Software Economics. Metrics of Business Case Analysis Part 1

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1 Software Economics Metrics of Business Case Analysis Part 1

2 Today Last Session we covered FV, PV and NPV We started with setting up the financials of a Business Case We talked about measurements to compare investment options and talked about NPV, now we continue with Baseline (alternative) versus Upside Scenario Payback Period ROI (Return on Investment) IRR (Internal Rate of Return) 2

3 There is always an alternative Opportunity Cost When deciding to invest or not, you always have an alternative to compare with. If no other investment alternatives, the alternative is to do nothing, no-action, not to invest. Investing should be compared to at least the alternative of not doing anything (which we did in the Selver case). 3

4 Baseline versus Upside Scenario You always have at least two scenarios to invest or not to. If you continue business as usual (not to invest), that is your baseline scenario. If you invest, hopefully you will get a better scenario, the upside (sunshine) scenario. We are interested in the added value of investing, i.e. what we get more if we invest as compared to not investing (increment). 4

5 Do I have to do baseline? Not really BUT sometimes it is much easier to get the numbers correct when setting up a baseline scenario. 5

6 Sangar Case Study ü Download Sangar Case study text from the course wikipage. ü Read it. ü Lets set up the baseline scenario (the business as it is if we do not do anything) together. 6

7 Step by Step 1. Read the text so you get the whole view and what is asked understand what is the investment project, why it is being considered and so on. 2. Gather the data and cluster them according to Data (numbers) concerning the investment in general Data (numbers) concerning the benefits / gains /profit expected from the investment Data (numbers) concerning the costs of the investment 7

8 Step by Step.. ü Set up the structure of your calculations Set up all the numbers with explanations Begin with the years (including year 0) Year 0 or Upfront is the costs you will have today and is therefore not discounted. For simplicity we assume that its all costs until 31 st of December regardless of when it is, as long as it is in this year. 8

9 Sangar Baseline Scenario 9

10 Sangar Upside Scenario ü The baseline scenario is not set. ü Lets set up the upside scenario. ü Exactly the same way BUT with the benefits/gains from the investment. ü Don t forget to get the when the investment will start giving benefits. 10

11 Sangar Upside Scenario 11

12 Step by Step (costs) ü Then we move on to the costs (the money we have to spend to make the investment). We have two types of costs. Costs that are one-time investments Costs that are occurring with some regularity to maintain the investment 12

13 Sangar Investment Costs 13

14 What is the benefit? By doing the investment, how much more profit / benefit will we gain? 14

15 Sangar Investment NPV? 15

16 Payback Period Payback period tells you how long it takes for the investments net cash flows to be positive (recover the initial investment). length of time required to get back the cost of an investment Usually expressed in years and months. Calculate the payback time of the following cash flows: 16

17 Calculating the Payback Period Net CF of Year 0 (-5000) + Net CF of Year 1 (1000) Before the end of year 3, we cover the investment. We need to cover 1000 and we will get 3400 during year 3 so =1000/3400 = 0,29 *12 = 3.5 months. Payback Period is therefore 2 years and 3.5 months 17

18 Sangar Payback Period 18

19 Discounted Payback Period 19

20 Return on Investment Return on Investment Simple ROI (Gain from investment Cost of investment) Cost of Investment Or ROI = Net profit / Cost of investment Simple and flexible tool to measure profit in relation to cost. 20

21 An example Initial Year 1 Year 2 Year 3 Sum Total Total Costs 10,000 2,500 2,500 2,500 17,500 Total Benefits 0 20,000 20,000 20,000 60,000 Net Benefits -10,000 17,500 17,500 17,500 42,500 ROI 243% 42,500 / 17,500 21

22 Example 22

23 Calculating ROI For calculating ROI, we need ü Inflow (to determine gain) ü Outflow (to determine cost) ü Time horizon (to determine when) 23

24 Weakness of ROI ROI is easy to use, but also flexible (and easily manipulated). When given a ROI, look at the numbers behind the ROI ROI does not consider risk and uncertainty of the investment ROI is not good for comparing investments with different time horizons Usually, ROI does not consider the time value of money 24

