Capital Budgeting Models
Capital budgeting models are one of several techniques used to measure the value of
investing in long-term capital investment projects. The process of analyzing and
selecting various proposals for capital expenditures is called capital budgeting. Firms
invest in capital projects to expand production to meet anticipated demand, or to
modernize production equipment to reduce costs. Firms also invest in capital projects
for many no economic reasons, such as to install pollution control equipment, or to
convert to a human resources database to meet some government regulations, or to satisfy
no market public demands. Information systems are considered long-term capital
investment projects.
Six capital budgeting models are used to evaluate capital projects:
The payback method
The accounting rate of return on investment (ROI)
The cost-benefit ratio
The net present value
The profitability index
The internal rate of return (IRR)
Cash Flows
All capital budgeting methods rely on measures of cash flows into and out of the firm.
Capital projects generate cash flows into and out of the firm. The investment cost is
an immediate cash outflow caused by the purchase of the capital equipment. In subsequent
years, the investment may cause additional cash outflows that will be Balanced by cash
inflows resulting from the investment. Cash inflows take the form of increased sales
of more products (for reasons including new products, higher quality, or increasing
market share), or reduction in costs of production and operation.
The difference between cash outflows and cash inflows is used for calculating the financial worth
of an investment. Once the cash flows have been established, several alternative methods are available
for comparison among different projects and decision making about the investment.
Limitations of Financial Models
Financial models are used in many situations: to justify new systems, explain old
systems post hoc, and to develop quantitative support for a political position. Political
decisions made for organizational reasons have nothing to do with the cost and benefits of a system.
Financial models assume that all relevant alternatives have been examined, that
all costs and benefits are known, and that these costs and benefits can be expressed
in a common metric, specifically, money. When one has to choose among many complex
alternatives, these assumptions are rarely met in the real world, although they may be
approximated. Table 11.9 lists some of the more common costs and benefits of systems.
Tangible benefits can be quantified and assigned a monetary value. Intangible benefits,
such as more efficient customer service or enhanced decision making, cannot be
immediately quantified but may lead to quantifiable gains in the long run. Indeed, if
intangible benefits do not at some reasonable point lead to tangible benefits, then they
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may not be "worth" much. Information Systems as a Capital Project Many well-known problems
emerge when financial analysis is applied to information systems (Dos Santos, 1991).
Financial models do not express the risks and un- certainty of their own cost and benefits
estimates. Costs and benefits do not occur in the same time frame---costs tend to be
upfront and tangible, whereas benefits tend to be back loaded and intangible. Inflation
may affect costs and benefits differently. Technology--especially information
technology---can change during the course of the project, causing estimates to vary
greatly. Intangible benefits are difficult to quantify. These factors play havoc with
financial models.
The difficulties of measuring intangible benefits give financial models an application bias: Transaction and clerical systems that displace labor and save space always produce more measurable, tangible benefits than management information systems,
decision-support systems, or computer-supported collaborative work systems
Table 11.9 Cost and Benefits of Information System
Costs
Hardware
Benefits
Tangible:
Cost savings
Telecommunications
Increased productivity
Low operational costs
Software
Reduced work force
Lower computer expenses
Services
Lower outside vendor costs
Lower clerical and professional costs
Personnel
Reduced rate of growth in expenses
Reduced facility costs
Intangible:
Improved asset utilization
Improved resource control
Improved organizational planning
Increased organizational flexibility
More timely information
More information
increased organizational learning
Legal requirements attained
Enhanced employee goodwill
Increased job satisfaction
Improved decision making
Improved operations
Higher client satisfaction
Better corporate image
There is some reason to believe that investment in information technology requires
special consideration in financial modeling. Capital budgeting historically concerned
itself with manufacturing equipment and other long-term investments such as electrical
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generating facilities and telephone networks. These investments had expected lives of
more than one year and up to twenty-five years. Computer-based information systems are
similar to other capital investments in that they produce an immediate investment cost,
and are expected to produce cash benefits over a term greater than one year.
Information systems differ from manufacturing systems in that their expected life
is shorter. The very high rate of technological change in computer-based information
systems means that most systems are seriously out of date in five to eight years. Although
parts of old systems survive as code segments in large programs-- some programs have
code that is fifteen to twenty years old--most large-scale systems after five years
require significant investment to redesign or rebuild them.
The high rate of technological obsolescence in budgeting for systems means simply
that the payback period must be shorter, and the rates of return higher than typical
capital projects with much longer useful lives.
The bottom line with financial models is to use them cautiously and to put the results
into a broader context of business analysis. Let us look at an example to see how these
problems arise and can be handled. The following case study is based on a real-world
scenario, but the names have been changed.
