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DEFINITION: An investment's payback period in years is

equal to the net investment amount divided by the ave-

rage a nnu al cash flow from t he investmen t.

WHAT IT MEANS: How long will it take to g et m y money

back?

STRENGTHS: It 's easy to compute, easy to understand

and provides some indication of risk by separating long-

term projects from short-term projects.

WEAKNESSES: It doesn't measure profitability, doesn'taccount for the time value of money and ignores finan-

cial performance afte r the b reak-even p eriod.

CALCULATING IT: The most widely used measure for

evaluating pote ntial investmen ts. Consider t he two exam-

ples of Rs 1-crore pro jects shown in the chart. A ban k can

spend Rs 1 crore on server consolidation and save one-

third that a mou nt in each of the following three years on

reduced licence fees, telecommunications costs and

systems administration labour. Or it could spend the same

amount to install ATMs, eliminate four teller positions

an d save Rs 25 lakh pe r year inde finite ly.

Which is a b ett er investme nt ? Payback ana lysis clearly

favours server con solidation , which recoup s its investme nta year earlier than the ATM project. But the ATM project

goes on to produce returns after three years and is

therefore a better long-term investment. In fact, the

server pro ject isn't even profita ble; it just breaks even.

PAYBACK PERIOD11 PAYBACK PERIOD

PAYBACK PERIOD: Look and feel

Investment: Rs 1 crore

SERVER CONSOLIDATIONSERVER CONSOLIDATION

YEAR SAVINGS

1

2

3

4

5

TOTAL

Rs 33.3 lakh

Rs 33.3 lakh

Rs 33.3 lakh

Rs 1 crore

Payback period : 3 years

Investment: Rs 1 crore

ATM INSTALLATIONATM INSTALLATION

YEAR SAVINGS

1

2

3

4

5

TOTAL

Rs 25.0 lakh

Rs 25.0 lakh

Rs 25.0 lakh

Rs 25.0 lakh

Rs 25.0 lakh

Rs 1.25 crore

Payback period : 4 years

RESOURCES: " Mana ging Risk an d Flexibility: A Look at Payback Period" from Nucleu s Resea rch Inc.(www.nucleusresearch.com); Payback p eriod tuto rial and calculato r fromww w.pren ha ll.com/divisions/bp/app /cfldem o//CB/Payba ckPeriod.h tm l; Business Ow ne r's Toolkit from CCH Inc. a twww.toolkit.cch.com/text/P06_6510.asp

C AL C UL A T E YOUR R o I

5 CLASSIC METHODS

DEFINITION: The net present value (NPV) of an invest-

ment is the present (discounted) value of future cash

inflows minus the present value of the investment and

any associated future cash outflows.

WHAT IT MEANS: It 's the net result of a multiyear

investment expressed in to day's rupees.

STRENGTHS: By considering the time value of money, it

allows consideration of such things as cost of capital,

interest rates and investmen t o ppo rtunity costs.

WEAKNESSES: Unlike payback period, NPV accounts for

the time value of mo ney by expressing future cash flows

in terms of their value today. So when the NPV is the

same it wo uld always prefer a p roject with less capital.

CALCULATING IT: Requires use of a discount rate equal

to some minimum desired rate of return. This could be

your company's weighted average cost of capital (debt

and equity). The discount rate (say, 10 per cent)

determines the discount factor for each year that is

applied to that year's cash flow to convert i t to today's

rupees.

For year n th e discount fa ctor wou ld be = 1/(1+i)n,

where i is the target rate of return. So at a discount rate

of 10% in Year 1, discou nt factor = 1/(1.1), or .909. Thu s,

the present value of Rs 1.10 a year from now is

Rs 1.10 x .909, or Rs 1.00.

Spread shee ts come loaded with such fo rmulae, so you

don t h ave to keep making calculations. You ent er on ly

the und iscounted cash flows, the years in w hich t he flows

are expected and some target interes t ra te , to get the

NPV.

NET PRESENT VALUE

22NET PRESENT VALUE

APRIL 2003Smart Inc 27

10 PROVEN WAYS TO DO THE MATH

5 CLASSIC METHODS

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This chart shows the same two projects as in Payback

Period . Each ha s an initial investme nt of Rs 1 crore an d a

minimum desired rate of return of 10%. On the basis of

an absolute (undiscounted) return, the ATM installation

is better because it generates Rs 25 lakh more cash over

the life of the investment. But when the time value of

money is considered, the server consolidation project

looks slightly better, with an NPV higher by Rs 90,000. Its

present value is higher b ecause the returns occur e arlier

in the pro ject's life.

