ROI as an Effective Communications Tool for Engineers
Abstract
Ron Fredericks writes: Engineers want to build compelling products that meet their project requirements. Corporate executives want to invest in innovative people that build products that, in turn, meet their market’s window; while, both want to stay within budget. Yet both groups may feel overwhelmed with the prospect of expressing the very heart of their inspiration at some critical times during the life of these projects. In today’s post, I try to address this issue from the engineer’s perspective reaching out to the financial decision makers that ultimately control the purse strings of every project.
Table of Contents
Introducing Financial-Speak to Engineers
ROI Example: Embedded Linux
Evaluating Incremental Cash Flows
ROI Example: Simple Project Comparisons Using Net Present Value
ROI Example: Evaluating an Infrastructure Project
ROI Example: The Original Design Manufacturer
References
Errors and Changes Planned for this Blog Post
Introducing Financial-Speak to Engineers
In a previous post I introduced the idea that ethics might be the common framework between this dichotomy in communication between engineers, marketers, and executives. In this post, I suggest that engineers might apply this ethical approach by taking some time out to learn the language of business development from a financial management perspective – a conversational framework suitable for an interdisciplinary team concerned with engineering risk and strategic business value, but expressed using financial definitions.
The term Return On Investment (ROI) can be used for all three disciplines: engineering, marketing, and finance. ROI is just vague enough to cover most any discussion an engineer may encounter through-out the life of a project: from the initial decision to fund your project, to evaluating change requests during the design, build, test, and deployment cycle of an ongoing project. Evaluating ROI from a financial perspective is an ethical approach to decision-making because the financial terms I promote for this ethical framework have very precise meanings. So precise in fact, that I too have had to go back and rewrite several sections of this blog post thanks to One Nomad’s Blog comments received in this blog’s first posting.
It was the lack of financial precision embedded within my first draft for this blog post which my guest reader used to convince me of my own mistakes. Yet to be clear, identifying my mistake is also my gain. Effective communication is a process of two or more people sharing ideas…
Learning to converse and plan using financial terms for ROI decision-making can level the playing field between engineers, marketers, and business executives since ROI itself is not a common financial term. Engineers practicing Financial-Speak centered around ROI as the goal, can help reduce many of the common problems related to individuals trying their best to participate in team decision making. This leveling of the playing field – between team members – can also enhance the power of their conversation, leading the way for the much sought after innovations that are in popular demand today.
Consider building a financial model around ROI before presenting your most important technical needs to executives, marketers, and other decision makers. Read on to learn how. Of course ROI from a financial perspective is not the only way to build effective interdisciplinary teams with engineers involved. In a future post I may suggest a corollary to this ethical approach for executives and marketers who would like to reach out to engineers – using Six Sigma, CMMI, and emerging techniques developed by Dr. Thomas J. Buckholtz as useful processes seeped in ROI terminology.
Figure 1: Net Present Value Equation
![NPV(CF_k, R, IV) := IV+delim{[}{sum{k=1}{N}{CF_k/(1+R/100)^k}}{]}](https://www.embeddedcomponents.com/wp-content/plugins/wpmathpub/phpmathpublisher/img/math_952.5_bfeb240f8e08138085d65c76df21909d.png "NPV(CF_k, R, IV) := IV+delim{[}{sum{k=1}{N}{CF_k/(1+R/100)^k}}{]}")
Where:
is the Net Present Value function, in dollars
is a project’s Cash Flow, in dollars
is the hurdle Rate, in percent per period
is the Initial Investment (a negative number), in dollars
And:
is the cash flow’s time increment, or period
is the total number of cash flow periods for
Time increment for and might be in years, quarters, or months, for example
ROI Example: NPV’s Effect on Embedded Linux
The equation in Figure 1 forms the heart of my “ethics in engineering” proposal. Namely, the sooner a new device gets to market, the sooner a firm can realize new income. New income realized sooner, is much better than income realized later. A finance discussion around NPV would call this time’s negative impact on the value of money. I’m talking about the exponential effect that the prevailing interest rate, R, has in the NPV equation shown in figure 1.
