INFO 630
Evaluation of Information Systems
Dr. Jennifer Booker
Week 10 – Chapters 16-18
INFO630 Week 10
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Income Taxes and After-Tax
Cash-Flow Streams
Chapter 16
Based on notes from Tockey
INFO630 Week 10
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Income Taxes and After-Tax Cash-Flow Streams
Outline
•
•
•
•
Taxes and income taxes, defined
Federal income taxes for corporations
Effective income tax rates
Combining effective federal, state, and
local income tax rates
• Calculating after-tax cash-flow streams
• Tax credits
• Inflation and after-tax cash-flow streams
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Taxes
• Tax
A charge, usually of money, imposed by an authority on persons or
property for public purposes, or a sum levied on members of an
organization to defray expenses
– E.g., sales tax, property tax, excise tax, …
• Income tax
– Really a tax on net income (aka profit)
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Why Important?
• Taxes can have a dramatic effect on
profitability
– Amount and timing usually know ahead of time
• Handles as expense in proposal cash-flow stream
• Income Tax another issue
– Do not know how much to pay until know how
much profit
• Rate vary and can be as high as 50%
– Including federal, state and local taxes
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US Federal Income Taxes for Corporations
Corporation’s
taxable income
$0 to $50,000
$50,001 to $75,000
$75,001 to $100,000
$100,001 to $335,000
$335,001 to $10,000,000
$10,000,001 to $15,000,000
$15,000,001 to $18,333,333
Over $18,333,334
Marginal
tax rate
15%
25%
34%
39%
34%
35%
38%
35%
Tax on net income (revenue – expense)
INFO630 Week 10
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Computing Federal Income Taxes for
Corporations
• If taxable income is $450,000
Part of
taxable income
First $50,000
Next $25,000
Next $25,000
Next $235,000
Next $115,000
Marginal
tax rate
15%
25%
34%
39%
34%
Total
INFO630 Week 10
Tax
owed
$7500
$6250
$8500
$91,650
$39,100
$153,000
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Federal Marginal Tax Rates
$120,000
•
34%
$100,000
Note: Marginal
rates are set up
to give tax break
to companies
with < $100,000
income
$75,000
34%
39%
$50,000
$25,000
•
15%
•
•
34%
25%
$50,000 $100,000 $150,000 $200,000 $250,000 $300,000 $350,000
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Effective Income Tax Rates
• Average tax rate over a range of
incomes
Tax
 Tax
t
Income
 Income
• Example
RangeTop
RangeTop
RangeBottom
RangeBottom
– What is Effective Tax Rate over range of
income between $40k and $60k?
• At $40k taxable income, tax is $6000
• At $60k taxable income, tax is $10,000
$10,000 - $6,000
t
 0.20  20%
$60,000 - $40,000
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Combining Effective Federal, State, and
Local Income Tax Rates
• State and local income taxes are
deductible as expenses on federal returns
t  EffFederalRate * (1  EffStateAndLocalRate )  EffStateAndLocalRate
• Example
– Effective federal rate is 39%
– Effective state and local rate is 7%
t  39% * (1  7%)  7%  43.3%
INFO630 Week 10
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How to address taxes
• Use before-tax MARR
– Accounts for taxes but results might not be accurate enough
for decision analysis
• Use after-tax MARR on after-tax cash flow (recall ch. 10 for
more detail).
– Example
• After-tax MARR = (Before-tax MARR) * (1-Eff Tax Rate)
• E.g. Before-tax MARR = 21%, Eff tax rate = 38%
After-tax MARR = 0.21 * (1-0.38) = 0.13 = 13%
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Recall Minimum Attractive Rate
of Return (MARR)
• A statement that the organization is
confident it can achieve at least that rate
of return
• Aka “Opportunity cost”
– By investing in A, you forego the opportunity
to invest in B
– If you’re confident you can get X% there, all
other alternatives should be evaluated against
that X%
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REVIEW - Significance of the
MARR
• The MARR is used as the interest rate
in for-profit business decisions
– PW(MARR) = how much more, or less,
valuable that alternative is than investing
same $ in an investment that returns the
MARR
• i.e., PW(MARR) = $1000 doesn’t really mean
you’ll gain just $1000, it means that the cashflow stream is equivalent to $1000 more today
than investing those same resources in
something that returns the MARR
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REVIEW - Significance of the
MARR
– Note: MARR is usually set by policy
decision from organization’s management
team
• Too high or too low?
• How set?
• Impact?