Case Example: Primrose, Mendelson, and Hansen
Primrose, Mendelson, and Hansen is a 250-person law partnership on Manhattan's West Side.
Founded in 1923, Primrose has excelled in corporate, taxation, environmental, and health
law. Its litigation department is also well known.
The Problem
Spread out over three floors of a new building, each of the hundred partners has a
secretary. Many partners still have 486 PCs on their desktops but rarely use them except to read the e-mail. Virtually all business is conducted face-to-face in the office,
or when partners meet directly with clients on the clients' premises. Most of the law
business involves marking up (editing), creating, filing, storing, and sending documents. In addition, the tax, pension, and real estate groups do a considerable amount
of spreadsheet work.
With overall business off 10 percent since 1995, the chairman, Edward W. Hansen
III, is hoping to use information systems to cut costs, enhance service to clients, and
bring partner profits back up.
First, the firm's income depends on billable hours, and every lawyer is supposed
to keep a diary of his or her work for specific clients in 30-minute intervals. Generally,
senior lawyers at this firm charge about $500 an hour for their time. Unfortunately,
lawyers are not good record keepers; they often forget what they have been working on,
and must go back to reconstruct their time diaries. The firm hopes that there will be
some automated way of tracking billable hours.
Second, much time is spent communicating with clients around the world, with other
law firms both in the United States and overseas, and especially with Primrose's
branches in Los Angeles, Tokyo, London, and Paris. The fax machine has become the
communication medium of choice, generating huge bills and developing lengthy
queues. The firm looks forward to using some sort of secure e-mail, perhaps Lotus
3
Notes or even the Internet. Law firms are wary of breaches in the security of confidential client information.
Third, Primrose has no client database! A law firm is a collection of fiefdoms
each lawyer has his or her own clients and keeps the information about them private.
This, however, makes it impossible for management to find out who is a client of the
firm, who is working on a deal with whom, and so forth. The firm maintains a billing
system, but the information is too difficult to search. What Primrose needs is an integrated client management system that would take care of billing, hourly charges, and
making client information available to others in the firm. Even overseas offices want
to have information on who is taking care of a particular client in the United States.
Fourth, there is no system to track costs. The head of the firm and the department heads who compose the executive committee cannot identify what the costs are,
where the money is being spent, who is spending it, and how the firm's resources are
being allocated. Perhaps, for instance, health law is declining and the firm should
trim associates (nonpartnered lawyers). A decent accounting system that could identifity the cash flows and the costs a bit more clearly than the existing journal would
be a big help.
The Solution
There are many problems at Primrose; information systems could obviously have
some survival value and perhaps could grant a strategic advantage to Primrose if a
system were correctly built and implemented. We will not go through a detailed systems analysis and design here. Instead, we will sketch the solution that in fact was
adopted, showing the detailed costs and estimated benefits. These will prove useful
for estimating the overall business value of the new system--both financial and nonfinancial.
The technical solution adopted was to create a local area network composed of
100 fully configured Pentium multimedia desktop PCs, three Windows NT file
servers, and an Ethernet 10 MBS (megabit per second) local area network on a coaxial cable. Multimedia computers are required because lawyers access a fair amount
of information stored on CD-ROM. The network connects all the lawyers and their
secretaries into a single integrated system, yet permits each lawyer to configure his
or her' desktop with specialized software and hardware. The older 486 machines
were given away to charity.
All desktop machines were configured with Windows 95 and Office 97 application software, while the file servers ran Windows NT. A networked relational database was installed to handle client accounting and mailing functions. Lotus Notes
was chosen as the internal mail system because it provided an easy-to-use interface
and good links to external networks (including the internet) and mail systems.
Frequently the partners send documents to Paris and San Francisco where the firm maintains
satellite offices. The Internet was specifically rejected as an e-mail technology because
of its uncertain security. Lotus Notes is still much more versatile than the Web at
groupware functions and accounting functions such as simple client management and billing
applications. Notes can also incorporate spreadsheets. The Primrose local area network
is linked to external networks so that the firm can obtain information on- line from
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Lexis (a legal database) and several financial database services.
The new system required Primrose to hire a chief information officer and director
of systems--a new position for most law firms. Four systems personnel were required to
operate the system and train lawyers. Outside trainers were also hired for a short period.
Figure 11.7 shows the estimated costs and benefits of the system. The system had
an actual investment cost of $1,210,500 in the first year (Year 0) and total cost over
six years of $3,683,000.'The estimated benefits total $6,075,000 after six years. Was
the investment worthwhile? If so, in what sense? There are financial and nonfinancial
answers to this question. Let us look at the financial models first. They are depicted
in Figure 11.8.
