Net Present Value (NPV) and Cost of Capital
Basically, NPV represents the relationship between a projectýs expected cash flow and the cost of capital. ýIn simplest terms, cost of capital is what you have to pay or give up for the money you need for operating the business ý for buying new computers and other assets,ý explains Susan Koski-Grafer, a vice president at the Financial Executives Institute in Morristown, N.J.
Knowing how to calculate NPV and cost of capital can get you a leg up over other internal departments vying for the same funding dollars, says Alan J. Schneider, treasurer at Chicago-based Wm. Wrigley Co.
NPV and cost of capital can help assess potential external investments, like stock purchases or corporate acquisitions. But organizations are also using these equations to evaluate investments in internal projects. Those projects can range from building a new manufacturing plant to replacing an aging mainframe with a Web-based system.
The cost of capital is generally measured as weighted average cost of capital (WACC). WACC is the cost of debt, such as interest on a loan, and the cost of equity investment, or rate of return. For internal investments, though, cost of debt typically doesnýt come into play.
One example of rate of return is the interest on a bank savings account. If your bankýs annual interest rate is 4%, your rate of return on the money youýve invested is also 4%.
In many organizations today, a project must meet a ýhurdle,ý or minimum requirement for rate of return, before it can be considered for internal funding. The hurdle is used to help calculate NPV. If the project meets the organizationýs hurdle, NPV will be a positive number. Conversely, if the project hasnýt met the hurdle, NPV will be a negative number.
The higher the rate of return, the greater the chances the project will obtain the stamp of approval.
Letýs say that an organizationýs hurdle is 12%, for example. If a proposal submitted by IT yields a 16% rate of return, while a competing departmentýs proposal brings a 14% rate of return, the IT department will get the edge thanks to its higher NPV.
There are other factors to consider as well. IT projects deliver intangible benefits that canýt be quantified using mathematical equations like NPV, such as better information access, workflow and customer satisfaction.
Haim Mendelson, James Irvin Miller Professor of Information Systems at Stanford University in Stanford, Calif., recommends talking about intangible benefits as well as quantifiable NPV results in proposals to the finance department. ýSome of the most convincing arguments are that the project will bring strategic benefits or a business restructuring,ý he says.
Organizations vary, too, in terms of who calculates NPV and cost of capital. At Bentley College in Waltham, Mass., for instance, the finance department does that job. ýBut I certainly get a lot of input from my IT people,ý says Joanne Yestramski, the college's vice president of business and finance. Bentley has used these calculations to make computer lease-or-buy decisions, as well as to predict return on investment from network upgrades to a new, $20 million building called the Smith Technology Center thatýs slated to open in the fall of 2000.
IT and Finance
Even at organizations in which the finance department does all the math, itýs important for IT managers to comprehend NPV and cost of capital.
ýThereýs going to be a discussion anyway, and you will have to justify the project. IT managers are in a much better position if they know a project has already passed the hurdle based on its quantifiable benefits,ý Mendelson says.
ýPartnering between IT and finance is critical,ý according to Ron Brezinski, principal at Wilmette, Ill.-based Transformation Associates. ýFinance can help IT to either look good or look bad. By speaking the same language as finance, IT managers show that theyýre playing on the same team, instead of sitting on the sidelines as outsiders.