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After Tax Cash Flow Stream
How to calculate
• Need to know four pieces of information
– Before-tax cash-flow
– Loan principal and interest payments (ch 6)
– Depreciation accounting (ch 14)
– Effective income tax rate (this chapter)
• Most straight forward method
– Use table on next page
• Income – positive number
• Expense – negative number
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Calculating After-Tax
Cash-Flow Streams
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
…
…
N/A
…
N/A
…
…
…
1
…
…
…
…
…
…
…
…
2
…
…
…
…
…
…
…
…
3
…
…
…
…
…
…
…
…
4
…
…
…
…
…
…
…
…
5
…
…
…
…
…
…
…
…
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An Example Project (From Ch 3 lecture):
Automated Test Equipment (ATE)
• Assume one person-year of labor = $125k
• Initial investment
– $300k for test hardware and development equipment (Year 0)
– 20 person-years of software development staff (Year 1)
– 10 person-years of software development staff (Year 2)
• Operating and maintenance costs
– $30k per year for test hardware and dev equipment (Years 1-10)
– 5 person-years of software maintenance staff (Years 3-10)
• Sales income
– None
• Cost avoidance
– $1.3 million in reduced factory staffing (Years 2-10)
• Salvage value
– Negligible
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The ATE Example – Cash Flow Stream
$645K
0
1
$20K
2
-$300K
-$2.53M
3
4
5
6
7
8
9
10
Example from Ch 3 Lecture Slides
To get to the next slide, assume:
Loan is ($250k, 8%, 5 year, annual pmts)
depreciable investment ($300K hardware)
depreciation method (MACRS, 5 year)
Effective income tax rate (36%)
company profitable overall
INFO630 Week 10
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After-Tax Cash-Flow Stream for
ATE
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
$0
$250K
N/A
-$300K
N/A
$0
$0
-$50K
1 -$2.53M -$43K -$20K
-$60K
-$2.61M
$937K
-$1.65M
2
$20K
-$46K -$17K
-$96K
-$93K
$33K
-$9K
3
$645K
-$50K -$13K
-$58K
$574K
-$207K
$376K
4
$645K
-$54K
-$9K
-$35K
$601K
-$216K
$366K
5
$645K
-$58K
-$5K
-$35K
$605K
-$218K
$365K
6
$645K
-$17K
$628K
-$226K
$419K
7
$645K
$645K
-$232K
$413K
8
$645K
$645K
-$232K
$413K
9
$645K
$645K
-$232K
$413K
10 $645K
$645K
-$232K
$413K
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Tax Credits
• At a given effective income tax rate, each
additional dollar of income gives (before tax)
$1.00 – (Effective income tax rate as cents) of additional after-tax income
– E.g., at 36% effective income tax rate
$1.00 – (0.36) = $0.64
• Tax credits, in contrast, are added directly
to the after-tax cash-flow stream
– $1 in tax credit gives $1 in after-tax income
Note: Currently there are no tax credits for software related activities
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Tax Credits
• Purpose
– Used to stimulate investment in a particular
area of economy
• Example
EOY0 = end of year zero
– Next slide
– $300k investment at EOY0 leads to $30k
investment tax credit, EOY0 after-tax cashflow instance -$50k +$30k  -$20k
• Compared to slide 19
• See underlined area on next slide
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After-Tax Cash-Flow Stream
with 10% Investment Credit
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
$0
$250K
N/A
-$300K
N/A
$0
$0
-$20K
1 -$2.53M -$43K -$20K
-$60K
-$2.61M
$937K
-$1.65M
2
$20K
-$46K -$17K
-$96K
-$93K
$33K
-$9K
3
$645K
-$50K -$13K
-$58K
$574K
-$207K
$376K
4
$645K
-$54K
-$9K
-$35K
$601K
-$216K
$366K
5
$645K
-$58K
-$5K
-$35K
$605K
-$218K
$365K
6
$645K
-$17K
$628K
-$226K
$419K
7
$645K
$645K
-$232K
$413K
8
$645K
$645K
-$232K
$413K
9
$645K
$645K
-$232K
$413K
10 $645K
$645K
-$232K
$413K
NOTE $300k investment at EOY0 leads to $30k investment tax credit, EOY0 after-tax cash-flow instance $50k  -$20k
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Inflation and After-Tax Cash-Flow Streams
• Some cash-flow components are affected by inflation …
– Revenues, O&M costs, future salvage values, etc.
• … and some are not
– Loan repayment schedules, lease fees, depreciation amounts,
etc.
• When calculating after-tax cash-flows from before-tax
cash-flows, use actual dollar analysis
– Separate constant dollar components from actual dollar
components and apply inflation adjustments only to actual
dollar components
INFO630 Week 10
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Recall - Accounting for Inflation
(Ch 13)
Two Methods
• Actual dollar analysis
– Cash-flow instances represent actual out-ofpocket dollars paid/received at that time
– Aka current dollars, escalated dollars, inflated
dollars, …
• Constant dollar analysis
– Cash-flow instances represent hypothetical
constant purchasing power amounts
– Aka real dollars, deflated dollars, today’s
dollars, …
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REVIEW - Actual-Constant Dollar Analogy
Rock on shore
(Beginning of planning horizon)
Boat speed through water
(Interest)
Ball
River speed
(Inflation)
Distance between boat and rock
(Constant dollars)
Distance between boat and ball
(Actual dollars)
Does this analogy help anyone? Just curious…
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Key Points
• Most taxes can be estimated beforehand, income taxes
cannot
• “Income tax” is really a tax on profit
• Federal tax rates are “marginal rates”
• Effective income tax rates approximate actual income tax
rates over ranges of taxable incomes (to simplify
computations)
• State and local income taxes are deductible from federal
income taxes
• A table for calculating after-tax cash-flow streams is helpful
• Tax credits add directly to after-tax income
• Inflation affects elements of cash-flow streams differently
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Consequences of
Income Taxes on
Business Decisions
Chapter 17
Based on notes from Tockey
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Consequences of Income Taxes
Outline
• Additional Areas that may be impacted by
income taxes
–
–
–
–
–
–
Interest expenses and income taxes
Interest income and income taxes
Depreciation method and income taxes
Depreciation recovery period and income taxes
Capital gains and losses for corporations
Gain or loss when selling or scrapping depreciable
assets
– Comparing financing methods in after-tax cash-flow
terms
– After-tax analysis of replacements
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Interest Expenses and Income
Taxes
• Most loan interest is deductible
– Effectively reduces the interest rate
• Example
– P-Systems and Q-Soft have identical incomes
($465k) and all other expenses
– P-Systems averages $200k in loans at 9%,
Q-Soft has no loans
P-Systems
Q-Soft
Income before interest deduction
Interest expense
Taxable income
Taxes (effective rate, 36%)
INFO630 Week 10
$465,000
$18,000
$447,000
$160,920
$465,000
$0
$465,000
$167,400
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Interest Expenses and
Income Taxes (cont)
• P-Systems pays $6480 less income tax
– Subtracting this from their interest expense means P-Systems
effectively paid only $11,520 in interest
$11,520
= 0.0576 = 5.76%
$200,000
• In general
EffectiveAfterTaxInterestRate = (1-EffectiveIncomeTaxRate) * LoanInterestRate
P-Systems’ EffectiveAfterTaxInterestRate = (1-36%) * 9% = 5.76%
Result: When interest rates are tax deductible, borrowing money might not
be quite as expensive.
