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Net Present Value (NPV) and Cost of Capital

What it is: Net present value (NPV) is used to evaluate return from internal investments such as IT projects or external investments such as mergers.

Why you need to know it: NPV can help your IT department win internal investment dollars by showing the finance department that investing in a Web server, for example, will yield a high return.

By Jacqueline Emigh
(July 26, 1999) Understanding net present value (NPV) can increase an information technology managerıs chances of getting the OK from corporate finance for IT expenditures.

Basically, NPV represents the relationship between a projectıs expected cash flow and the cost of capital. ıIn simplest terms, cost of capital is what you have to pay or give up for the money you need for operating the business ı for buying new computers and other assets,ı 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.

Evaluating Investments

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 doesnıt come into play.

One example of rate of return is the interest on a bank savings account. If your bankıs annual interest rate is 4%, your rate of return on the money youıve invested is also 4%.

In many organizations today, a project must meet a ıhurdle,ı 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 organizationıs hurdle, NPV will be a positive number. Conversely, if the project hasnıt 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.

Letıs say that an organizationıs hurdle is 12%, for example. If a proposal submitted by IT yields a 16% rate of return, while a competing departmentıs 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 canıt be quantified using mathematical equations like NPV, such as better information access, workflow and customer satisfaction.

Intangible Benefits

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. ıSome of the most convincing arguments are that the project will bring strategic benefits or a business restructuring,ı 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. ıBut I certainly get a lot of input from my IT people,ı 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 thatıs slated to open in the fall of 2000.

IT and Finance

Even at organizations in which the finance department does all the math, itıs important for IT managers to comprehend NPV and cost of capital.

ıThereıs 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,ı Mendelson says.

ıPartnering between IT and finance is critical,ı according to Ron Brezinski, principal at Wilmette, Ill.-based Transformation Associates. ıFinance can help IT to either look good or look bad. By speaking the same language as finance, IT managers show that theyıre playing on the same team, instead of sitting on the sidelines as outsiders.


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