Possibilities of applying classical and specialist investment evaluation methods in it projects

Uniwersytet Gda
ski

Summary

This article aims at showing possibilities of applying classical methods for the evaluation of investments to analyse profitability of IT projects. The subject of studies are methods of evaluating investments the application of which at early stages of planning enables managers to make adequate decisions concerning further fate of projects being prepared. This article presents computer transaction systems as the only ones among all kinds of IT projects in which one can successfully apply traditional investment evaluation methods. It has been proven that in case of all other kinds of IT projects those methods are not fully reliable. Next, new universal tools for the investment analysis of all kinds of projects in the IT sector have been presented.

Keywords: IT projects, investments, investment evaluation methods 1. Introduction

Investments in IT projects should bring profit. Although it is an obvious statement, only in 18% of IT projects effectiveness of the planned projects is analysed [4]. Why is that so? Why are decisions concerning start-up of a vast majority of IT investments made without prior evaluation of their profitability? Tools for investment evaluations, such as NPV and IRR, have been known and used successfully for many years. We should not suspect managers of IT projects of lack of knowledge or omissions in decision-making processes. The situation is different, namely traditional tools for investment evaluation known from classical investments science applied in the IT sector do not fully fulfil their purpose. When using them, it might very often happen that one cannot calculate the desired values being the basis of decisions about performance or rejection of the project being analysed. There is a need to construct new investment evaluation measures, designed especially for checking profitability of IT projects.

2. Classical investment evaluation methods

Basic goals of every business organisation concerned with investments include the following ones [3]:

• growth of the company's goodwill; this is a strategic (long-term) goal and • maximisation of profit; this is a current (short-term) objective.

Achievement of tasks formulated in this way requires undertaking investment projects, ensuring further development of a business organisation. The company's competitiveness, its market share, and thus a possibility of generating income depends on accuracy of the initiated investments.

That is why, in order to become acquainted with the bases necessary to make rational decisions, it is necessary to evaluate accurately every planned investment. Evaluation methods concerning investments in computer software and hardware are divided into [3]:

• simple ones, based on relationship between capital expenditures and effects, on the one hand, and time, on the other,

• complex ones, based on a discount rate, taking into account change in value of money in time, risk and inflation.

Some methods of evaluating IT projects performance include: • return of capital employed,

• rate of return,

• accounting rate of return (ARR). Complex methods include the following ones:

• net present value (NPV) of projects, • internal rate of return (IRR).

In practice, in both groups (simple and complex) there are various variants of detailed methods. Additionally, there are methods combining certain features of both groups (e.g. multi-criteria methods).

The payback period (PP) is the simplest method of evaluating investment performance. This is a measure determining the expected time that has to elapse so that capital expenditures made for the performance of a given investment project are fully covered by net benefits generated by that project.

The first decision rule used when accepting an investment project using this method is not exceeding -during the project rate of return period - the formerly determined minimum rate of return. The other method, applied in practice slightly less frequently is to compare the project rate of return to the threshold value e.g. average rate of return from similar investments in the same sector.

The accounting rate of return is the development of a rate of return measure from the accounting perspective. In practice, there are a number of variants used for calculating its value. In basic interpretation of the accounting rate of return this is a ratio of income (calculated on an annual base) to total capital expenditures (accumulated from the moment of stating an investment project to the period for which this value is determined).

The most frequently used method of calculating the rate of return is the quotient of the average annual profit from a given investment decreased by the value of the investment divided by the value of capital expenditures during the term of investment. This is the so-called average rate of return (ARR), expressed with the following formula (1):

I

I

Ni

ARR

¦

−

=

i – period of investment operation in years (0...n),

Nii – total profits generated from the investment in particular operational periods [PLN],

The average rate of return provides information about which part of capex will be covered with an average annual net profit. In detailed interpretation, the ARR value specifies the average net benefit expressed in net profit per one zloty of total capital expenditures. A negative ARR value means which part of capex will be covered by profits from one year of investments operation, whereas a positive ARR shows what part of the annual profit from projects will be dedicated to the investment.

The above-described methods which provide evaluation by means of periods and rates of return are subjective methods. A given investment is selected on the basis of comparing the calculated values with the value established a priori, assumed as the limit value. Other drawbacks of simple methods used for investment evaluation include:

• ignoring a changeable value of money in time, • ignoring cash flows after a limit period,

• inability to compare projects with different risks.

Another group of investment evaluation methods constitute the so-called complex methods, also referred to as dynamic ones [7, p. 735]. They take into consideration a time factor in their relationships. This is a very important variable, since the value of money fluctuates. All basic financial figures concerning a given investment project are performed in a specific period of time and they are cash flows in nature.

When persons responsible for investments in a company have suitable data at their disposal, they have to make a decision e.g. which project to perform or which performance option to select, and they should make a selection based on a suitable decision rule. Such a rule has to make it possible to differentiate options which can be accepted from those the acceptance of which will be unjustified for many reasons. This rule cannot contradict the goals of the organisation as a whole, since it will make their achievement impossible. The most frequently used dynamic rule is the net present value (NPV) rule.