www.ischool.drexel.edu
Interest Income and Income
Taxes
• Most interest income (loan) is considered
taxable
– Interest from municipal bonds is an exception
• Usually exempt from federal income tax
• Two bonds to compare (more in Ch 18)
– $10k municipal bond at 9%
– $10k corporate bond at 12%
– Buyer’s effective income tax rate = 35%
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Interest Income and Income
Taxes (cont)
• Comparing in pre-tax terms
– IRR of $10k corporate bond is 12%
– IRR of $10k municipal bond is 9%
• Comparing in post-tax terms
Result: “Income
taxes can
significantly impact
the desirability of
alternatives”
– Corporate bond’s $1200 interest is taxed at 35%,
or $420
• Actual after-tax income is $780
– After-tax IRR of $10k corporate bond is 7.8%
– After-tax IRR of $10k municipal bond is still 9%
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Depreciation Method and
Income Taxes
• Depreciation method (Ch 14) will affect the after-tax cash-flow
stream
– Two depreciation methods
• Straight-line
• 150% declining balance switch to straight line
• Example
–
–
–
–
–
–
–
–
Q-Soft is starting a new ASP line of business
7 year planning horizon
Non-depreciable cash-flow stream shown
$120K of depreciable expenses, 5 year useful life
No borrowing
Profitable overall
Effective income tax rate is 38%
After-tax MARR is 17%
INFO630 Week 10
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After Tax Cash Flow
5-Year Straight-Line Depreciation
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
1
2
3
4
5
6
7
-$40K
$20K
$40K
$80K
$90K
$70K
$50K
$30K
$0
N/A
-$120K
N/A
-$24K
-$24K
-$24K
-$24K
-$24K
INFO630 Week 10
-$40K
-$4K
$16K
$56K
$66K
$46K
$50K
$30K
$15.2K
$1.5K
-$6.1K
-$21.3K
-$25.1K
-$17.4K
-$19.0K
-$11.4K
-$144.8K
$21.5K
$33.9K
$58.7K
$64.9K
$52.5K
$31.0K
$18.6K
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After Tax Cash Flow
150% Declining-Balance Switching
to Straight-Line Depreciation
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
1
2
3
4
5
6
7
-$40K
$20K
$40K
$80K
$90K
$70K
$50K
$30K
$0
N/A
-$120K
N/A
-$36.0K
-$25.2K
-$24.0K
-$24.0K
-$10.8K
INFO630 Week 10
-$40K
-$16K
$15K
$56K
$66K
$59K
$50K
$30K
$15.2K
$6.1K
-$5.6K
-$21.3K
-$25.1K
-$22.5K
-$19.0K
-$11.4K
-$144.8K
$26.1K
$34.4K
$58.7K
$64.9K
$47.5K
$31.0K
$18.6K
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Comparing Depreciation
Methods After Taxes
Straight
line
PW(17) of the depreciation amounts
-$76,784
PW(17) of the income tax payments
-$33,791
PW(17) of the after-tax cash flow stream $1040
After tax IRR
17.25%
150% Declining-balance
switching to straight-line
-$81,897
-$31,848
$2983
17.74%
NOTE: Which is better? Why?
