Talking to a financial officer about the benefits of an IT project is a skill unto itself.

David Floyer - CTO, ITCentrix
Michelle Bailey - Director of Research, ITCentrix

Given the economic challenges of the last three years, IT executives are more than ever being called upon to deliver a sound business case for proposed IT projects. There are many considerations a savvy IT manager will weigh in order to highlight the merits of their projects - alignment with overall business goals of the company, the level of risk of the project, the impact of the project to the IT department, and the return on investment. Each of these translates into a business benefit.

Good managers can easily provide commentary on all these attributes; the challenge lies in quantifying these benefits in a common financial language. Most IT executives will admit that often, the projects that get funding are those headed by managers with the greatest political clout, or ability to impress. The lack of standardized metrics to provide a relative comparison of IT projects is conspicuous by its absence.

Creating a financial case for IT investments is one of the prickliest aspects of the project justification process for many IT managers. A recent survey by the Kellogg School of Management found that 80% of CIO's believe that the lack of financial skills of their staff makes quantifying IT benefits difficult. A better understanding of financial jargon on the part of the IT organization can improve communication with the finance department, and ultimately improve the success of obtaining funding.

Demystifying the complexities of a financial analysis

There are really only three things that are important in understanding a traditional IT financial business case:

Ultimately, the size of the project is what matters; however, financial investments must take into account a level of risk. Unless a project manager can answer "Yes" to the first two questions, it is pointless to determine value of the project, as the project will be perceived as too risky. The following pages provide the calculations required to perform the analysis of each financial component and demonstrate how to interpret the results of the math with examples.

Cash Flow Analysis: Meeting a Hurdle Rate

Hurdle Rate is a financial term that describes the bare minimum return required by a financial officer of an organization before an investment can be considered. An important determinant of hurdle rate for many organizations is the level of risk involved in the project. For a "normal" IT project, today's hurdle rates will normally run around 50%. "Risky" IT projects have an even higher hurdle rate, relying on the traditional investment maxim that the greater the risk of the investment, the greater return you should expect. A hurdle rate can be a low as 30%, maybe for something that has low risk, but below this, organization are usually better off banking their money. Projects that exceed a specified hurdle rate can be considered; those that do not exceed the hurdle rate are thrown out. There are two common metrics for determining if the returns from a project will meet a minimum hurdle rate threshold:

1) Internal Rate of Return (IRR); and
2) Return on Investment (ROI).

Internal Rate of Return

The IRR of a project is the interest rate received for an investment that involves cash being spent (costs) and cash received (income/benefits) at regular periods.

In considering any capital investment, a financial officer will always contemplate if taking the money allocated for the project and putting it in the bank could achieve a better rate of return. If the answer to this question is "Yes", good luck getting the project approved. A project manager will always want to ensure that the IRR of his project is a greater than the hurdle rate set by their organization as a threshold for capital spending.

The IRR is a cash flow view, meaning that the rate of return is determined based on how much money is coming in vs. how much is going out over a given period (rather than how much is made at the end of this project). Given that it is a cash flow view, the formula for IRR is somewhat complicated, so for the purposes of running the math, most people just use the IRR function in Excel rather than torturing themselves with high school algebra.

Taking a simple example, suppose a 5-year IT project is proposed that requires an initial investment of $1 million. For the sake of simplicity, we will exclude any mention of depreciation of assets and the resulting tax implications. The goal of the project is to increase user productivity to reduce headcount, centralize IT functions to lower management costs and bring in additional revenue to the company by launching a new product. Then imagine that the organization does not receive any benefit from the project until the 2nd year, to the order of $500,000. Then in years 3, 4 and 5 the company garners additional benefits of $600,000, $1.5 million and $2 million respectively.

The calculated IRR of this project is displayed in Table 1 and is 48%, meaning that if an organization was to take the initial $1 million and invest it with the local bank, they would need to get more than a 48% return annually on the money over the 5-year period from the bank to equal the returns from the IT project. Now, while this number seems high compared to what you would get at the bank, IT is far from the guarantee of a CD account, so therefore, hurdle rates for IT are usually set high at around 30-50% return.

In this example, an IRR of 48% is sufficiently high enough for an IT manager to continue to explore a more detailed financial analysis. If the IRR was calculated at say 20%, the likelihood of the project making the cut is unlikely, regardless of the size of the returns.