A few years ago several of the leading embedded operating system suppliers used this equation to show that embedded Linux was a poor choice for new embedded device development projects. One such paper published by Dr. Jerry Krasner in 2003, Total Cost of Development, presents the typical argument pretty well. At that time Dr. Krasner and many others may have been right. Now in 2007, times have changed significantly. A recent blog entry on CNET shows the missing element from Dr. Krasner’s report and is a Harold for the embedded industry going forward: Oracle touts Linux deals.
How times have changed…
Because of the significant adoption of Linux in enterprise projects, the total project cost of using embedded Linux has gone down too. Indeed, the migration and reuse of enterprise Windows operating system application programming interfaces (API’s), kernel components, and development tools into embedded device projects was a key part of Dr. Krasner’s report, see link above. Dr. Krasner concluded at the time that embedded Windows CE made the best choice for new projects from a total cost of ownership perspective – just another way of looking at NPV!
Now the ROI benefits behind projects that select embedded Linux follows Dr. Krasner’s logic perfectly. Embedded Linux is now experiencing the same reduced total cost of ownership that only embedded Windows CE enjoyed just a few years ago. The reduced total cost of ownership comes from new and improved tools, components, and API’s that cross over from enterprise projects to the embedded marketplace. There is a significant overlap in Linux kernel updates, components, and tools driven by enterprise projects that are also suitable for use in embedded projects.
The available pool of engineers that know how to work with Linux can now support embedded development projects that use embedded Linux too. The marketing movement around the value and excitement of using Linux may also reduce the cost of taking an embedded device to market. In short: lower upfront costs, more options, more solutions, and faster time to market. Even Dr. Krasner has decided to post an update to his old white paper showing total cost of development to be favorable for embedded Linux projects. Download his updated paper.
None of these enterprise driven benefits exist with respect to the traditional embedded real-time operating system (RTOS). To be clear, there are other benefits to using an RTOS. I discuss one significant benefit to using an RTOS in another post: How to Leverage the Value of a Board Support Package.
Evaluating a Project’s Incremental Cash Flow
NPV is just one example of applying the principle of ROI to making project decisions. NPV falls into the general category of capital budgeting, a process of evaluating proposed investments into new projects. The capital budgeting process is concerned only with incremental cash flows. So the vague concept of ethics can be transformed into a specific financial discussion.
Two financial functions can measure time’s effect on money:
(1) Net Present Value (NPV) expressed as a monetary value,
and
(2) Internal Rate of Return (IRR) expressed as a percentage.
Where:
Net Present Value (NPV) of a capital budgeting project is the dollar amount of change in the value of the firm as a result of undertaking the project [Ref: Financial Management: Principles and Practice P.234]. The mathmatic definition for NPV is:
NPV = IV + Sum[ CF(k) / (1+R)^k ], k ranges from 1 to N
Where:
IV = Initial Investment (a negative number)
CF(k) = cash flow value (project outputs – project inputs) for period k
R = hurdle rate per period
period = a unit of time, typically year, quarter, or month
N = total number of periods for the project
Present Value (PV) is the value today of a future, or expected, cash flow. The mathematic definition for PV is:
PV = Sum[ CF(k) / (1+R)^k ], k ranges from 1 to N
NPV can be expressed in termis of its present value (PV):
NPV = IV + PV
Hurdle Rate is the required rate of return before launching a new project. The hurdle rate must be carefully chosen. It can be expressed as a percent per period. The period is commonly defined as one year, but other convenient time period could be selected such as one quarter, or one month. The same unit of time will need to be associated with cash flow. Other rate terms can be used in addition to, or instead of, hurdle rate: discount rate, cost of capital, or interest rate.
Internal Rate of Return (IRR) is the discount rate at which the
NPV of the project is zero. [Ref: Financial Management: Principles and Practice P.240]. The mathematic definition for IRR is related to NPV:
0 = IV + Sum[ CF(k) / (1+IRR)^k ], k ranges from 1 to N
NPV and IRR are related to each other:
What follows is a list of relationships between NPV and IRR. Use these relationships after calculating the NPV and IRR for each of the proposed project alternatives.