• From after tax perspective - 150% switching to straight
- More tax dollars avoided earlier, just from changing
depreciation strategy
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Depreciation Recovery Period
and Income Taxes
• Depreciation recovery period also affects the
after-tax cash-flow stream
– In general it is better to write off more dollars
sooner from an after-tax perspective
– Shorter recovery periods better than long ones
– Note: Might lead to higher taxes in later years, but
PW of after-tax cash-flow stream will be greater
• Try the same Q-Soft example with 3-year
straight-line depreciation
INFO630 Week 10
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3-Year Straight-Line Depreciation
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
-$40K
$0
N/A
-$120K
N/A
-$40K
$15.2K
-$144.8K
1
$20K
-$40K
-$20K
$7.6K
$27.6K
2
$40K
-$40K
$0K
$0.0K
$40.0K
3
$80K
-$40K
$40K
-$15.2K
$64.8K
4
$90K
$90K
-$34.2K
$55.8K
5
$70K
$70K
-$26.6K
$43.4K
6
$50K
$50K
-$19.0K
$31.0K
7
$30K
$30K
-$11.4K
$18.6K
INFO630 Week 10
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Comparing Depreciation
Recovery Periods After Taxes
From
slide 34
PW(17) of the depreciation amounts
PW(17) of the income tax payments
PW(17) of the after-tax cash flow stream
After tax IRR
5-year
straight-line
-$76,784
-$33,791
$1040
17.25%
3-Year
straight-line
-$88,383
-$29,383
$16,324
20.86%
NOTE:
• 3-year higher PW of depreciation amounts and lower PW income
taxes because of accelerated write offs
• PW of after tax cash-flow stream and IRR favor 3-year
• Conclusion: from after-tax perspective the sooner you can write off, the
better
INFO630 Week 10
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Capital Gains and Losses for
Corporations
• Ordinary income comes from activity
– Capital gain comes from increase in value
without explicit activity
– Capital loss is opposite
• “Short-term” gains are <1 year
– Long-term gains are >1 year
– Taxes on short-term and long-term gains may
be different
INFO630 Week 10
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Capital Gains and Losses for
Corporations (cont)
• Recently, capital gains were taxed like ordinary income
but with a 34% limit
– Capital gains could be taxed at less than, or equal to, 34%, but
not more
• Examples ( See Income tax rates Ch 16)
– AlphaSystems has $55k of ordinary income and $20k of capital
gain, capital gain would be taxed at 25%
– BetaSystems has $80k of ordinary income and $20k of capital
gain, capital gain would be taxed at 34%
– GammaSystems has $180k of ordinary income and $20k of
capital gain, capital gain would be taxed at 34% (even though
GammaSoft is otherwise in a 39% bracket)
INFO630 Week 10
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Capital Gains and Losses for
Corporations (more)
• May be restrictions on addressing capital losses
– Only usable to offset capital gains
– Can carry capital losses back up to 3 years, carry forward up to 5
• This is why politicians make such a big deal about
capital gains taxes!
• Examples
– DeltaSystems has no ordinary income , $10k of capital loss this
year, and $20k of capital gain last year  amend last year’s tax
return to only $10k of capital gain
– ThetaSystems has no ordinary income , $10k of capital loss this
year, and no capital gain for last 3 years  capital loss is held in
reserve against future gains for up to 5 years
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Gain or Loss When Selling or
Scrapping Depreciable Assets
• When a depreciable asset is sold or
scrapped, the difference between its book
value and amount received needs to be
addressed
– Amounts less than book value subtract from
ordinary income
– Amounts greater than book value add to
ordinary income (“depreciation recapture”)
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Comparing Financing Methods
in After-Tax Cash-Flow Terms
• When buy asset
– Three ways of paying for assets
• Buy with retained earnings
– Buy with money already earned as profit
– Owned entirely by company
– All tax benefits from ownership is available
• Buy with a loan
– Borrow all or part of acquisition costs
• Lease
– Lease fee’s deductible as ordinary expense
– Tax consequences are different for each
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Comparing Financing Methods
in After-Tax Cash-Flow Terms
Example: OmegaSoft buys $60k in
equipment to support ASP service
– $9000 annual operating and maintenance
costs
– 7 year planning horizon
– MACRS 5 year depreciation
– OmegaSoft is profitable overall
– Effective income tax rate is 43%
– After-tax MARR is 10%
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Buy With Retained Earnings
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0
0.0K
N/A
-$60K
N/A
$0K
$0K
-$60.0K
1
-$9.0K
-$12.0K
-$21.0K
$9.0K
$0.0K
2
-$9.0K
-$19.2K
-$28.2K
$12.1K
$3.1K
3
-$9.0K
-$11.5K
-$20.5K
$8.8K
-$0.2K
4
-$9.0K
-$6.9K
-$15.9K
$6.8K
-$2.2K
5
-$9.0K
-$6.9K
-$15.9K
$6.8K
-$2.2K
6
-$9.0K
-$3.5K
-$12.5K
$5.4K
-$3.6K
7
-$9.0K
-$9.0K
$3.9K
-$5.1K
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Buy With 13% Loan
(B)
Before(A) tax
End Cash(C)
(D)
(E)
(F)
of
flow
Loan
Loan Depreciable Depreciation
Year Stream Principal Interest Investment
Expense
0
0.0K
$60K
N/A
-$60K
N/A
1
-$9.0K
-$5.8K -$7.8K
-$12.0K
2
-$9.0K
-$6.5K -$7.1K
-$19.2K
3
-$9.0K
-$7.4K -$6.2K
-$11.5K
4
-$9.0K
-$8.3K -$5.2K
-$6.9K
5
-$9.0K
-$9.4K -$4.2K
-$6.9K
6
-$9.0K -$10.6K -$2.9K
-$3.5K
7
-$9.0K -$12.0K -$1.6K
(H)
Income
(I)
(G)
Tax
After-tax
Taxable Cash-flow
Cash-flow
Income
Stream
Stream
(B+D+F) (–Rate*G) (B+C+D+E+H)
$0K
$0K
$0.0K
-$28.8K
$12.4K
-$10.2K
-$35.3K
$15.2K
-$7.4K
-$26.7K
$11.5K
-$11.1K
-$21.1K
$9.1K
-$13.4K
-$20.1K
$8.6K
-$14.0K
-$15.4K
$6.6K
-$15.9K
-$10.6K
$4.6K
-$18.0K
Note: $60k loan, 13%, 7 years, annual payments
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Lease
(B)
(H)
BeforeIncome
(I)
(A) tax
(G)
Tax
After-tax
End Cash(C)
(D)
(E)
(F)
Taxable Cash-flow
Cash-flow
of
flow
Loan
Loan Depreciable Depreciation Income
Stream
Stream
Year Stream Principal Interest Investment
Expense
(B+D+F) (–Rate*G) (B+C+D+E+H)
0 -$12.0K
N/A
N/A
-$12.0K
$5.2K
-$6.8K
1 -$21.0K
-$21.0K
$9.0K
-$12.0K
2 -$21.0K
-$21.0K
$9.0K
-$12.0K
3 -$21.0K
-$21.0K
$9.0K
-$12.0K
4 -$21.0K
-$21.0K
$9.0K
-$12.0K
5 -$21.0K
-$21.0K
$9.0K
-$12.0K
6 -$21.0K
-$21.0K
$9.0K
-$12.0K
7
-$9.0K
-$9.0K
$3.9K
-$5.1K
Note: $12K annual lease payments at end of all but last year
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Comparing Financing Methods
After Taxes
PW(10%)
Buy with retained earnings
Buy with loan
Lease
-$59,116
-$54,393
-$56,005
Note: Looking at expenses only since this is a service alternative.
