Being familiar with an educational organization justifying new IS projects and the technologies used is very competitive because of the rapid technological changes. Justification takes place mainly in traditional capital budgeting decisions, which does not take into consideration the various different factors affecting Information System projects ranging from small applications to larger projects according to different aspects of organizational requirements. In this light, other than time, projects consume other quantifiable resources, which can be valued in monetary or dollars. These methods are categorized as under; non discounted cash flow and discounted cash flow. The following list explains them together with their importance and difficulties.
Non-Discounted Cash Flow Methods – no time considerations
Payback period
In this method, the project selected in an array of possible projects to be mounted is the one that gives the shortest period of return on the initial investment. Thus payback period is the number of years required to return the original investment. In an educational organization witnessed, this method is the most used with over 70% preferences – As the organization requires critical decision making urgently in ensuring that variables and project deliverables are dealt with according to the specification from the system analyst.
Formula: Payback Period= Investment / Annual Cash Inflows
This method is used because; it is very easy to calculate as it involves knowing the equity in a business enterprise and its yearly cash inflows. It emphasizes quick return on investment so that they can be put into use in other places or meet other requirements. On the other hand, it brings some sort of decision conflict as it does not consider post-payback cash flows, time value of money, and risk; moreover, it can lead to wrong decisions being incorporated in the strategic management level making structured decisions.
Accounting Rate of Return (ARR)
Data from the income report is used. It is a non-discounting cash flow project evaluation method. It is computed by using the following formula.
Formula: Accounting Rate of Return=Annual average profits / Average Profits
Or
Accounting Rate of Return = Increase in expected average operating income / Initial increase in investment.
This method is also known as the accrual accounting rate of return, unadjusted rate of return model, and the book value model.
It is integrated into its components with Conventional accounting models of calculating income and required investment; it is also related to showing the effect of an investment on a project’s financial statement. This method is used because; it is simple to calculate using the data from accounting—each year’s earnings in incorporated in project profitability calculation. The difficulty with it is that; there is no time value of money, and it does not have a decision criterion. Since it uses accounting data, it includes the number of accruals in calculating the earnings ‘net equity. Last but not least, it is based on accrual accounting.
Discounted Project Selection Methods – time considerations
Profitability Index (PI)
It is also known as the present value index or Cost-Benefit Analysis. It is calculated by taking the present value of cash inflows divided by the initial cost. The decision criterion is to accept the project with a Profitability Index (PI) greater than one.
Formula: Profitability Index = Present Value Of Cash Inflows / Initial Cost (Initial Outflow)
The ratio specifies the return in the present terms per unit invested. Using this criterion, IS projects will be categorized from one with the highest PI down to one with the lowest. Thus project selection will be carried out according to the ranking until an exhaustion point of the budget is reached.
This criterion is simple but suffers the following main limitations;
It cannot be applied to focus in cases where there is only a single constraint.
It sees IS projects individually and does not take into account the regressions or rather the correlation among them.
Net Present value (NPV)
In this method, cash flows are discounted summed up, and the initial cost of the project is subtracted to obtain the net present value taking into account the time value of money. This method finds the present value of desired net cash flows of an investment, discounted at the cost of capital, and subtract from it the initial cash outlay of the project. In case the present figure is positive, the project will be accepted; if negative, it should then be rejected. If the projects under consideration are mutually exclusive, then the one with the highest net present value is the one to be chosen. The formula for Net Present Values is as follows.
Formula: NPV= F1/ (1+k) 1 + F2/ (1+k) 2 + F3/ (1+k) 3 + ……………… Fn/ (1+k) n – I 0
Where
Fn = Net cash Flow at a specific time (subscripted)
K = cost of capital
I 0 = Initial cash outflow
Problems with NPV include: It is difficult to explain to non-finance people. The solution is in dollars but not as percentage rates of return.
Internal Rate Of Return (IRR)
The IRR is the estimated rate of return for a proposed project, given its incremental cash flows. It is the discount rate at which the NPV is equal to zero. This rate means that the present value or the cash inflow of the project would be equal to the present value of its cash outflows. IRR is the break-even discount rate. IRR, like NPV, takes into consideration the time value of money. Most often, IRR is obtained by trial and error.
Formula: IRR= F1/(1+R)1 + F2/(1+R)2 + F3/(1+R)3 + ……………… Fn/ (1+R) n = 0
Where R= Internal rate of return, F= Cash flows
Some value of R will cause the sum of the discounted inflows to be equal to the initial cost of the project, making the equation equal to zero, and the value of R will be the project’s internal rate of return.
The goodness with this method is that it considers all cash flows and the time value of money. However, it does not show dollar improvement in the value of the firm if the project is accepted, IRR can be affected by the project size and the existence of multiple IRRs
Pure financial analysis methods of evaluating project proposals require quantified values from the desired project because of their objectivity. They are not appropriate for all IS projects as the cost and benefit of strategic factors are very difficult to quantify accurately or not available. This means that if there is any weakness in the evaluation of an IS project falling under a critical or real-time system. It means that the battle is lost; the system does not meet its requirements specifications. Subjective methods acknowledge the frailty of such value estimates and hence emphasize attitudes and opinions. Simple techniques such as payback are often preferred over more complex quantitative models.
References
David L Olson (2004) Introduction to Information Systems Project Management, 2nd Edition: University of Nebraska—Lincoln.
Article (2005 – 2007), Information Systems Project Selection Practice. Universitas 21 Global Pte Ltd.
Financial Analysis Session 2. Web.
David L Olson (2004) Introduction to Information Systems Project Management, 2nd Edition: University of Nebraska—Lincoln.
Sommerville I (1999) Software Engineering 6th Edition: Pearson Education Limited, England.
Yeates J & Cadle J (2004) Project Management For Information Systems 4th Edition: Pearson Education Limited, Harlow.