Even if a system project supports a firm’s strategic goals and meets user information requirements, it needs to be a good investment for the firm. The
value of systems from a financial perspective essentially revolves around the issue of return on invested capital. Does a particular information system investment produce sufficient returns to justify its costs?
INFORMATION SYSTEM COSTS AND BENEFITS
Table 14.3 lists some of the more common costs and benefits of systems. Tangible benefits can be quantified and assigned a monetary value. Intangible benefits, such as more efficient customer service or enhanced decision making, cannot be immediately quantified but may lead to quantifiable gains in the long run. Transaction and clerical systems that displace labor and save space always produce more measurable, tangible benefits than management information systems, decision-support systems, and computer- supported collaborative work systems
INFORMATION SYSTEM COSTS AND BENEFITS
Table 14.3 lists some of the more common costs and benefits of systems. Tangible benefits can be quantified and assigned a monetary value. Intangible benefits, such as more efficient customer service or enhanced decision making, cannot be immediately quantified but may lead to quantifiable gains in the long run. Transaction and clerical systems that displace labor and save space always produce more measurable, tangible benefits than management information systems, decision-support systems, and computer- supported collaborative work systems
Capital Budgeting for Information Systems
To determine the benefits of a particular project, you’ll need to calculate all of its costs and all of its benefits. Obviously, a project where costs exceed benefits should be rejected. But even if the benefits outweigh the costs, additional financial analysis is required to determine whether the project represents a good return on the firm’s invested capital. Capital budgeting models are one of several techniques used to measure the value of investing in long-term capital investment projects.
Capital budgeting methods rely on measures of cash flows into and out of the firm; capital projects generate those cash flows. The investment cost for information systems projects is an immediate cash outflow caused by expenditures for hardware, software, and labor. In subsequent years, the investment may cause additional cash outflows that will be balanced by cash inflows resulting from the investment. Cash inflows take the form of increased sales of more products (for reasons such as new products, higher quality, or increasing market share) or reduced costs in production and operations. The difference between cash outflows and cash inflows is used for calculating the financial worth of an investment. Once the cash flows have been established, several alternative methods are available for comparing different projects and deciding about the investment. The principal capital budgeting models for evaluating IT projects are: the payback method, the accounting rate of return on investment (ROI), net present value, and the internal rate of return (IRR).
REAL OPTIONS PRICING MODELS
Some information systems projects are highly uncertain, especially investments in IT infrastructure. Their future revenue streams are unclear and their up-front costs are high. Suppose, for instance, that a firm is considering a $20 million investment to upgrade its IT infrastructure its hardware, software, data management tools, and networking technology. If this upgraded infrastructure were available, the organization would have the technology capabilities to respond more easily to future problems and opportunities. Although the costs of this investment can be calculated, not all of the benefits of making this investment can be established in advance. But if the firm waits a few years until the revenue potential becomes more obvious, it might be too late to make the infrastructure investment. In such cases, managers might benefit from using real options pricing models to evaluate information technology investments.
Real options pricing models (ROPMs) use the concept of options valuation borrowed from the financial industry. An option is essentially the right, but not the obligation, to act at some future date. A typical call option, for instance, is a financial option in which a person buys the right (but not the obligation) to purchase an underlying asset (usually a stock) at a fixed price (strike price) on or before a given date.
For instance, let’s assume that on April 25, 2012, you could purchase a call option for $17.09 that would give you the right to buy a share of Procter & Gamble (P&G) common stock for $50 per share on a certain date. Options expire over time, and this call option has an expiration date of January 17, 2014. If the price of P&G common stock does not rise above $50 per share by the stock market close on January 17, 2014, you would not exercise the option, and the value of the option would fall to zero on the strike date. If, however, the price of P&G stock rose to, say, $100 per share, you could purchase the stock for the strike price of $50 and retain the profit of $50 per share minus the cost on the option. (Because the option is sold as a 100-share contract, the cost of the contract would be 100 × $17.09 before commissions, or $1,709, and you would be purchasing and obtaining a profit from 100 shares of Procter & Gamble.) The stock option enables the owner to benefit from the upside potential of an opportunity while limiting the downside risk.
ROPMs value information systems projects similar to stock options, where an initial expenditure on technology creates the right, but not the obligation, to obtain the benefits associated with further development and deployment of the technology as long as management has the freedom to cancel, defer, restart, or expand the project. ROPMs give managers the flexibility to stage their IT investment or test the waters with small pilot projects or prototypes to gain more knowledge about the risks of a project before investing in the entire implementation. The disadvantages of this model are primarily in estimating all the key variables affecting option value, including anticipated cash flows from the underlying asset and changes in the cost of implementation. Models for determining option value of information technology platforms are being developed.