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Loans, Interest Rates, and MARRs
• In prior example, why borrow at 13% when MARR is
10%?
– In this example loan interest rate is before-tax and MARR is
after-tax
• When effective tax rate is 43%, actual after-tax cost of
borrowing is
(1 - 43%)  13%  7.41%
• At an effective income tax rate of 43%, a 10% after-tax
loan interest rate is equivalent to a before-tax loan
interest rate of
10%
 17.5%
(1 - 43%)
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Buy With 17.5% Loan
(B)
Before(A) tax
End Cash(C)
(D)
(E)
(F)
of
flow
Loan
Loan Depreciable Depreciation
Year Stream Principal Interest Investment
Expense
0
0.0K
$60K
N/A
-$60K
N/A
1
-$9.0K
-$5.0K -$10.5K
-$12.0K
2
-$9.0K
-$6.0K -$9.6K
-$19.2K
3
-$9.0K
-$6.9K -$8.6K
-$11.5K
4
-$9.0K
-$8.1K -$7.4K
-$6.9K
5
-$9.0K
-$9.6K -$6.0K
-$6.9K
6
-$9.0K -$11.2K -$4.3K
-$3.5K
7
-$9.0K -$13.2K -$2.3K
(H)
Income
(I)
(G)
Tax
After-tax
Taxable Cash-flow
Cash-flow
Income
Stream
Stream
(B+D+F) (–Rate*G) (B+C+D+E+H)
$0K
$0K
$0.0K
-$31.5K
$13.5K
-$11.0K
-$37.8K
$16.3K
-$8.3K
-$29.1K
$12.5K
-$12.0K
-$23.3K
$10.0K
-$14.5K
-$21.9K
$9.4K
-$15.2K
-$16.8K
$7.2K
-$17.3K
-$11.3K
$4.9K
-$19.6K
Note: $60k loan, 17.5%, 7 years, annual payments
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Loans, Interest Rates, and MARRs (cont)
PW(10%)
Buy with retained earnings
Buy with 17.5% loan
-$59,116
-$59,101

Conclusion: As long as the after-tax loan interest rate
is less than the after-tax MARR, buying with a loan is
better than buying with retained earnings
•
Because MARR represents opportunity cost, buying
with retained earnings prevents opportunity to invest
@ MARR. As long as (after-tax loan interest rate) <
(after-tax MARR), cost of money used is less.
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After-Tax Analysis of Replacements
• Income tax has special effects on
replacement decisions
– Existing assets (defenders)
• Defer possible depreciation recapture
– Replacement alternatives (challengers)
• Might lead to tax credits
• Need depreciation schedules determined
• Replacement analysis needs to be done in
after-tax terms to avoid making a wrong
decision
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Key Points
• Deducting loan interest effectively reduces
the loan interest rate
• Interest income is usually considered
taxable income
• Depreciation methods that allow you to
write off more of the value sooner are
better
• Shorter depreciation recovery periods are
also better
• Capital gain comes from an increase in the
value of something and can affect taxes
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Key Points
• When a depreciable asset is sold or scrapped,
any difference between its book value and the
actual amount received needs to be accounted
for in the corporation’s income taxes
• Buying with retained earnings, a loan, or leasing
affects the after-tax cash flow stream
– Buying with a loan may actually be the least
expensive
• After-tax replacement analysis should address
depreciation recapture for existing assets,
depreciation accounting for new assets, and
potential tax credits
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Not-for-profit Business
Decisions
Chapter 18
Based on notes from Tockey
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Not-For-Profit Business Decisions
Outline
•
•
•
•
•
•
Introducing not-for-profit decisions
Software and governments
Software and nonprofit organizations
Benefit-cost analysis for single proposals
Benefit-cost analysis for multiple proposals
Cost effectiveness analysis
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Introducing Not-for-profit Decisions
• For-profit decision techniques don’t apply
when the organization’s goal isn’t profit
– E.g., government and nonprofit organizations
• Not-for-profits have different goals, so
different decision techniques are needed
– Benefit-cost analysis
– Cost-effectiveness analysis
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Software and Governments
• “But the government doesn’t do software”
– The Department of Defense (DoD) is probably the single largest
customer of software development in the US
– The U. S. Internal Revenue Service (IRS) has been processing
Form 1040s by computer since the early 1980’s
– Many state and local agencies have been moving toward
computer-based support of 911 emergency call centers, welfare
administration, public schools, …
– Some states, counties, and larger cities are using Enterprise
Resource Planning (ERP) packages for payroll, inventory
management, and so on
• With each passing year, more and more software is
being used (and developed) in the public sector
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The Aim of Government
• According to the U. S. Constitution, two
primary drivers of the U. S. Federal
Government:
– National defense
– General welfare of the population
• Smaller government units (states,
counties, and cities) should follow this
same general objective
– Maximize the general welfare of the
constituents in that unit
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The Nature of Public Activities
• Public activities tend to be inherently inefficient
– Government services are hard to put a dollar value on
• What is the value of a fire department, a jail, an elementary school,
etc?