28Smart Inc APRIL 2003

NET PRESENT VALUE: Lo o k a n d fe e l

RESOURCES: Prentice Hall's tu to rial an d calculato r at

www.pre nh all.com /divisions/bp /app/cfldem o/CB/NetPresent Value.h tml; Investop edia' s g lossary en try at

www.investopedia.com/terms/n/npv.asp

DEFINITION: The internal rate of return (IRR) is the

discount rate that results in a net present value of zero

for a series of futu re cash flows.

WHAT IT MEANS: It 's a cutoff rate of return; avoid an

investment or project if its IRR is less than your cost of

capital or minimum desired rat e of retu rn.STRENGTHS: It provides a simple hurdle rate for

investment decision-making. It 's the meth od favoured b y

man y accoun tant s and finance peop le.

WEAKNESSES: It 's not as easy to understand and not as

easy to compute (even Excel uses approximations).

Comp uta tional ano malies can p roduce misleading results,

particularly with regard to reinvestments.

CALCULATING IT: IRR computes a break-even rate of

return. It shows the discount rate below which an

investme nt re sults in a po sitive NPV (and sho uld be mad e)

and abo ve which a n investme nt results in a neg ative NPV

(and should be a voided ).

Consider the three scenarios in the table, each

involving an initial investment of Rs 1 crore. The

investment returns Rs 30 lakh (undiscounted) per year in

each of the five years after the initial investment, for anet return of Rs 50 lakh.

A company evaluating this investment using cash flow

discounted at 10% would compute an NPV of Rs 13.7

lakh, a decent but not spectacular result. But if the

company evaluates the same investment at 15%, the

project has a present value of only Rs 60,000, essentially

just breaking even, and is negative at 20% the project 's

present value. The IRR is a fraction of a percentage point

abo ve 15%; at that discount percenta ge, the investmen t's

NPV is zero .

INTERNAL RATE OF RETURN33 INTERNAL RATE OF RETURN

PRESENT VALUE OFCASH FLOW

-Rs 1 crore

+Rs 45.45 lakh

+Rs 41.3 lakh

+Rs 37.55 lakh

+Rs 34.15 lakh

+Rs 31.05 lakh

+Rs 89.5 lakh

ATM INSTALLATIONATM INSTALLATION

CASH FLOW

-Rs 1 crore

+Rs 50 lakh

+Rs 50 lakh

+Rs 50 lakh

+Rs 50 lakh

+Rs 50 lakh

+Rs 1.5 crore

DISCOUNTFACTOR @ 10 %

1.000

0.909

0.826

0.751

0.683

0.621

YEAR

0

1

2

3

4

5

TOTAL

PRESENT VALUE OFCASH FLOW

-Rs 1 crore

+Rs 90.9 lakh

+Rs 61.95 lakh

+Rs 37.55 lakh

+Rs 90.4 lakh

SERVER CONSOLIDATIONSERVER CONSOLIDATION

CASH FLOW

-Rs 1 crore

+Rs 1 crore

+Rs 75 lakh

+Rs 50 lakh

+Rs 1.2 5 crore

DISCOUNTFACTOR @10%

1.000

0.909

0.826

0.751

0.683

0.621

YEAR

0

1

2

3

4

5

TOTAL

YEAR

0

1

2

3

4

5

INTERNAL RATE OF RETURN

DISCOUNTFACTOR@10%

-100

30

30

30

30

30

50

CASH FLOW(Rs lakh)

1.00

0.91

0.83

0.75

0.68

0.62

-100.00

27.27

24.79

22.54

20.49

18.63

1.00

0.87

0.76

0.66

0.57

0.50

DISCOUNTFACTOR@15%

PVOFAMOUNT @10 %

(Rs lakh)

-100.00

26.09

22.68

19.73

17.15

14.92

1.00

0.87

0.75

0.65

0.57

0.49

DISCOUNTFACTOR@IRR%

PVOFAMOUNT @15%

(Rs lakh)

-100.00

26.03

22.59

19.60

17.01

14.76

1.00

0.83

0.69

0.58

0.48

0.40

DISCOUNTFACTOR@20%

PVOFAMOUNT @IRR%

(Rs lakh)

-100.00

25.00

20.83

17.36

14.47

12.06

PVOFAMOUNT @IRR%

(Rs lakh)

TOTAL

NPV(Rs lakh) 0.5613 .72 -10.28

The rate o f retu rn calculated b y the IRR (in t his case 15.2382%) is the d iscoun t rate at w hich the NPV of t he

investm ent is equ al to zero. Make the investm ent if the d iscount rate is less that that; avoid it if it is more..

coverFEATURE

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DEFINITION: A set of principles and analytic techni-

que s for improving an o rganisation's performan ce in fou r

general areas: financials, customers, learning and internal

processes.