NPV is the value received as a result of discounting, separately for each year, a difference between revenues and cash outflows during the whole term of investment operation at the specific permanent level of discount rate. The investment value refers to the present moment (or to the moment of starting the investment) and is expressed with the following formula (2):

o n t t d t

_I

r

R

NPV

₋

+

=

¦

(

1

)

Rt – value of net financial resources (excluding capital expenditures) projected as at the year

end t,

rd – discount rate,

I0 – initial expenditures,

t – subsequent periods (most frequently years) of investment operation (0…n).

The NPV determined according to the above formula gives unambiguous prerequisites in the area of investment decisions. The project is accepted if its NPV>0. If NPV=0, it is assumed that the project is feasible from the point of view of profitability (in this situation it does not matter whether the company invests in the project or if it puts money into bank deposits) or rejected if NPV<0.

In exceptional situations IT companies decide to carry out projects even with NPV<0. This occurs in situations, when it is necessary to perform non-profitable activities in order to open up a

path to profitable ones, e.g. despite a negative NPV, a company will make a decision to start a project of building a website maintenance service, since the system will be necessary in order to start the investment (with NPV >0), being a large internet system for a public institution.

The internal rate of return (IRR) is another dynamic method used for evaluating effectiveness of investment projects. This is a measure of investment profitability. It shows a real profit margin from projects. The higher the value of IRR, the higher the income from investments. From a different point of view, the value of IRR is a maximum rate of an investment loan that will still allow financing the project without incurring loss.

The value of IRR specifies an interest for which NPV=0. It means that IRR shows at what interest updated (discounted) expenditures will be balanced with updated revenues. In other words, this is a profitability rate of a given project. A given project is profitable if IRR is equal or larger than the limit rate, i.e. the lowest profitability rate that can be accepted by an investor (usually it is the value equal to the interest of long-term loans or the interest paid by a possible borrower). The higher the difference between IRR and the limit rate, the higher the profitability and a safety margin of a given project [5].

In practice, a frequently used way of calculating IRR is the following algorithm [3]: • to determine the value of net flows for all years of project performance,

• to find - by means of the method of subsequent approximations - such two levels of a discount rate for which: the difference (r1 – NPV) is close to zero, but positive, marked as

PNPV and the difference (r2 – NPV) is close to zero, but negative, marked as NNPV, the

difference between r1 and r2 should not exceed one percent, as a bigger difference causes

inadequacy of calculations,

• by means of a linear interpolation method it is possible to calculate IRR based on the following formula (3).

NNPV

PNPV

r

r

PNPV

r

IRR

+

−

+

=

(

)

The IRR method is usually used, when we do not know values of the interest for which NPV=0, i.e. such that the investment will be profitable above it. In case of untypical projects, the calculated IRR can have more than one value. It happens in cases when there are negative cash flows not only in beginning years, but also in final years in a project under analysis.

The investment evaluation methods presented above used in the IT sector calculate a coefficient on the basis of financial statements of a given company. They are used for evaluating possibilities of performing planned investments and for controlling the company's status. They also help top management in analysing current standing of the organisation. In the situations of applying for a loan, they allow evaluation of the company's solvency.

3. Drawbacks of applying classical investment evaluation methods in IT projects

From the business point of view, the evaluation of IT project profitability should be the basis for making investment decisions. One can reach an entirely different conviction when analysing results of surveys carried out among IT projects decision makers. As shown in research conducted by McKinsey Company in 2002, only the largest projects are subject to investment evaluation, which constitutes 18% of IT projects [4]. Only 1% of projects are accounted for after their completion in the area of the compliance of achieved results (budgetary, time and functional ones) with those adopted in the planning process [1].

As it turns out in practice, although investors express often radical judgements concerning financial liability of top managers, only few of them make an effort to calculate (any) rate of return of the planned IT project. In practice, what they value more is that the project will be completed on time, without exceeding the adopted budget and in accordance with particular functional possibilities [6]. In many companies, managers admit that the described situation has been changing since the beginning of the 21st century, first of all, due to efficiency requirements imposed by the investors and reporting obligations concerning the course of IT projects performance [4].

The main reason for not-applying classical investment evaluation methods is that in order to determine even the simplest measures of evaluating IT projects profitability (a period of return or a rate of return), it is necessary to calculate simulated profit to be generated by information provided by the planned investment – an information system that is to be performed.

Information that is delivered on time, and is complete and legible, is the basis of proper functioning of all business organisations. Possession of information conditions the possibility of making accurate decisions by managers. Although computer systems, together with the related software, are concerned with collection, sending and processing of information, the notion of information itself is not totally clear in science. Information is a primary notion, which is indefinable. In consequence, one cannot estimate the cost of information in a number of daily operations carried out by a business organisation.

