest rate. This calculates the present value (PV) of the future cash. This approach is clearly simplistic because it fails to take into account risk factors associated with the predicted future cash, but more on this later. For now, we'll assume the future cash is certain. As an illustration, imagine that the interest rate is i%. The present value of $x in n years' time is defined as follows:

  • PV = $x / (1 + i/100)n

In other words, if we assume an interest rate of 5% per year, receiving $1 million in 20 years is equivalent to gaining 1/(1 + 0.05)20 = approximately $377,000 now. On the other hand, receiving $1 million next year is equivalent to gaining approximately $952,000 now.

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