WHAT IT MEANS: Lon g-term org an isat ional excellence

can be achieved only by taking a broad and holistic

ap pro ach, not by focusing solely on financials.

STRENGTHS: This approach is potentially all-encom-

passing, combining financial and non-financial goals and

measures. It can encompass the performance of entire

companies or business units, not just individual invest-

men ts or p rojects.

WEAKNESSES: This method is potentially so broad that itmay divert resources from t hose few areas tha t rea lly are

vital to shareholder return. It doesn't readily weigh the

relative importance of the different metrics it uses.

CALCULATING IT: The scorecard is an an alytic framew ork

for translating a company's visions and high-level

business strategies into specific, quantifiable goals and

for monitoring performance against those goals. The

methodology breaks high-level strategies into objectives,

measureme nts, target s and initiatives.

For example, US-based Southwest Airlines uses a

num ber o f scorecards, one of wh ich relates ground-crew

performan ce to company pro fitab ility (see chart). It a rran-

ges the four quadrants of the balanced scorecard

learning, internal, customer and financialin a hierarchythat show s how objectives relate to o ne an oth er.

BALANCED SCORECARD44 BALANCED SCORECARD

A b a l a n c e d s c o r e ca r d t a k e s a b r o a d , h o l is t i c l o o k a t o r g a n i s a t i o n a l g o a l s - n o t j u s t t h e f i n a n c ia l s .

For e xample, this Sout hwest Airlines scorecard shows tha t t he well-trained groun d crews mea n faster turna oroun d

and more on-time flight s, which lead to higher customer satisfaction, lower costs and greate r profits.

SOUTHWEST AIRLINES* BALANCED SCORECARD: Lo o k a n d fe e l

OBJECTIVES MEASURES TARGETS INITIATIVES

Market value

Seat revenue

Plane lease cost

FAA on-timearrival rating

Customer ranking(market survey)

Time on ground

On-time departure

% ground-crewshareholders

% ground crew trained

30% CAGR*

20% CAGR*

5% CAGR*

No.1

No. 1

30 minutes

90 %

Year 1 : 7 0%

Year 3 : 9 0%

Year 5: 1 00 %

Quality managemen t

Customer loyaltyprogram

Cycle-time optimisationprogram

Employee stockoption plan

Ground-crewtraining

FINANCIAL

CUSTOMER

I

NTERNAL

LEARNING

*CAGR= Compound Annua l Growth Rate

RESOURCES: Prentice Hall's tutorial and calculator at www.prenhall.com/divisions/bp/app/cfldemo//CB/IBR.html;

CCH's tut orial at www.to olkit.cch.com /text/P06_6550.asp; an d Investop ed ia's glossary en try at

www.investopedia.com/terms/n/irr.asp

APRIL 2003Smart Inc 29

PROFITABILITY

Increased revenue

Ground crewalignment withcompany goals

Fast groundturnaround

Lowest prices

On-time flights

Lower costs


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30Smart Inc APRIL 2003

DEFINITION: Economic Value Added (EVA) subtracts the

capital charge (the capital investment times the cost of

capital) from the net finan cial bene fits of th e investme nt.

WHAT IT MEANS: Economic profit is wealth created

above the capital cost of the investment. EVA prevents

man agers from th inking th at t he cost o f capital is free.

STRENGTHS: EVA focuses managers on the question,

"For any given investment, will the company generate

returns above the cost of capital?" Companies that emb-

race EVA have bo nus compen sation schem es that reward

or punish managers for adding value to or subtracting

value from the comp any.

WEAKNESSES: As with any metric, it's hard to link

precise EVA return s to a specific techn ology investmen t.

