Information Technology Reference
In-Depth Information
Table 1. Comparison between financial metrics
Metrics
Advantages
Disadvantages
Net Present Value (NPV) (McCready, 2005;
Harvard Business School, 2002; Gama, 2006;
Dos Santos, 1991; Silvius, 2006)
- Does not give any indication about the
project's magnitude and risk.
- Discount rate can be hard to calculate.
- Takes under consideration the discount
rate.
- Does not give any indication about the
project's magnitude.
- Requires vendors to share “sensible”
information.
- Can only compare project with the same
level of risk.
- Does not recognize when the cash flows
take place.
- Perfect for one-to-one project comparison.
- Commonly used.
- Takes under consideration the cost of
capital.
Return On Investment (ROI) (McCready,
2005; Harvard Business School, 2002; Sil-
vius, 2006)
- Not easy to compute and understand.
- Does not give any indication about the
project's magnitude.
- Assumes that the cash inflow from an
investment is reinvested at the same dis-
count rate.
- Hurdle rate varies from company to
company.
- Identifies investments with irregular
profits.
- Takes under consideration the discount
rate.
Internal Rate of Return (IRR) (McCready,
2005; Harvard Business School, 2002)
- Does not take under consideration the
discount rate.
- Does not give any indication about the
project's magnitude.
- No information about the investment
performance after the 'break even' point.
- Does not identify when the cash flows
take place.
- Expresses the time it takes for an invest-
ment to reach the 'break even' point.
- Separates, in terms of risk, long-term from
short-term investments.
PayBack Period (PBP) (McCready, 2005;
Harvard Business School, 2002; Gama, 2006;
Silvius, 2006)
- CIOs analyze investment with share-
holder's lens.
- Easy to understand.
- Simple methodology.
- Calculation includes cost of capital
charges.
- Cannot be used by organizations that are
not publicly traded.
- EVA is uncertain.
- Cost of capital varies from organization to
organization.
Economic Value Added (EVA) (McCready,
2005; Harvard Business School, 2002; Sy-
mons, 2005)
Risk Analyses
normal distribution shape with a 95% confidence
interval, which means that the probability that a
value falls within 2σ (standard deviation) of the
mean is 95%, so as to generate several scenarios
through a random distribution of values, which
belong to the area defined by the normal distribu-
tion curve (Hubbard, 2007; Ross, 2004).
Furthermore, several variables can be included
in the Monte Carlo simulation and correlated
with each others. For example, if the correlation
between two variables is null then the coefficient
is zero, but if there is a perfect level of correlation
between two variables then the coefficient is one.
If the level of correlation between two variables is
high, independently of being a positive or nega-
In terms of sensitivity analysis, the gross sensitivity
analysis reveals how sensitive the estimated ROI
is to given changes in the considered variable.
In addition, stress testing consists of making
an analysis of the extremes by calculating the
worst/best case scenarios, and the baseline ROI
is calculated by using expected values for all the
variables used. Then, the ROI is recalculated by
using, respectively, the smallest and the largest
value for each of the variables (Stæhr, 2006;
Ross, 2004).
The Monte Carlo simulation calculates the
chances of success of the investment by using a
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