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This chapter is from the book

An Example

In this example project we analyze a software development effort over five one-year periods.

An early release of the software allows revenue to start flowing in year 4, though in practice it's not until year 5 that the real revenue flow starts. On the cost side there are some early capital outlays associated with buying the hardware and software needed to do the development work. A technology refresh cycle in year 4 updates the development hardware and some of the data center facilities. In addition to the capital costs, there are operational costs related to personnel, support, data center facilities fees, and marketing.

In addition some savings arise from using the software internally within the organization. Figure 2.2 captures these figures. The numbers are $US in thousands.

02fig02.gifFigure 2.2. Classic ROI Analysis ($US in Thousands)

Figure 2.2 shows that we have a five-year project that requires $2,760,000 to fund. The project generates cash in years 4 and 5. After five years, the total cash returned is $1,288,000. This represents a ROI of 1,288,000/2,760,000 = ~47% over five years.

We now turn to the PV analysis to examine the NPV of the project. The table in Figure 2.3 shows the calculations for three annual discount rates: 5%, 10%, and (for reasons that will be clear in a moment) 12.8%. We have used the standard NPV convention of assuming the cash is generated, or the cost incurred, at the end of each period. Values have been rounded to the nearest integer.

02fig03.gifFigure 2.3. NPV Analysis ($US in Thousands)

The discount rate at which the NPV is zero turns out to be 12.8%. By reference to Figures 2.2 and 2.3, we can draw the following conclusions about this application development project:

  • The project generates $5.6 million over five years, at a total cost of $4.3 million.

  • The business invests a total of $2.76 million at various points over that period to fund it.

  • The project pays back that investment and returns an additional $1.288 million to the business after five years.

  • The resulting ROI over that period is 47%.

  • The project reaches self-funding status in year 4.

  • Breakeven status is achieved somewhere in year 5.

  • The NPV of the project, assuming an annual discount rate of 5%, is $650,000.

  • The NPV of the project, assuming an annual discount rate of 10%, is $194,000.

  • The IRR of the project is 12.8%.

Despite the apparent attractiveness of the ROI, the IRR indicates that it's only worth undertaking this development project if we're unable to find other uses of investment capital yielding better than 12.8% over five years.

If the project is perceived to be risky, this rate of return is probably insufficient to persuade a CIO to proceed. An alternative but lower-risk use of the money with just (say) a 10% rate of return may be thought more attractive.

The bottom line is that at this IRR and in today's market, the project will probably not get approved.

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