25 Time (risk) Adjusted ROI Simple ROI does not consider time value of money. Profits in the future has same value as today Simple ROI better for short term investments Risk Adjusted ROI considers the time value of money Risk Adjusted ROI = NPV of Total Gains NPV of Total Costs NPV of Total Costs 25

26 Calculating ROI ROI is basically a cost-benefit analysis Looks at positive (benefits) and negative (costs) cash flows. Calculating the ROI in a Business Case 1. Put the Baseline Scenario down 2. Put the Investment (Upside) Scenario down 3. Divide the net gains (total gain costs) of the investment with the costs of the investment 26

27 Example Selver Business Case Exercise: Open the Selver Case we did last week and calculate the ROI in groups of

28 What is the ROI? ROI = Total benefit total costs / total costs ROI = ( ) / ) ROI = 56 % 28

29 Interpreting ROI Scenario Interpretation Impact on Decision ROI > 0 The investment will add value (positive return). If its inline with strategy, choose the one with highest ROI (regard how large the ROI is) ROI = 0 ROI < 0 The investment neither adds nor decreases value. The Investment decreases the value (negative return) Use other criteria to decide. Do not invest unless other benefits (intangible) justify the investment. 29

30 When considering ROI ROI states only relative gains, not absolute gains. Be aware of the assumptions behind the ROI number. Don t use only ROI, combine it with other measures for a better understanding and better decision. 30

31 Quick Summary How much profit will my investment give? When do I get benefit from my investment? Net Present Value (NPV) Payback Period Return on Investment (ROI) Discounted Payback Risk Adjusted ROI 31

32 What is lacking? 32

33 Discount Rate Expected Return (Discount Rate) = Risk-free rate + Risk Premium [not used often for discount rate but good to know] Expected Rate of Return Risk Premium Risk-free rate of Return 33

34 Discount Rate - WACC WACC Weighted Cost of Capital the rate that a company is expected to pay on average to all its security holders to finance its assets 34

35 WACC Formula 35

36 The Balance Sheet 36

37 WACC and Rate of Return 12% 10% 8% 6% 2% 2% 4% 2% 8% 6% 8% 0% WACC Project A Project B Rate of Return Net 37

38 Discount Rate Discount Rate / Rate of Return must be higher than the WACC. If not, the project will deliver value that is LESS than what it costs to fund it, in other words, it will not increase the value of the company. 38

39 Recap of NPV Calculate NPV for the following cash flows: with discount rate of 0, 5, 10, 15 and 20 %. Then make a simple graph where you have the discount rate on the x-axis and the NPV on the y-axis. 39

40 Recap of NPV What does these numbers and the graph tell you about the profitability of the investment? At what rate is our does this investment have zero value for the investor? 40

41 41

42 Internal Rate of Return IRR gives you the rate at which your investment NPV is 0. It gives you the discount rate at which your investment will have a NPV of zero, i.e. your investment does not add value. Therefore it is a measure of the risk sensitivity of your investment. The higher IRR is, the more things can go wrong before your NPV becomes 0. 42

43 Objective measurement Some say IRR is an objective measurement as compared to NPV. Why? Answer: The discount rate is not chosen. 43

44 Calculating IRR 1. Calculate the NPV and then change the discount rate until the NPV gets to zero 2. Use the IRR function of Excel Open the Sangar Case and calculate the IRR. What do you get? What does it mean? 44

45 Quick Summary How much profit will my investment give? What is the Risk of my Investment? When do I get benefit from my investment? Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period Return on Investment (ROI) Modified Internal Rate of Return (MIRR) Discounted Payback Risk Adjusted ROI 45

46 46

47 Practice Business Case 1. Read the Spotify case 2. List the assumptions 3. Do the baseline 4. Do the upside 5. Calculate NPV, ROI, IRR and Payback Period 6. Interpret the results 47

Software Economics. Introduction to Business Case Analysis. Session 2

Software Economics. Introduction to Business Case Analysis. Session 2 Software Economics Introduction to Business Case Analysis Session 2 Today Last Session we covered FV, PV and NPV We started with setting up the financials of a Business Case We talked about measurements