– Government projects tend to serve more than one purpose
• A dam is both
– New power source
– New recreational facility
– When services are paid for (taxes)
• People’s use might be disconnected from when those services are
received
– You might not pay for service when you receive it
– Hard to associate value of money spent
– Where do property tax dollars go?
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The Nature of Public Activities
• Public activities tend to be inherently inefficient
– Lack of correlation between the benefits any one person gets
and how much he or she pays for them
• Taxation is often based on ability to pay
• Spending is based on equalizing opportunity
– The government is the sole provider of many services
• Lack of competition  no need to worry about efficient use
of taxpayer funds
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Financing Government Activities
• Taxes
– Corporate income, individual income, property, excise, estate, import
duties, ...
• Fee-for-use
– Post Office, public utilities like power and water, government-run parks
and museums, etc.
• Bonds
– Like an interest-only loan
• how much to borrow, how long, etc.
– Types
• General obligation bond
– Backed by ability to tax
• Revenue bond
– Backed by anticipated income from project
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Cash-flow Diagram for a Bond
CFD for a 10-year, $5000 bond at 8%.
$5400
$400 $400 $400 $400 $400 $400 $400 $400 $400
0
1
2
3
4
5
6
7
8
9
10
-$5000
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Software and Nonprofit
Organizations
• More and more nonprofit organizations are either using commercial
software or are developing their own
• The goal is to increase the general welfare of a given population
– The Object Management Group (OMG) develops “technically excellent,
commercially viable and vendor independent specifications for the
software industry”
– Institute for Electrical and Electronics Engineers (IEEE)
– Association for Computing Machinery (ACM)
– Internet Engineering Task Force (IETF), part of The Internet Society
(ISOC)
– Software Productivity Consortium (SPC)
• Nonprofit organizations are typically financed through membership
fees, fee-for-use, donations, and (in some cases) government grants
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Decision Analysis in Government and
Nonprofit Organizations
• A rural public utility district (PUD) needs to choose
between computerizing its billing system and
computerizing inventory management
– Has enough money for one of these, but not both
• PUD can’t base the decision on profit because neither
will generate any directly measurable income
– Choice needs to be based on which contributes more to the
general welfare of the citizens
– If PUD can consider the benefits of either in relation to its cost,
they can establish a basis for choice
– This is the foundation for Benefit-cost Analysis (or cost-benefit
analysis)
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Benefit-Cost Analysis
• One of the most widely used methods for
evaluating nonprofit proposals
• The U. S. Flood Control Act of 1936 is
generally acknowledged as the first
description of this technique
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Flood Control Act of 1936
“It is hereby recognized that destructive floods upon the rivers of the United
States, upsetting orderly processes and causing loss of life and property,
including the erosion of lands, and impairing and obstructing navigation,
highways, railroads, and other channels of commerce between the States,
constitute a menace to national welfare; that it is the sense of Congress that
flood control on navigable waters or their tributaries is a proper activity of
the Federal Government in cooperation with the States, their political
subdivisions, and localities thereof; that investigations and improvements of
rivers and other waterways, including watersheds thereof, for flood-control
purposes are in the interest of the general welfare; that the Federal
Government should improve or participate in the improvement of navigable
waters or their tributaries, including watersheds thereof, for flood control
purposes if the benefits to whomsoever they may accrue are in excess of
the estimated costs, and if the lives and social security of people are
otherwise adversely affected”
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Benefit-Cost Analysis for a
Single Proposal
•
“Benefits to whomsoever they may accrue”
– Measurable advantages to the population caused by the proposal,
minus any measurable “dis-benefits”
– Always in the context of that population
• Costs
– All expenses, minus all savings, incurred by the sponsor
– Includes initial investment and ongoing operating and maintenance
costs
– Always in the context of the sponsor
• Cost savings aren’t benefits to the population; they are reductions in
expenses to the sponsor
– Adding an amount to the numerator does not have the same effect as
subtracting the same amount from the denominator
• Incorrect accounting of sponsor savings can result in misleading
benefit-cost ratios
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Benefit-Cost Analysis for a
Single Proposal
• Benefits and costs can be expressed in any basis for
comparison
– PW(i), AE(i), FW(i), ...
– Use same basis for both
• Comparing PW(i) benefits to AE(i) costs would be extremely
misleading
• A proposal is only desirable when its net benefits are
greater than its net costs
Benefits Costs
or
• Leads to idea of benefit-cost ratio:
INFO630 Week 10
 Benefits 

 1
 Costs 
 Benefits To Public
BC(i)  
 Costs To Sponsor





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Benefit-Cost Analysis for a
Single Proposal
• Any proposal with BC(i) < 1 can usually
be discarded without further analysis
– It costs more than it would benefit
– Only reason to continue would be when there
are overriding irreducible benefits or the
investment is mandated for some other
reason (e.g. legislation)
• Proposals should also be discarded if the
initial investment can’t be afforded
– A proposal with an enormous BC(i) is
irrelevant if the initial investment is too high
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Proper Point of View
• Important when analyzing proposal
• Points of view are typically based on:
– Geography—everybody who lives or works in some
particular area
– Social groups—peoples interested in some particular
issue
– Organizations—members of a particular group (e.g.,
union)
– Products or markets—e.g., agricultural markets,
fisheries markets, etc.
