Understanding net present value (NPV) can increase an
information technology managerıs chances of getting the OK from
corporate finance for IT expenditures.
Basically, NPV represents the relationship between a projectıs
expected cash flow and the cost of capital. ıIn simplest terms, cost
of capital is what you have to pay or give up for the money you need
for operating the business ı for buying new computers and other
assets,ı explains Susan Koski-Grafer, a vice president at the
Financial Executives Institute in Morristown, N.J.
Knowing how to calculate NPV and cost of capital can get you a
leg up over other internal departments vying for the same funding
dollars, says Alan J. Schneider, treasurer at Chicago-based Wm.
Wrigley Co.
Evaluating Investments
NPV and cost of capital can help assess potential external
investments, like stock purchases or corporate acquisitions. But
organizations are also using these equations to evaluate investments
in internal projects. Those projects can range from building a new
manufacturing plant to replacing an aging mainframe with a Web-based
system.
The cost of capital is generally measured as weighted average
cost of capital (WACC). WACC is the cost of debt, such as interest
on a loan, and the cost of equity investment, or rate of return. For
internal investments, though, cost of debt typically doesnıt come
into play.
One example of rate of return is the interest on a bank savings
account. If your bankıs annual interest rate is 4%, your rate of
return on the money youıve invested is also 4%.
In many organizations today, a project must meet a ıhurdle,ı or
minimum requirement for rate of return, before it can be considered
for internal funding. The hurdle is used to help calculate NPV. If
the project meets the organizationıs hurdle, NPV will be a positive
number. Conversely, if the project hasnıt met the hurdle, NPV will
be a negative number.
The higher the rate of return, the greater the chances the
project will obtain the stamp of approval.
Letıs say that an organizationıs hurdle is 12%, for example. If a
proposal submitted by IT yields a 16% rate of return, while a
competing departmentıs proposal brings a 14% rate of return, the IT
department will get the edge thanks to its higher NPV.
There are other factors to consider as well. IT projects deliver
intangible benefits that canıt be quantified using mathematical
equations like NPV, such as better information access, workflow and
customer satisfaction.
Intangible Benefits
Haim Mendelson, James Irvin Miller Professor of Information
Systems at Stanford University in Stanford, Calif., recommends
talking about intangible benefits as well as quantifiable NPV
results in proposals to the finance department. ıSome of the most
convincing arguments are that the project will bring strategic
benefits or a business restructuring,ı he says.
Organizations vary, too, in terms of who calculates NPV and cost
of capital. At Bentley College in Waltham, Mass., for instance, the
finance department does that job. ıBut I certainly get a lot of
input from my IT people,ı says Joanne Yestramski, the college's vice
president of business and finance. Bentley has used these
calculations to make computer lease-or-buy decisions, as well as to
predict return on investment from network upgrades to a new, $20
million building called the Smith Technology Center thatıs slated to
open in the fall of 2000.
IT and Finance
Even at organizations in which the finance department does all
the math, itıs important for IT managers to comprehend NPV and cost
of capital.
ıThereıs going to be a discussion anyway, and you will have to
justify the project. IT managers are in a much better position if
they know a project has already passed the hurdle based on its
quantifiable benefits,ı Mendelson says.
ıPartnering between IT and finance is critical,ı according to Ron
Brezinski, principal at Wilmette, Ill.-based Transformation
Associates. ıFinance can help IT to either look good or look bad. By
speaking the same language as finance, IT managers show that theyıre
playing on the same team, instead of sitting on the sidelines as
outsiders.
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