In most business activities, the value of information is very precious (on a subjective scale), but non-measurable. It cannot be expressed in any financial units. It cannot be converted into money from the investment perspective. On the other hand, one can calculate how much the company has to invest in developing and implementing an IT system, but nobody knows the worth of information provided by developed and used software.

This situation causes that traditional investment evaluation methods used for the analysis of IT projects are justified and can be applied only in exceptional cases (e.g. transaction systems). In practice, in most IT projects neither simple nor complex investment measures are calculated.

We could ask: what should investors in the IT sector take into account? What criteria should they regard as reliable to base their decisions on whether it is worthwhile investing in a given project or not?

The answer to the above question is of strategic importance for investors, since - according to the reports called The Chaos Chronicles, issued regularly by the Standish Group, an American institution concerned with monitoring of IT projects - ca. 2/3 IT projects are not completed with full success. During their performance (from a statistical point of view, in every other project) there are deviations from time and budget arrangements, non-performance of all planned programme functions or finally abandoning performance of the whole project [1].

4. Investment evaluation of transaction systems and the proposal of a new measure

The analysis of the planned IT projects performance is done by means of comparing the expected costs with planned benefits the achievement of which is expected as a result of the project performance.

The above reservations concerning justification of applying classical investment evaluation methods to analyse IT projects, do not regard all kinds of IT projects. Careful analysis of the history of IT projects allows identification of one exception. The exceptions are projects during the performance of which transaction software is developed. Projects of building this kind of systems

can be certainly analysed by means of traditional tools (simple or complex ones) used for investment evaluation. It regards both new projects and the modification of the already operational systems.

If a given transaction system is supposed to, among others, handle establishment of bank deposits, in a simple way one can calculate the cost of traditional activities, which are necessary to perform that task (the employee's working time plus costs of documents). When a new planned computer system allows performance of the same activities by means of websites, the previous costs will be removed from the bank's economic account. The number of transactions possible to be completed will increase (previously, e.g. necessary employee's working time constituted limitation to the number of bank deposits opened in the bank). As can be seen, for information systems which aim at eliminating simple jobs, it is possible to calculate the amount of savings (and profits in further analyses) that will be obtained as a result of implementing the planned system. Thus, it becomes justified to apply classical investment evaluation methods in projects of this kind. Unfortunately, transaction systems constitute a small group of information systems operating in business entities.

Other specialist methods should be used to analyse profitability of investments in other kinds of projects. B. Czarnecka-Chrobot presented an interesting proposal in [2]. She proposes to introduce a new measurement. The author assumes that the planned information system will have a specific usable value, and thus it will make it possible, through the performance of a specific set of functions, to satisfy real employees' needs. The usable value of the set of programme functions can be measured. There are methods enabling to express the size of an information system in the so-called functional points (ordinary or complete). The other parameter necessary to determine the proposed new measure of the evaluation of an IT investment is labour necessary to perform the planned system. The amount of labour can be also determined. In science and in practice there are a number of methods making it possible to calculate that value.

The author uses both parameters: system functionality and labour consumption to construct the measure of the so-called functional profitability, which enables an investment evaluation of the planned project. However, the proposed measure does not analyse an investment (an IT project) from the point of view of classical profitability; she does it from the perspective of the usable value of a set of functions corresponding to a unit of labour consumption. To generalise the author's proposals, functional profitability is calculated as the quotient of system functionality divided by the planned labour consumption. On the basis of predicted minimum and maximum amounts of the parameters being discussed, the author formulates conditions of investment acceptability of the project.

6. Conclusion

Investments in the IT sector have to be planned according to the company's business strategy. Investors want to have effective methods for estimating anticipated profits from IT projects. Presently, they do not have any reliable measures of return on investment. In IT companies, in most projects, successes and failures are evaluated based on operating or cost indicators. Only in less than twenty percent of projects effectiveness of the planned projects is analysed by means of return on investment measures or any other financial measures. In practice, due to the fact that information is non-measurable, most of investors prefer result indicators, such as time to completion, percentage of exceeding\decreasing of the planned budget.

In economics, new investment evaluation methods are searched for, which would make it possible to analyse IT projects in an effective way. One of the proposals of such measures is the method of functional profitability proposed by B. Czarnecka-Chrobot. When analysing world literature in the area of software engineering one can hope that such measures will be developed eventually soon, and that their application will increase significantly the percentage of IT projects completed within the planned budget, time and scope.

In the method proposed by Czarnecka-Chrobot the calculation of profitability of a planned IT project should be done three times. The first calculation is performed in order to estimate the rate of profitability. The second one is for precise evaluation of profitability. The last profitability calculation is done when the IT project is completed. Every calculation cycle consists of 15 stages, including evaluation of functionality of the planned system at the beginning, describing conditions which are obligatory for making the project profitable and finally categorization, in values 0 or 1, if the system is going to be profitable.

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Jacek Winiarski

Jacek.Winiarski@ug.gda.pl

Zakład Gospodarki Elektronicznej, Wydział Ekonomiczny Uniwersytet Gda
ski