– ...
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Proper Point of View
• Identify everyone who would:
– Benefit from the proposal
• Utility customers—bills would be more accurate
and timely, less likely to have their payment lost or
forgotten
– Be adversely impacted by the proposal
• PUD managers or clerks could lose their jobs
because computerization makes them no longer
necessary
– Pay for the proposal
• PUD would pay for the proposal
• Part might be paid through state or federal grants
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Identifying Benefits,
Dis-Benefits, and Costs
• Don’t analyze benefits and costs before and
after the proposal
– There may have been changes independent of the
proposal
• Evaluate benefits and costs with and without the
proposal
– Only changes caused by the proposal itself are
important in benefit-cost analysis
• All benefits and costs that have a market value
need to be represented in terms of money
– Those that don’t have market value should also be
included (“irreducibles” in Chapter 4)
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Identifying Benefits,
Dis-Benefits; Two Types
• Primary benefits represent value to the public
of direct products or services from the
proposal
– U. S. Federal Aviation Administration’s (FAA) Air
Traffic Modernization program intends to support
more airplanes and allow more fuel-efficient
routing
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Identifying Benefits,
Dis-Benefits; Two Types
• Secondary benefits are additional products and
services gained from the activities of, or stimulated
by, the project
– Commercial hand-held Global Positioning System (GPS) is a
secondary benefit of military investment in navigation
– National Aeronautics and Space Administration (NASA)
space program has led to secondary benefits like:
• World-wide communication, satellite imagery, climate
research and long-range weather forecasting, highdensity batteries, solar cells, advanced materials and
structural designs, advanced food processing and waste
purification systems, …
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Valuing Benefits, Dis-Benefits,
Costs, and Savings
• If component has a market price, that price
might be appropriate way to value the
component
– Market price isn’t always accurate because of
subsidies, price supports, or restraints
• Find the least expensive way to provide that
same service
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Valuing Benefits, Dis-Benefits,
Costs, and Savings
• Estimate what a user is willing to pay by seeing
how much he/she spends to take advantage of it
– Common method for finding the “value” of
recreational facilities like parks is to multiply the
expected number of visitors by the anticipated
entrance fee
• Could be impossible to assign some values
– Inappropriate to value fish in a river by multiplying the
estimated pounds of it by the market price of that kind
of fish
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Valuing Benefits, Dis-Benefits,
Costs, and Savings
Example – 10 year planning horizon
•
PUD estimates customers spend hundreds of hours each year fixing
billing problems
– Considering average income for customers and annual increase in
customers, PUD estimates this is worth $42,000 in AE(i) terms
– Some customers will need to buy computers and pay ISP connection fees
estimated at $3000 in AE(i) terms
– AE(i) net benefits to public are $39,000
•
PUD estimates hardware and software costs for both acquisition and
support, in AE(i) terms, are $44,000
– PUD billing department is overworked, combining annual overtime bill with
growth rate in customers, estimates savings are $7000 in AE(i) terms
– PUD also estimates that reduction in missing and late payments each year,
in light of annual growth rate, will be worth $3,000 in AE(i) terms
– AE(i) net cost to PUD is $34,000
•
BC(i) = $39,000 / $34,000 = 1.15
– BC(i) > 1.00 so this proposal is worth considering further
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Choosing an Interest Rate
• Benefits and costs need to be expressed in a common
form
– PW(i), FW(i), AE(i), …
• The interest rate used needs to reflect the actual cost of
money
– For a government agency, this could be the interest rate on
bonds issued to finance the project
– Another way is to look at the rate that could have been earned
by the citizens if the money hadn’t been removed from the
private sector
• Use the more appropriate rate in any particular situation
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Summarizing Benefit-Cost
Analysis for Single Proposals
• Unless there is some overriding reason, a proposal with
BC(i) <= 1.00 should be dropped
• If the organization can’t afford the proposal’s initial
investment, the benefit is irrelevant
– Proposals should be dropped here, too
• If PUD can afford the initial investment in the billing
computerization proposal, its BC(i) = 1.15 means this
project deserves further investigation
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Benefit-Cost Analysis for
Multiple Proposals
• May be possible to carry out more than one proposal at
a time
– May also have dependencies among proposals
• Use Chapter 9 process to build mutually exclusive
alternatives
– Dependencies, exclusivities, budget constraints, etc
– Benefits for an alternative will be sum of benefits for all
proposals in that alternative
– Costs will be sum of costs for all proposals in that alternative
– All benefits and costs need to be in the same terms, PW(i),
FW(i), AE(i), …
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Multiple BC(i) Requires Incremental Analysis
• Table shows PW(i) benefits, PW(i) costs, and BC(i) for
four mutually-exclusive alternatives
Alternative
A1
A2
A3
A4
PW(i) Benefits
$136,500
125,200
71,200
86,300
PW(i) Costs
$68,600
59,600
37,500
58,900
BC(i)
1.99
2.10
1.89
1.47
– A2 looks best because it has highest BC(i)
• Benefit-cost analysis with multiple alternatives must be
done incrementally
– Don’t think of highest overall BC(i)
– Think of the incremental benefit gained from an avoidable
increment of cost
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Incremental Analysis for Multiple BC(i)
Alternatives
Sort alternatives in order of increasing cost
Alternative with lowest cost is defender
{* As long as proposals with BC(i) < 1 have
been
discarded, you can skip the A0 (do
nothing)
alternative *}
Repeat
Alternative with next lowest cost is challenger
Incremental benefit = challenger benefit defender benefit
Incremental cost = challenger cost defender cost
Incremental BC(i) = incremental benefit /
incremental cost
If incremental BC(i) > 1.0
then challenger becomes defender
Until there are noINFO630
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Incremental Analysis for Multiple BC(i)
Alternatives—Example
• Sort alternatives in order of increasing costs
– A3, A4, A2, A1 (assuming all proposals have BC(i) > 1.0)
• First incremental choice is between A3 and A4
$86,300 - $71,200
$15,100
=
= 0.71
$58,900 - $37,500
$21,400
BC(i) =
– Incremental BC(i) <= 1.0, A3 remains defender
• Next incremental choice is between A3 and A2
BC(i) =
$125,200 - $71,200
$87,700
=
= 4.00
$59,600 - $37,500
$22,100
– Incremental BC(i) > 1.0, A2 becomes defender
• Last incremental choice is between A2 and A1
BC(i) =
$136,500 - $125,200
$11,300
=
= 1.26
$68,600 - $59,600
$9,000
– Incremental BC(i) > 1.0 so A1 is best
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Explaining Incremental BC(i) Analysis
Incremental BC(i)
A2
A1
2.10
$136,500
.