CALCULATING IT: Consider a case where cost-benefit

analysis reveals that a Rs 5-lakh IT investment will return

Rs 80,000 in net quantifiable benefits. The RoI is 16%

(Rs 80,000 divided by Rs 5 lakh). The cost of capital for the

company is 12%. Using the formula above, the EVA in

this case is Rs 20,000: Rs 80,000 net benefits - (Rs 5 lakh

capita l investm en t x 12% cost of ca pita l) = Rs 20,000 EVA.

Anoth er w ay to calculate EVA in t his example is to simp ly

deduct the 12% cost of capital from the 16% RoI, then

multiply by the investment: 4% x Rs 5 lakh = Rs 20,000

EVA.

EVA is always expre ssed as a sum of m on ey.

ECONOMIC VALUE ADDED55 ECONOMIC VALUE ADDED

RESOURCES: Ste rn Stewa rt & Co.s tuto rial Wh at Is EVA? at w ww.sternstew art.com/evaab ou t/wha tis.shtm l and

Peter Keen' s take on EVA at www.peterkeen .com/emgb p007.htm

1. BUSINESS VALUE INDEX

EXPONENT:The Hackett Group, USA

THE PROCESS: BVI lets users compare themselves against

other enterprises. Hackett has benchmarked 2,000 IT

organ isations on th eir alignment with corporate strateg y,

ability to pa rtner with suppliers, and level of t echnology

integration. Client companies can compare their IT prac-tices and business value with top-quartile corpo-rations

on a continuous basis. A BVI analysis can take as little as

two weeks.

WEAKNESSES: May not offer the hard numbers

you're seeking; also, the index is new a nd u ntested.

2. INFORMATION ECONOMICS

EXPONENT:The Beta Group, USA

THE PROCESS: A four-step approach. First, a user lists

an d p rioritises its strate gic busine ss en de avours. The n it is

asked to catalogue its technology investments. Next, a

scorecard committee, composed of business, financial and

IT executives, develops a relative valuation for each IT

pro ject. Finally, the compa ny create s a scorecard , which isa list of proposed IT expenditures ranked according to

their business value. A typical engagement lasts six to

12 weeks.

WEAKNESSES: Requires a major effort from the

scorecard committee, and the results of the exercise are

only as strong as that grou p's comm itme nt.

3. IT PERFORMANCE MANAGEMENT SCORECARD

EXPONENT: IT Performa nce Mana ge men t Group , USA

THE PROCESS: The user establishes critical success factors

associated with the health of its IT organisation. Then,

ITPMG's scorecard software, which the firm installs on

clients' servers, helps companies develop 8-15 key perfor-

mance indicators. That translates typical IT jargon into

business-value terms. Developing a scorecard for one

dep artmen t of a compa ny takes six to eight weeks.

WEAKNESSES: Lost of evangelising is needed for

translating o lder IT measureme nts into information th at 's

useful for bu siness peo ple. To fully exploit the IT

scorecard, a business must be ready and willing to

confront the historical divide between IT and other

departments .

4. TOTAL ECONOM IC IMPACT CHAMPION

EXPONENT:Giga Information Group

THE PROCESS: Essentially expands on traditional cost

analysis by adding benefits and flexibility to the mix. TEIC

assessment begins with identification of an IT project's

goals. It then determines technology costs. Next, affected

business units decide what benefits they stand to gain.

Flexibility an d risk a re t he n factore d in. Finally, th e results

of the assessment are communicated to all concerned

parties, and metrics for measuring the project's success

are determined.

WEAKNESS: In some companies, the a dditional conside-

ration s like flexibility and risk ma y dilut e t he RoI messag e.

5. TOTAL VALUE OF OPPORTUNITY

EXPONENT: Gartne r Inc.

THE PROCESS: To ge t starte d, a bu sine ss uses Gartn er's

business metrics to determine what opportunities are

available and translates them into standard business

terms such as on-time delivery, bill rate, marketshare and

sales close index. One of TVO's strengths is that this

translationwhich is where many efforts founderis laid

out in excruciating, step-by-step detail, eliminating

ambiguity.

WEAKNESS: This painstaking detail adds a degree of

complexity. Senior managers may simply not have the

time to de al with it .

RESOURCES: White p ape r from Corvu Corp.,"The New Balanced Scorecard " a t

www.Corvu.com/library/whitep ap ers/new bsc.pd f; Balanced Scorecard Collabora tive Inc. a t www.bscol.com;

nvestopedia's glossary entry at www.investopedia.com/terms/b/balancedscrorecard.asp

5 NEW TECHNIQUES5 NEW TECHNIQUES

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