LIMITATIONS OF FINANCIAL MODELS
The traditional focus on the financial and technical aspects of an information system tends to overlook the social and organizational dimensions of information systems that may affect the true costs and benefits of the investment. Many companies’ information systems investment decisions do not adequately consider costs from organizational disruptions created by a new system, such as the cost to train end users, the impact that users’ learning curves for a new system have on productivity, or the time managers need to spend overseeing new system-related changes. Benefits, such as more timely decisions from anew system or enhanced employee learning and expertise, may also be overlookedin a traditional financial analysis
To determine the benefits of a particular project, you’ll need to calculate all of its costs and all of its benefits. Obviously, a project where costs exceed benefits should be rejected. But even if the benefits outweigh the costs, additional financial analysis is required to determine whether the project represents a good return on the firm’s invested capital. Capital budgeting models are one of several techniques used to measure the value of investing in long-term capital investment projects.
Capital budgeting methods rely on measures of cash flows into and out of the firm; capital projects generate those cash flows. The investment cost for information systems projects is an immediate cash outflow caused by expenditures for hardware, software, and labor. In subsequent years, the investment may cause additional cash outflows that will be balanced by cash inflows resulting from the investment. Cash inflows take the form of increased sales of more products (for reasons such as new products, higher quality, or increasing market share) or reduced costs in production and operations. The difference between cash outflows and cash inflows is used for calculating the financial worth of an investment. Once the cash flows have been established, several alternative methods are available for comparing different projects and deciding about the investment. The principal capital budgeting models for evaluating IT projects are: the payback method, the accounting rate of return on investment (ROI), net present value, and the internal rate of return (IRR).
REAL OPTIONS PRICING MODELS
Some information systems projects are highly uncertain, especially investments in IT infrastructure. Their future revenue streams are unclear and their up-front costs are high. Suppose, for instance, that a firm is considering a $20 million investment to upgrade its IT infrastructure its hardware, software, data management tools, and networking technology. If this upgraded infrastructure were available, the organization would have the technology capabilities to respond more easily to future problems and opportunities. Although the costs of this investment can be calculated, not all of the benefits of making this investment can be established in advance. But if the firm waits a few years until the revenue potential becomes more obvious, it might be too late to make the infrastructure investment. In such cases, managers might benefit from using real options pricing models to evaluate information technology investments.
Real options pricing models (ROPMs) use the concept of options valuation borrowed from the financial industry. An option is essentially the right, but not the obligation, to act at some future date. A typical call option, for instance, is a financial option in which a person buys the right (but not the obligation) to purchase an underlying asset (usually a stock) at a fixed price (strike price) on or before a given date.
For instance, let’s assume that on April 25, 2012, you could purchase a call option for $17.09 that would give you the right to buy a share of Procter & Gamble (P&G) common stock for $50 per share on a certain date. Options expire over time, and this call option has an expiration date of January 17, 2014. If the price of P&G common stock does not rise above $50 per share by the stock market close on January 17, 2014, you would not exercise the option, and the value of the option would fall to zero on the strike date. If, however, the price of P&G stock rose to, say, $100 per share, you could purchase the stock for the strike price of $50 and retain the profit of $50 per share minus the cost on the option. (Because the option is sold as a 100-share contract, the cost of the contract would be 100 × $17.09 before commissions, or $1,709, and you would be purchasing and obtaining a profit from 100 shares of Procter & Gamble.) The stock option enables the owner to benefit from the upside potential of an opportunity while limiting the downside risk.
ROPMs value information systems projects similar to stock options, where an initial expenditure on technology creates the right, but not the obligation, to obtain the benefits associated with further development and deployment of the technology as long as management has the freedom to cancel, defer, restart, or expand the project. ROPMs give managers the flexibility to stage their IT investment or test the waters with small pilot projects or prototypes to gain more knowledge about the risks of a project before investing in the entire implementation. The disadvantages of this model are primarily in estimating all the key variables affecting option value, including anticipated cash flows from the underlying asset and changes in the cost of implementation. Models for determining option value of information technology platforms are being developed.
LIMITATIONS OF FINANCIAL MODELS
The traditional focus on the financial and technical aspects of an information system tends to overlook the social and organizational dimensions of information systems that may affect the true costs and benefits of the investment. Many companies’ information systems investment decisions do not adequately consider costs from organizational disruptions created by a new system, such as the cost to train end users, the impact that users’ learning curves for a new system have on productivity, or the time managers need to spend overseeing new system-related changes. Benefits, such as more timely decisions from anew system or enhanced employee learning and expertise, may also be overlookedin a traditional financial analysis
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