Topic 5

TECHNOLOGY JUSTIFICATION MODEL

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 Justification Models

• Managers need to know how to:

1. Formulate business relationship into mathematical relationship
2. Interpret findings resulting from quantitative models
• IT investment is more likely to be approved through scientifically
sound analysis rather than political or perception means
• This is why managers need to use justification models

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 Justification models

• Why managers need for justification models?

– To convert the relationship between IT investment and anticipated payoff
into logical or mathematical form
– Isolate the surplus profits that can be attributed to the investment
• Example of Justification models
– Intuition-based models
– Cost-benefit analysis
– Break-even point
– Net present value (NPV)
– Economic Value Added (EVA)
– Regression-based statistical models

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 Scenario for IT investment (pg80-81)

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 Intuition-Based Model

• Decision made based on observations and experience.

• It does not backed up by projections and scientific calculations
• E.g. An observation of tremendous reduced complains convinced
the stakeholders on the benefits/payoff of the investment of the
helpdesk

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 Cost-benefit analysis

• Mathematical model of calculating payoff by substracting total

cost from the expected derived benefits
– Payoff = total benefits – total costs
– Payoff = (savings (in hours) for all problem resolution) x avg hourly rate) -
(cost of help desk implentation)
– Additional saving and cost can be included
…Additional Saving – quick troubleshooting, better customer service,
improve customer satisfactions, etc
…Additional Cost – staff training, system upgrades, software
maintenance, etc.

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 Example 1
• ABC Medical invest RM2 million in a Health Diagnostic Support system.
To maintain the system, the hospital has to pay the vendor RM10,000
monthly for monitoring and support activities. The system is projected to
increase the hospital revenue by RM50,000 monthly. If the system is to
be utilized by the hospital for 10 years, calculate the payoff of the
investment using Cost benefit analysis.

= Total benefit for 10 years total costs for 10 years

= (50,000 x 120months) (2,000,000 + 120(10,000))
= 6,000,000 3,200,000
= 2,800,000

• Does the Health Diagnostic Support system a good investment? Justify.

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 Example 2
• An investment in a Helpdesk System by XYZ company costs the
company to pay the vendor RM200,000 during the installation and
maintenance of RM15,000 for the first two years, and RM8,000 for the
remaining years. If the system can help XYZ company to save
RM50,000 a year for the next 5 years, calculate the payoff using Cost
benefit analysis.

= Total benefit for 5 years total costs for 5 years

= (50,000 x 5yrs) (200,000 + 2(15,000)+3(8,000))
= 250,000 254,000
= ,000

• Does the Helpdesk system a good investment? Justify.

• If the management insisted on approving this project, what could
possibly be the reason to justify the project?

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 Break-even point
• Used to identify the point at which the system investment has paid for itself
• Normally used to evaluate investment that perceived not adding value or
just cost of doing business
• It is a period where the payoff is 0, or when the benefits equals to cost
– Cost – benefit = 0
• Looking for the payback period
– Determines the duration of time in which the system is paying for itself

break-even point

Payback period

time
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 • Payback period formula

Where
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A

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 Example 1
• ABC Medical invest RM2 million in a Health Diagnostic Support system.
To maintain the system, the hospital has to pay the vendor RM10,000
monthly for monitoring and support activities. The system is projected to
increase the hospital revenue by RM50,000 monthly. Identify the break-
even point of this investment.
Year Cost Benefit Cashflow Accumulated
benefits
0 -2,000,000 0 -2,000,000 -2,000,000
1 -120,000 600,000 480,000 -1,520,000
2 -120,000 600,000 480,000 -1,040,000
3 -120,000 600,000 480,000 -560,000
4 -120,000 600,000 480,000 -80,000 B
A 5 -120,000 600,000 480,000 400,000
6 -120,000 600,000 C 480,000 880,000
7 -120,000 600,000 480,000 1,360,000
8 -120,000 600,000 480,000 1,840,000
9 -120,000 600,000 480,000 2,320,000
10 -120,000 600,000 480,000 2,800,000
TOTAL -3,200,000 6,000,000

Break-even between year 4 to 5

Payback period = A + |B|/C
= 4 + 80,000/480,000
= 4.2 or 4 tahun 2 bulan
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 Example 2
• An investment in a Helpdesk System by XYZ company costs the
company to pay the vendor RM200,000 during the installation and
maintenance of RM15,000 for the first two years, and RM8,000 for the
remaining years. If the system can help XYZ company to save
RM50,000 a year. Identify the break-even point of this investment..

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 Return on Investment (ROI)
• ROI is a measure used to evaluate the efficiency of an
investment
• It measure the amount of return on a particular investment,
relative to the investment’s cost
• The benefits of an investment is divided by the cost of the
investment

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 Return on Investment (ROI)
• ABC Medical invest RM2 million in a Health Diagnostic Support system.
To maintain the system, the hospital has to pay the vendor RM10,000
monthly for monitoring and support activities. The system is projected to
increase the hospital revenue by RM50,000 monthly. If the system is to
be utilized by the hospital for 10 years, calculate the rate of return of the
investment using ROI.

