Business Analysts: How to make investment decisions beyond your best guess?
Whenever we are trying to make a significant investment, we must be careful because if the investment turns out to be wrong, it affects us as an individual, and it would affect our organization as well. So, is there a technique that we can learn and apply to ensure that the investment we are making is the correct type of investment?
Financial Analysis
Financial analysis techniques explore the financial aspects (benefits and costs) of an investment. One should consider initial cost within a time frame of investments, expected financial benefits within a time frame, ongoing usage, support costs, and risk factor. When making a comparison between potential investments, one must use the same period for both investments.
Cost of Investment
It is the expected cost of building or acquiring the solution.
Cost of change
Cost of investment+ costs of transitioning (includes training cost).
Total cost of ownership (TCO)
Cost of change + (Usage cost + Support cost) for a given period.
Opportunity cost
Value of next best alternative which is not pursued.
Sunk cost
An investment that can’t be recovered.
Total benefit
Sum total of all benefits for a given period. This may be additional revenue or a reduction in cost.
Net benefit
Expected total benefits – Expected total costs.
Return on investment (RoI)
Return on Investment = (Total Benefits – Total Costs) *100 / Cost of
Investment)
Payback period
The time period needed to generate enough benefits to recover the cost of change.
Discount rate (r)
r = Interest rate (~3-4%) + Risk premium (~5 to 10%).
Free cash flow (C1, C2, C3…)
Net cash flow after all costs is taken care of.
Present value (PV)
Present value = Sum of (Net Benefits in that period / (1 + Discount Rate for that period)) for all periods in cost-benefit analysis. Present value does not consider the cost of the original investment.
PV = C1/ (1+r) + C2/(1+r) 2 + C3/(1+r) 3 + C4/(1+r)4 +….
Net present value (NPV)
Net Present Value = Present Value – Cost of Investment
Internal rate of return (IRR)
Discount rate at which NPV becomes 0.
IRR MUST be greater than the cost of funds for an investment to be viable.
Strengths
· Objective (quantitative) comparison of investments.
· Assumptions and estimates are clearly stated.
· Reduces uncertainty by identifying and analyzing influencing factors.
Limitations
· Costs and benefits are difficult to quantify.
Example
Let us learn financial analysis by means of an example. Governance, Risk, and Compliance (GRC) management system are developed for the IT and ITES domain. The primary objective of the GRC management system is to help companies implement Governance, Quality, and Information Security Management Systems in an integrated manner. It has various features, one of which is to plan and track projects and programs using standards such as CMMI, ISO 9001, ISO 27001, etc.
Let us try to understand the NPV calculation for a company called ABCT with the Governance, Risk, and Compliance (GRC) management system in place through this example.
ABC Technologies (NASDAQ: ABCT) is a US-based technology service and solutions organization. Currently, ABCT runs more than 120 active projects at any point in time. Due to the lack of an integrated project governance system, management finds it hard to understand how each project is performing. The management thus has to do a lot of firefighting to bring the projects back on track. There is also a perception in the company that many projects are incorrectly estimated, leading to a loss of revenue.
ABCT top management has envisioned developing an integrated project governance system which will cost USD 500K in the first year and USD 75K per year for maintenance.
It is expected to save 10% of project management effort. Currently, it has 50 project managers, which are expected to grow in a linear manner to 200 in the next 6 years. The approximate project manager’s per hour cost is USD 25. Therefore, per-hour project management cost is likely to increase 12% year on year. ABCT assumes 1500 productive hours per year for a Project Manager.
ABCT management expects 20% annual return on any investment.
| Year –> | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Remarks |
| Costs | 500 | 75 | 84 | 94 | 105 | 118 | 132 | Initial cost = 500K. Maintenance cost = 75K/Year |
| No. of PMS | 50 | 75 | 100 | 125 | 150 | 175 | 200 | Linear growth in 6 years |
| Per Hour PM Rate | 25 | 28 | 31 | 35 | 39 | 44 | 49 | Increases by 12% year on year |
| PM Hours saved per PM | 150 | 150 | 150 | 150 | 150 | 150 | 10% of 1500 (productive hours/year) | |
| PM Effort Saved | 0 | 315 | 470 | 659 | 885 | 1157 | 1480 | # of PM*Per hour PM rate*Hours saved/PM |
| Net savings | -500 | 240 | 386 | 564 | 780 | 1039 | 1348 | Effort saved-Costs |
| Discounting rate | 1.00 | 1.20 | 1.44 | 1.73 | 2.07 | 2.49 | 2.99 | (1+r)^n where r is the discount rate and n is the number of years |
| Discounted cashflow | -500 | 200 | 268 | 327 | 376 | 417 | 452 | PV=FV/(1+r)^n where PV is present value and FV is future value |
| Estimated NPV | 1540 | NPV = – CF0 + CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+r)^3 where CF is the cashflow |
The NPV for this project is 1540K. Thus, financial analysis is the assessment of the expected financial viability, stability, and benefit realization of an investment option. It allows decision-makers to objectively assess various options and come up with the best. However, there can be some uncertainty about the expected costs and benefits.
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