Information Technology Reference
In-Depth Information
14.1.1.1 Payback Method
The payback method calculates the number of years it will take before the ini-
tial investment of the project is paid back. The shorter the payback time, the
more attractive a project is as it reduces the risk of longer-term payouts. The
method is quite popular due to its simplicity; the weakness of the method is
it ignores the time value of money:
Original investment
Annual net
Number of years to pay back
=
cash flow
Although a popular investment appraisal method, payback period only
qualifies as a first screening technique to initially appraise a project. Its scope
is limited to the period the investment is recovered; hence, it ignores poten-
tial benefits as a result of investment gains or shortfalls thereafter.
14.1.1.2 Accounting Rate of Return on Investment (ROI)
This method calculates the return on investment (ROI) by calculating the
resulting cash inflows (produced by the investment) for depreciation. The
investment inflows are totaled and the investment costs are subtracted to
derive the profit. The profit is divided by the number of years invested, then
by the investment cost, to estimate the annual rate of return.
An ROI analysis calculates the difference between the stream of benefits
and the stream of costs over the lifetime of the system discounted by the
applicable interest rate. In order to find the ROI, the average net benefit has
to be calculated:
Total benefits
-
total costsdepreciation
Useful
−
Net benefits
=
life
leading to
Net benefits
Initial investment
ROI
=
14.1.1.3 Net Present Value (NPV)
The Net Present Value (NPV) approach calculates the amount of money that
an investment is worth, taking into account its costs, earnings, and time
value of money (inflation). Thus, it compares the economic value of a proj-
ect today with the value of the same project in future, taking inflation and
returns into account. If NPV of a prospective project is positive, it should
be accepted. If the NPV is negative, the project should probably be rejected
because the resulting cash flows will also be negative.
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