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FAST  ROI Calculator for IT

Frequently Asked Questions -- General ROI Questions


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   

     

   

   

   

   

   

   

   

   

   

   

   

   

   

   

   

   

  

   

   

  

   

   

   

   

   

   

   

   

   

   

  

  

  

  

  

  

  

  

  

  

    

  

  

  

  

  

  

  

  

  

  

  

  

  

    

  

  

   

   

   

   

   

   

   

   

   

   

   

   

     

   

   

     

 

GENERAL ROI QUESTIONS

1.  What is ROI?
2.  Is there only one ROI measure?
3.  Are there any general Ďrules-of-thumb" for the metrics?
4.  What is a "discount rate"?
5.  How is discount rate used for decision-making?
6.  How long should the "analysis period" be for an IT project?
7.  What does a negative "net present value" indicate?
8.  Can you give me a simple explanation of "internal rate of return"?
9.  Canít I just set up a spreadsheet to do the calculations?

 

What Is ROI?

ROI (Return On Investment):  Vendors Promise It, Management Demands It, What Is It?

Definitions Abound -- You might find these definitions in a finance or economics textbook:

 A measure of a corporation's profitability, equal to a fiscal year's income divided by common stock and preferred stock equity plus long-term debt.

 A calculation of the return (earnings) as a percentage of the assets employed (investment).

These definitions may be accurate; but, they are not helpful to most people.


What Most Decision-Makers Really Want to Know

When people ask "Whatís the projectís ROI?" what they are really asking is:

 Is this project worth the money we will spend?

 Are the returns (benefits) greater than the costs?

In other words, they want to know the value of an investment before they decide to spend time and money.


Three Ways People Measure ITís Value

There are many ways to measure a projectís value. Three of the most common financial measures (or metrics) are:

 Payback Period (PP)

 Net Present Value (NPV)

 Internal Rate of Return (IRR)


Few non-financial professionals really understand what all of these terms mean. Here they are translated into plain-English:

 How quickly does this project pay for itself? (Payback Period)

 How much is this project worth in todayís money? (Net Present Value)

 If the financial benefits are restated as an interest rate, what would the rate be? (Internal Rate of Return)

Now that you know what ROI is, the challenge is to do the math. This is where FAST ROI saves you time and effort. Simply enter what you know (projectís cost and expected financial benefits) and the software automatically calculates Payback, NPV, and IRR for you.

 

Is There Only One ROI Measure?

No. Although the technology and finance journals discuss IT "ROI" as if there is a single number, the reality is that the term has different meanings in different settings. For instance, some organizations only consider financial "returns" while others believe that ITís benefits include both financial and non- financial returns.

The majority of organizations still consider financial returns as the paramount measure of ITís benefits. The most common indicators used are: Payback, NPV, and IRR (see "What is ROI" for plain-English definitions).

 

Are there any general Ďrules-of-thumb" for the metrics?

Yes there are:

 Internal Rate of Return (IRR) Ė If it is positive, consider the project for a "go" decision.

 Net Present Value (NPV) Ė If it is positive, consider the project for a "go" decision.

 Payback Period Ė If it is achieved within the analysis period, consider the project for a "go" decision. In general, the shorter the payback period, the better.

 

What is a "Discount Rate"?

Similar to ROI, discount rate can have several meanings. Weíll try to keep the answer simple. There are three common meanings of the term: 1. potential rate of return from alternative investments, 2. the rate an organization pays for borrowed money (the "cost of capital"), and 3. a "hurdle" rate that an IT project must clear before it will be considered before an organization will consider an investment.

 
  1. Alternative Investments. In theory, an organization can "invest" money in your project or it can invest money in something else. Sometimes, the "discount rate" represents the assumed rate of return on alternative investments.
  2. Cost of Capital. Many organizations borrow money to invest in capital projects. Sometimes, the discount rate used is the organizationís typical interest cost on the money it borrows.
  3. "Hurdle Rate".  IT projects can be risky investments (i.e., they may not deliver the expected benefits). Sometimes, organizations use the "discount rate" to establish a minimum rate of return or threshold that a project must meet before it will be considered favorably. For example, a high-risk projectís discount rate might be set at 30% while a low-risk projectís rate might be set at 5%. (Note: Some organizations use IRR as the "hurdle rate" and use the discount rate to reflect the cost of capital.)

 

 

How is the Discount Rate Used for Decision-Making?

It is the result of the discount rate on the Net Present Value calculation that affects decisions. For example, suppose that your project costs $20,000 and the annual financial benefit is $9,000 a year over 3 years. At a 5% "discount rate" your projectís NPV is $4,500 (see illustration below).

Suppose that instead of 5%, the discount rate is 20%; what is the NPV now? The answer is -$1,042.

(Note: The Payback Period and the IRR remain unchanged even though the NPV has moved into negative territory. Why? Because simple Payback Period and IRR are not affected by the "discount rate". This is the reason many organizations use at least two metrics in their evaluations.)

So, what does this tell us? Using NPV as the decision criterion: if the discount rate is 5% the project should be considered for a "go" decision; at a 20% rate, it would be a "no-go". The reason is that at 5%, the value of the projectís financial benefits is positive; at 20%, the value is negative.

 

How Long Should the "Analysis Period" Be for an IT Project?

Since projects donít produce returns until after the project is completed, the analysis period is a number of years post-implementation during which significant benefits will be received. (Note: Some organizationís definition of "analysis period" includes "project implementation."

Some organizations have standard analysis periods that you must use Ė these are often based upon a number of factors including the type of investment (e.g., hardware vs. software) or the "economic life" (the number of years that significant benefits are produced). If your organization has a standard, use it.

If there is no standard, here are a couple of questions to ask yourself; the answers will help you to choose an appropriate analysis period:

 After implementation, how long will the product last before significant changes need to be made? (E.g., Major program modifications or hardware upgrades.)

 How many years will the benefits of this project last? (E.g., If the IT solution will become obsolete in three years, then you should consider a 3-year analysis period.)

 Is there a "required payback period"? (E.g., If decision-makers want to see projects with a "fast ROI", you might decide to set your analysis period at one or two years.)

 

What Does a Negative "Net Present Value" Indicate?

A negative value indicates that the financial value of the project is less than its cost. (See the answer to "How is the discount rate used for decision-making?" for an example.)

 

Can You Give Me a Simple Explanation of "Internal Rate of Return"?

Think about a bank certificate of deposit (CD) or an interest bearing bond. Both the CD and the bond have an associated "interest rate". This interest rate gives you an idea of how hard the money you invest is working, e.g. a CD at 4% interest rate or a bond with a 5% "yield to maturity". IRR provides the same type of information for a project investment. You might prefer a project costing $100,000 with a 50% rate of return (IRR) over another project (also costing $100,000) with a 25% rate of return.

 

Canít I Just Set Up a Spreadsheet to do the Calculations?

Certainly you can. The real question to ask yourself is "Is it worth my time to create a spreadsheet?" If you are a financial whiz, you might only need a few hours or a day or two to do the setup. If you are not, you could spend months learning about the metrics, the formulas, tables, etc. and then hours or days for setup. The reason most professionals buy and use calculators is that it isnít worth their time Ė they have other work to do. Besides, if it were really so easy, why isnít everyone already doing it?

 

To learn more about FAST ROI Calculator for IT, Click Here

 

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Revised: January 16, 2003
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