ROI = (Total benefit – Total cost) / Total cost

= (Total benefit for 10 years total costs for 10 years) / Total cost for 10 years
= (50,000 x 120months) (2,000,000 + 120(10,000)) /(2,000,000 + 120(10,000))
= (6,000,000 3,200,000) / 3,200,000
= 0.875

Turn it to % by multiplying it with 100, therefore ROI is 87.5%

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 Net present value

• IT investment made today are not the same as IT invesment

made a year from today. Why?
– The interest of the money can gain
• NPV model include the ‘time value of money’ concept in its
calculation
– DF (discount factor) is the rate at which company would have
accumulated more money if it HAD NOT invested in an
investment
– DF normally based upon the interest rate of the rate of returns
from the stock market or other other investment opportunities
• Each cash inflow/outflow is discounted back to its present
value (PV).
Rt R = cash inflow/outflow
Present value = 1  i t t = time
i = discounted rate

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 Net present value
Present value (PV) =
Rt R = cash inflow/outflow
t = time
1  i t i = discounted rate

 R1 R2 R3 Rt 
Net Present value (NPV) =   (1  i)1 (1  i) 2 (1  i)3 (1  i)t 
  .. 
 

or
  1   1   1   1 
Net Present value (NPV) =   1  (1  i)1  2  (1  i) 2  3  (1  i)3  t  (1  i)t  
R    R    R   ..  R
        

1
Where, DFt =
1  i t

Net Present value NPV)  R DF  R DF  R DF ..  R DF 
1 1 2 2 3 3 t t
=
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 Net present value

EXAMPLE

• The company will be spending $2.5mil a year for a period of 4 years, that is,
$10mil to implement the system. The company expect to earn about 15%
return by investing in advertising instead. (discount rate or i=0.15)

Year Cost

1 $2,500,000

2 $2,500,000

3 $2,500,000

4 $2,500,000

TOTAL COST $10,000,000

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 Net present value
• Using Discount Factor

 R DF  R DF  R DF ..  R DF 

1 1 2 2 3 3 t t

Year Inflow/ Formula Calculation DF PV

(Outflow)
1 ($2,500,000) 1/(1.15)1 1/1.15 0.8696 $2,174,000

2 ($2,500,000) 1/(1.15)2 1/1.32 0.7576 $1,894,000

3 ($2,500,000) 1/(1.15)3 1/1.52 0.6579 $1,644,750

4 ($2,500,000) 1/(1.15)4 1/1.75 0.5714 $1,428,500

TOTAL 2.8550 $7,141,250

The $10m desktop system would cost only about $7.14mil at present value.
If the cost of advertising is $8mil, which investment is better?

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 Internal Rate of Return
• Is the rate at which the NPV of a project or investment equals to zero, 0.
• When NPV closest to 0, then you’ll find the IRR
• If IRR exceeds a company’s required rate of return, hurdle rate, that
project is desirable
• If IRR falls below the required rate of return, the project should be
rejected.

Year
Year Out
Out In
In R
R 15%
15% 30%
30% 28%
28% 29%
29%

11 (2.5m)
(2.5m) 00 (2.5m)
(2.5m) (2.18m)
(2.18m) (1.92m)
(1.92m) (1.95m)
(1.95m) (1.94m)

22 (2.5m)
(2.5m) 2m
2m (0.5m)
(0.5m) (0.38m)
(0.38m) (0.30m)
(0.30m) (0.32m)
(0.32m) (0.30m)

33 (2.5m)
(2.5m) 3m
3m 0.5m
0.5m 0.33m
0.33m 0.23m
0.23m 0.24m
0.24m 0.23m

44 (2.5m)
(2.5m) 8m
8m 5.5m
5.5m 3.14m
3.14m 1.93m
1.93m 2.05m
2.05m 1.99m

NPV
NPV 0.91m
0.91m -0.06m
-0.06m 0.03
0.03 -0.02

910,000
910,000 -60,000
-60,000 30,000
30,000 -20,000

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 The Real Option Approach

• Investment in real-world scenarios is more complicated

• Some previous method discussed does not take into account the
risks or opportunities of stopping, decreasing, or increasing
investment in the future
• Often time managers are facing with a situation whether or not to
invest in a technology for future benefits
– Sometimes, failure to make an investment in the network infrastructure can
severely restrict a company competitive capability to add application and new
services in the future
• Under this circumstances, to deal with future IT options, Real Option
(RO) approach is suitable

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 The Real Option Approach
The value of
investment
expected NPV
• In the real world businesses
have OPTIONs to:
– Change the level of investment
– Redirect the effort to support
Year 2 investment
Year 3
Year 4
– Stop the investment
• After second year, management
can evaluate the IT investment
New NPV
payoff and set future direction
• Key contribution of Real Option
is the ability to take advantage
of unexpected/ unforeseen
opportunities
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 • Please continue on your own for the rest of the chapter.

• The Statistical Approach (Correlation & Regression Analysis) will be

based on the individual assignment discussed.

• This slide end here.

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