The Payback Method
The payback method is quite simple: It is a measure of time required to pay back the
initial investment of a project. The payback period is computed as
Original investment
= Number of years to pay back
Annual net cash inflow
In the case of Primrose, it will take about 2.3 years to pay back the initial investment. (Since cash flows are uneven, annual cash inflows are summed until they equal
the original investment in order to arrive at this number.) The payback method is a popular
method because of its simplicity and power as an initial screening method. It is especially
good for high-risk projects in which the useful life is difficult to know. If a project
pays for itself in two years, then it matters less how long after two years the system
lasts.
The weakness of this measure is its virtues: The method ignores the time value of
money, the amount of cash flow after the payback period, the disposal value (usually zero
with computer systems), and the profitability of the investment.
Accounting Rate of Return on Investment (ROI)
Firms make capital investments to earn a satisfactory rate of return. Determining a
satisfactory rate of return depends on the cost of borrowing money, but other factors
can enter into the equation. Such factors include the historic rates of return expected
by the firm. In the long run, the desired rate of return must equal or exceed the cost
of capital in the marketplace. Otherwise, no one will lend the firm money.
The accounting rate of return on investment (ROI) calculates the-rate of return from
an investment by adjusting the cash inflows produced by the investment for depreciation. It gives an approximation of the accounting income earned by the project.
To find the ROI, first calculate the average net benefit. The formula for the average net benefit is as follows:
(Total benefits-Total cost-Depreciation)
= Net benefit
Useful life
This net benefit is divided by the total initial investment to arrive at ROI(Rate
of Return on Investment). The formula is
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Net benefit
= ROI
Total initial investment
Year
0
1998
1
1999
2
2000
3
2001
4
2002
5
2003
10,000.00
10,000.00
10,000.00
10,000.00
10,000.00 10,000.00
10,000.00 10,000.00
10,000.00
10,000.00
3,000.00
500.00
500.00
500.00
500.00
500.00
15,000.00
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
150,000.00
50,000,00
50,000.00
50,000.00
50,000.00 50,000.00
50,000.00
15,000.00
10,000.00
50,000.00
15,000.00
15,000.00
2,000.00
3,000.00
15,000.00
2,000.00
3,000.00
15,000.00 15,000.00
2,000.00 2,000.00
3,000.00 3,000.00
15,000.00
15,000.00
2,000.00
3,000.00
50,000.00
22,500.00
50,000.00
10,000.00
50,000.00
10,000.00
50,000.00 50,000.00
10,000.00 10,000.00
50,000.00
10,000.00
100,000.00
240,000.00
100,000.00 100,000.00 100,000.00 100,000.00 100,000.00
240,000.00 240,000.00 240,000.00 240,000.00 240,000.00
120,000.00
1,210,500
491,500.00 491,500.00 506,500.00 491,500.00 491,500.00
Billing enhancements
Reduced paralegals
Reduced clerical
Reduced messenger
Reduced
telecommunications
350,000.00
50,000.00
50,000.00
15,000.00
10,000.00
400,000.00
100,000.00
100,000.00
30,000.00
10,000.00
Lawyer efficiencies
Total Benefits
120,000.00
595000.00
240,000.00 360,000.00 360,000.00 360,000.00 360,000.00
880000.00 1150000.00 1150000.00 1150000.00 1150000.00
Costs:
Hardware：
File Servers3@20000 60,000.00
PCs
100@3000 300,000.00
Networkcards
10,000.00
100@100
Scanners
6@500
Telecommunications
Gateways（网关）
3@5000
Cabling
150000
Telephone connect
Costs
Software：
Database
50000
Network
10000
Groupware 100@500
Windows 100@150
Services：
Nexus(连结？) 50,000
Training
300hrs@75/hro
CIO
100000
Systems Personnel
4@60000
Trainers 2@60000
Total Costs
Benefits:
500,000.00
150,000.00
100,000.00
30,000.00
10,000.00
500,000.00
150,000.00
100,000.00
30,000.00
10,000.00
500,000.00
150,000.00
100,000.00
30,000.00
10,000.00
500,000.00
150,000.00
100,000.00
30,000.00
10,000.00
要求：
1．计算回收期（年）
。
2．计算 ROI 。
全部收益合计
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3．计算本利率（=
）
全部成本合计
4．用 EXCEL 计算：(贴现率取 ５％)
（1）净现值 NPV。
（2）获利能力指数（=NPV/投资）
。
（3）内含报酬率 IRR。
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