Software EconomicsIntroduction to

Business Case Analysis

Session 2

Georg Singer

georg.singer ät ut . ee

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Course Objective

• Introduce the principles and methods of Business Case Creation

• Emphasize the role of measures like NPV, ROI, TCO, IRR and the like for investment decisions

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Structure of the course

• Last Session

– The setting

– Definition of Business Case

– Business Case Principles

– Time Value of Money

– PV, NPV

• Today

– More business case concepts

• Next Session

– Solve a business case in class

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Today’s Session

• Return on Investment (ROI)

• Internal Rate of Return (IRR)

• Payback Period/Break Even Analysis

• Total Cost of Ownership (TCO)

• More about benefits & risk

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ROI – a very general concept

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Return on Investment ROI – The formula

• A general concept, where the earnings are expressed as a proportion of the outlay

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Investopedia explains Return On Investment -ROI

Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the revenue that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.

Source: Investopedia

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Cost – Benefit Analysis

• When people say ROI analysis they mean Cost-Benefit analysis

• Compares the project costs versus the projected benefits over time

– Analyzes positive and negative cash flows (benefits vs. costs)

• First step in the quantification of a project

• Cost – Benefit Analysis = Proposed Plan - Base Case(line) = Incremental Cash flow/Profit/ Etc. (Gain)

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Simple Example - ROI

For each $ that you put into this project, you get $ 2.4 back.

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Interpretation of the ROI measureScenario Type Interpretation Impact on Decisions

ROI >0 Project generates positive returns

If in line with strategyproject (with highest positive ROI shall be carried out)

ROI <0 Project generatesnegative returns

Project shall not be carried out unless intangible benefits justify a go decision

ROI = 0 Project does neither generate nor lose money

Decision must be based on other criteria

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Remarks

• ROI only states relative gains, it says nothing about absolute gains

• For making a sound decision, always use a combination of measures

• If you want to reflect the risk in the project, you can use the following formula

Risk Adjusted ROI=NPV(Net Cash Flows)/NPV(Costs)

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Exercise - ROI calculation Exercise

• 10 minutes, everybody alone

• ROI CALCULATION EXERCISE.pdf

• Exercises\Solution E-Learning.xlsx

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Session Progress

• Return on Investment (ROI)

• Internal Rate of Return (IRR)

• Payback Period/Break Even Analysis

• Total Cost of Ownership (TCO)

• More about benefits & risk

• Case Study Preparation

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IRR – “How risky can it be?”

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Internal Rate of Return (IRR)

• The Discount Rate which makes the NET Present Value of a project equal to zero

• Also called rate of return

• Measures the profitability of investments

• Interpretation: The higher the IRR the more desirable to carry out the project

– It’s a relative measure; does not say anything about the absolute returns of a project

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Example

• Initial = I(0) = - € 100,000

• Year 1 = I(1) = + € 175,000

• Year 2 = I(2) = + € 175,000

• Year 3 = I(3) = + € 175,000

• For this set of net cash flows, the IRR calculation that yields a NPV of zero is 166%.

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Session Progress

• Return on Investment (ROI)

• Internal Rate of Return (IRR)

• Payback Period/Break Even Analysis

• Total Cost of Ownership (TCO)

• More about benefits & risk

• Case Study Preparation

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Payback Period – “when are we profitable?”

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Payback Period (time)

• The time period from the start of the project until the cumulative cash flow turns positive

• The point where benefits exceed costs is often called the Break even point (BEP).

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Example – Payback Period

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Break Even Analysis (unit sales)

• The break-even point (BEP) is the point at which cost and revenue are equal

• one has "broken even“

• BEP (in terms of unit sales)

• Total Revenue=Total Costs

• Break Even (in terms of unit sales) = Fixed Costs / (Selling Price − Var.Costs)

• Selling Price – Var. Costs = “Margin”

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Example

• Software company

• Fixed costs (salaries, rent): $ 5 mio per month

• Sells software packages online for $ 105 each

• Production costs(variable costs) for each package: $5

• What is the BEP in terms of unit sales?

• BEP=5.000.000/(105-5)= 50.000 pieces

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Exercise 2 – 45 minutes – 5 teams• A company wishes to improve its “Engage to Close process”

(Sales) by applying a CRM solution.

• The costs of the project are analyzed, and the business process “AS IS” versus “TO BE: efficiency and effectiveness” are analyzed and summarized on slide 25

• Please calculate :– the 1-year ROI , the 2- year ROI and total ROI of the project

– the payback period

– the risk adjusted total ROI using a discount factor of 15 %

– the 1-year IRR, 2-year IRR and total IRR

• Please analyze the possible post project scenarios regarding the development of revenue and costs.

• Summarize the data of your analysis in a table of the structure illustrated on slide 24

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Realistic post project scenarios

Revenue (after project implementation)

Costs (after project implementation)

Interpretation (what does this mean for the project ?)

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Example