$125,200
.
1.99
1.26
1.00
Benefit
$59,600
$68,600
Cost
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Cost-Effectiveness Analysis
• Originated in the defense and space community
– Informally, “getting the biggest bang for the buck”
• Shares same philosophy and methodology with BC(i)
analysis
– Derived from benefit-cost analysis
• Three requirements for using Cost-effectiveness
Analysis:
– Problem must be bounded
– More than one possible solution to that problem
– Proposals are all valid solutions to that problem
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Cost-Effectiveness Analysis (cont)
• Two versions of cost-effectiveness analysis
– Fixed-cost maximizes benefit given an upper bound on cost
• Many software projects have a fixed Software Quality
Assurance (SQA) budget: plan and execute SQA within that
budget to maximize the probability of uncovering software
defects
• This is, literally, the biggest-bang-for-the-buck approach
– Fixed-effectiveness minimizes cost given a lower bound on
effectiveness
• In SQA this would mean planning and executing to get the
required level of reliability for the least cost
• Safety-critical or mission-critical software is more likely to use
this approach
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Measures of Effectiveness
• Measures of effectiveness need not be dollars
– In fact they probably won’t be
– If effectiveness could be measured in dollars then the analysis
could be done with Benefit-cost analysis
• Examples
– SQA group may define effectiveness as defects found before the
software is released to customer
– Number of controlled files handled by a revision control system
might be a measure of effectiveness
• Measure of effectiveness needs to be relevant to the
organization
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Steps in Cost-Effectiveness Analysis
1. Define goal(s)
2. Develop proposals that achieve goal(s)
1. Use optimum configurations for each alternative
3. Establish evaluation criteria for both cost and
effectiveness
1. May be other evaluation criteria in addition to cost and
effectiveness
2. Evaluation criteria should be prioritized
4. Choose fixed-cost or fixed-effectiveness approach
5. Analyze alternatives against evaluation criteria
1. Candidates that exceed fixed-cost or fall short of fixedeffectiveness can be dropped
2. Analyze remaining candidates in more detail to make final
choice
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Example Cost-Effectiveness
Analysis
1. Goal: find best inventory management software for
PUD
2. Proposals: buy from V1, buy from V2, lease from V3,
build in-house
3. Evaluation criteria are cost and amount of inventory
managed
Proposal
Buy V1
Buy V2
Lease V3
Build
PW(i) Cost
$256K
455K
242K
420K
Amount of inventory
565K
790K
580K
680K
4. Choose fixed-cost or fixed-effectiveness (key choice!)
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Fixed-Cost Example
•
Assume maximum budget of $300K
Proposal
Buy V1
Buy V2
Lease V3
Build
•
PW(i) Cost
$256K
455K
242K
420K
Amount of inventory
565K
790K
580K
680K
Analyze remaining candidates in more detail to make
final choice
–
–
–
Buy from V1 has 565K units for $256K = 2.2 units/$
Lease from V3 has 580K units for $242K = 2.4 units/$
Choose lease from V3 (more stuff per $)
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Fixed-Effectiveness Example
•
Assume minimum effectiveness of 650K units
Proposal
Buy V1
Buy V2
Lease V3
Build
•
PW(i) Cost
$256K
455K
242K
420K
Amount of inventory
565K
790K
580K
680K
Analyze remaining candidates in more detail to make
final choice
–
–
–
Buy from V2 has 790K units for $455K = 1.7 units/$
Build produces 680K units for $420K = 1.6 units/$
Choose buy from V2
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Key Points
• Government isn’t driven by profit, neither are non-profit
organizations
– Goal is to promote general welfare of respective populations
– Decision techniques need to be different
• Benefit-cost analysis is one of most widely used
methods
– A proposal is only desirable when net benefits > net costs
– Analysis of multiple proposals must be done incrementally
• Two versions of cost-effectiveness analysis: fixed-cost
and fixed-effectiveness
– Fixed-cost analysis maximizes benefit given upper bound on
cost
– Fixed-effectiveness analysis minimizes cost needed to achieve a
lower bound on benefit
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