Continuing with our discussion about financial issues in technology, now we will see a practical approach for technology projects valuation.
Finance people normally think of three valuation techniques:
1. NPV (Net present value)
2. IRR (Internal rate of return)
3. Real Options
1. NPV
For this NPV calculation, you should take into account the costs relating to investment associated with the project as the cash flows received of income.
Remember, longer time --> decreases the value of money
Thus, the value of cash flows today won’t be the same value in the future.
Flows related to income are usually estimated over several years, which mean they must be discounted and converted to their present value using a discount rate appropriate to the project risk.
Co =
total initial investment
r = free risk discount rate
t=number
of periods
The problem with this technique is that it does not measure the
scenarios that may occur during the same time the project is active.
If you don’t
know which discount rate should be used in the formula, just consider the WACC
rate of your company to reflect the opportunity cost.
2. IRR (Internal rate of return)
Is the interest rate at which the NPV of all the benefits and cost cash flows from a project or investment equal zero.
So, you need to compare r, with other investment IRR that the company
makes with the same duration. Notice that the IRR does not measure the absolute
size of the investment or the return. This means that IRR can be applied to investments
with high rates of return, even if the nominal amount of the return is very small.
Be aware that the IRR does not
consider cost of capital and cannot
be used to compare projects with different durations.
If you find a 5% IIR in your IT
project but you have other with 9% considering same duration, just choose the second
choice.
3. Real Options
A real option is a right, but not an
obligation, to make an action (defer, expand, leave ...) on a real underlying
asset (draft investment ...) at a specific cost.
In contrast with the traditional NPV method,
this approach recognizes the ability of managers to delay, suspend or abandon a
project once it has started. An investment is modeled with the equivalent of a
stock call option in which the project manager has the right, but not the
obligation, of buying something of value at a future date.
The concept of real options is based upon the
fact that management does have the flexibility to alter decisions as further
information becomes available. If future conditions are favorable, a project
may be expanded to take advantage of these conditions. On the other hand, if
the future is unfavorable, a project may be curtailed or even canceled as the
conditions suggest and warrant. A traditional NPV analysis does not take these
factors into account.
Most research related to the valuation of
information technology (IT) investment projects are real options, however, has
been limited to the application of the Black-Scholes (BS) formula. Other applications
use an options-tree approach based on the binomial model. From my experience,
the best choice.
In an IT development project, assets are not
acquired instantaneously; rather, it is the result of a development project
having an uncertain duration time in which the firm keeps investing at a rate
that is less than or equal to a maximum investment rate. Only until the project
is completed and the remaining cost (K) is zero, the firm will receive the
underlying asset (V).
Developing a model for the generic IT
investment project is not trivial because the time in which Cash flows start to
be received is also a random variable. However, if we assume a deterministic time
to start receiving the cash flows, we can easily adapt the acquisition model
for this purpose.
Real
options NPV = traditional NPV + real option value
A common strategy to mitigate risk in IT projects
is to divide the project into smaller phases. Each phase is committed sequentially
with a stage gate at the end of the phase.
This framework gives management the opportunity
to review the project at the end of each phase, if finished phases are not generating
business value, management may decide not to continue.
Expanding the analysis, read this paragraph from
Mark Jeffery:
“Each phase therefore incorporates real option
value, at the end of each phase management is actively deciding whether to
continue the project, and working to leverage learning to improve results in
later phases. These phases each have real option value, since at the end of a
consolidation phase management has the option to fund the next phase.
An important management question is: ‘What is
the optimal phase-wise deployment strategy that balances risk and return?’ We
will use a real options approach to answer this question, and show that the
answer depends upon the risk, or volatility, of the project and the traditional
NPV of each phase.” Mark Jeffery.
I will mention an example: the implementation of any kind
of information system requires one year and comprises four stages: initial preparation,
construction, test and go live and will be finished
in 1 year, so in 1 year we will know if the project will be successful or not.
According to the explanation in this article, we can have
3 ways to calculate the project value considering a real option to continue,
cancel or wait to star the project.
Note: If you choose the formula
of Black-Scholes, remember is a normal distribution assumption.
Soo, let’s start with numeric example:
Real
options NPV = traditional NPV + real option value
Real options Project = NPV project + NPV Start 1 year option value, for
example here we are considering 2 possible results, successful or not successful
project.
The initial investment of the project is 40.000
VEF and the benefits to be in 1 year 150.000 VEF, remember both variables
changes stochastically over time as we saw in the stages.
If project is successfully implemented, The NPV
of project in 1 year will be 150.000 VEF, if project is not successfully
implemented the NPV in 1 year will be 30.000 considering 10% free risk interest
rate.
The company wants to know the project value
considering a cost of opportunity of 20% of return based on the best second
opportunity to invest.
Then, we
choose the cost of opportunity as our best discount rate to calculate NPV.
Conclusion: in this example is not good
decision to implement the IT solution due to negative NPV considering two options. We can consider any options as we could
analyze, but depends on what requirements, assumptions and probabilities to
consider in each occurrence. In this case, I recommend making a complementary analysis
with Monte Carlo Simulation.
Next, what happen when we like to cancel an ongoing
project?? See you next..!
Daniel juvinao
Daniel juvinao