Return on Investment

ROI is a simpler alternative to IRR. There is no formal definition for ROI. In fact, there are many different variations for ROI, which makes it somewhat hazardous as different project managers use different measurements, yet call this metric the same thing. The generic formula for ROI is:

While IRR takes into account all money in and money out at regular intervals, ROI is a short cut that looks at the value of a capital investment into the final profit made on the project.

So for our previous example, ROI is
$3,600,000/$1,000,000/5

While ROI is also a cash view of money, it does not take into account the different returns over different years, but is a good short cut for a quick calculation. It is not great at assessing cases where there are significant ongoing investments for an IT project. This ROI of 72% is higher than the IRR, but is still sufficiently high enough to perform a deeper financial analysis.

Break Even - When do I get my money back?

After determining if the rate of return on the investment is sufficient, the next question an IT financial officer will ask is, "How long will I have to keep funding the project before I get my money back?"

This analysis is called break-even, or the point at which income from the project equals the money spent. The length of time that an organization is prepared to wait for a return on their investment depends on their financial strength. The stronger the organization (i.e. the more cash on hand), the longer they are able to wait, and maybe take on some of the higher risk, yet more profitable investments.

Presently, projects with a break-even above 18 months are unlikely to be funded. Some managers report that a break-even of 6-12 months is becoming a fact of life. Although capital is cheap, uncertainty is driving organizations to take on shorter projects. Five years is far too risky, organizations prefer to invest their money somewhere that is safer, even if it means lower returns. To mitigate this risk, the smart IT manager will break up a larger project into smaller components, each of which has its own measurable return.

Break-even is calculated by finding the equilibrium point at which the money coming in from the project is equal to the total investment. In the previous example, the break-even point occurs when the benefits from the project exceed the $1 million investments. This does not occur until month 10 of the third-year (assuming an even revenue stream in Year 3; see Table 3), making it an unlikely project for today's climate.

This table illustrates why larger IT projects are being postponed or pushed out as the break-even period is usually much longer than smaller-sized projects.

Net Present Value - How much money will I make on this investment?

Once an IT manager can understand if a proposed project meets the organizations threshold for rate of return and the break-even period, the final question is of course, "What will I get back for the risk I am taking with my investment?"

A tool that many IT managers use to compare the relative return of a list of projects is the Net Present Value (NPV). Net present value is the amount of money made on a project expressed in today's terms. If your NPV is higher than the total money invested in the project, then your project is profitable. NPV is calculated by taking the difference between the cost of an investment and the return on an investment, taking into consideration a discount rate on future benefits.

The discount rate takes into account the future value of money, or the level at which an organization can borrow money. For banks, this number is very low, around 1½%, for less solvent industries, it can be as high as 20%. For example, if you borrow $1000 at the beginning of the year and have to pay back $1110 at the end of the year, the cost of money for you is 11%.

Therefore, a project that costs $750,000 dollars upfront, and generates $200,000 dollars annually over 5 years does not generate a $250,000 profit if the time value of money is taken into consideration; this project is actually a loss. At an 11% discount rate each year, you could make $1 million over 5 years by taking about $740,000 to the bank and investing it. The project loses $10,000. Put another way, the current value of the cash generated from this project is worth about $740,000 today.

The formula for NPV is closely related to the formula for IRR. In fact, if the IRR of a project is used as the discount rate in a NPV analysis, the NPV will be zero, meaning that if future money is discounted at the same rate as the return on the project, no income is made on the project.

Using our original example, the Net Present Value of the project is about $3 million, meaning that the $4.6 million dollars made over the life of the project is worth about $3 million today. This is a large profit on the project ($2 million), but this number cannot be taken in isolation. Remember that the break-even on this project is almost 3 years.

Project Summary

The decision to move ahead on this project will be driven by the willingness of the organization to take on the risk of a lengthy project. While the rate of return is good, and certainly the magnitude of the profit is large, a lot can happen in 5 years from both an IT and business perspective. To stomach an almost 3-year break-even period on a project of this size would require a strong cash position. A better approach would be to break this project into several smaller projects that each have lower upfront costs, shorter pay back periods and their own profitable income.