(1) If NPV(CF,R, IV) = 0,
then the hurdle rate, R = IRR
(2) For any set of cash flows estimated for a prospective project,
there is only one value for NPV.
But, the same project model can result in several IRR values,
where NPV = 0.
(3) If IRR > Hurdle Rate,
then a prospective project may make an acceptable
investment.
(4) If IRR >> Hurdle Rate (i.e. significantly greater than),
then a prospective project may carry too much risk.
(5) The hurdle rate includes both a minimum desired rate
of return for a project, and a threshold representing risk.
(5-a) A typical hurdle rate for an E-Business project
might be 15%.
(5-b) A typical hurdle rate for an embedded systems project
might be 18%.
(5-c) Embedded Components, Inc. is focused on lowering risk
for its members by promoting the re-use of pre-existing
components through its online marketplace
for embedded device manufacturers and their
communities.
(6) In general seek to maximize NPV, not IRR.
(7) Yet, if two projects have NPV curves that cross over each
other,
then the interest R where the curves cross is called
the Crossover Point.
(7-a) If the Crossover Point > IRR,
then accept the project with higher NPV.
(7-b) If the Crossover Point < IRR,
then accept the project with higher IRR.
(8) An NPV value of zero also means the investment into that
project would neither gain nor loose value for the company.
Define a project’s return on investment (ROI):
1a) Profitability Index (PI), measured in % percent
1b) Open Source Profitability Index (PIFOSS)
2a) Payback Period (PP), measured in time such as years, quarters or months
2b) Open Source Payback Period (PPFOSS)
3) Sensitivity Analysis, a plot of NPV verses Interest Rate
Return on Investment (ROI) is a business case analysis concerned with the net financial impact associated with a set of costs and benefits. Most research around capital budgeting does not define a specific calculation associated with ROI. Unlike NPV and IRR, which use formulas generally agreed to by industry, ROI calculations can be industry specific. I found an excellent overview of ROI in a paper by Dr. Jeffery [Ref: Return on Investment Analysis for E-Business Projects equation 6, page 6]. In his paper Dr. Jeffery presents a definition for ROI as:
ROI = 100% x (Project Outputs – Project Inputs) / (Project Inputs)
Where:
Project Outputs represent the value created by a project such as new income generated, efficiency gains, cost savings from improved internal processes, new intellectual property created, and strategic benefits (such as increased marketshare, brand name recognition, incremental gains in product mix, and improved vendor relationships).
Project Inputs represent expenses related to a project such as the initial investment in software and tools, development costs (such as professional employee salaries), facilities expenses (including building depreciation, grounds maintenance, service level agreements, and equipment depreciation,) deployment costs (such as sales commissions, marketing, shipping, and 3’rd party software run-time fees), goernment fees (such as sales taxes, patent filings, and corporate governance), and legal fees.
The sections below are under re-construction as of 3/3/08
Profitability Index (PI):
PI adjusted for Free and Open Source Software (PIFOSS):
So one of several projects under consideration to fund, may be the most acceptable if its NPV is a large enough positive number. In other words, a project is acceptable if the IRR is greater than or equal to the hurdle rate. Where the hurdle rate is defined as the expected rate of return on a potential investment that a manager demands before investing his or her money into a project. I have seen hurdle rates in the range of 8% to 18%, for example.
Measuring the risk of a capital budgeting project can be done by calculating the coefficient of variation (CV) on the expected returns from a firm’s asset portfolio with and without the new project being undertaken. Since the CV is defined as the ratio of the standard deviation to the mean, it can be used to determine how much volatility (risk) will be assumed in comparison to the amount of return expected from the proposed project.
There are several wrinkles in the capital budgeting decision process to consider:
(1) Non-simple projects,
(2) Projects that have multiple IRRs,
(3) Comparison of projects with unequal project lives, and
(4) Strategic benefits.
Read on to learn how to manage the financial data behind project proposals with all 4 of these complicating factors taken into account.
ROI Example: Project Comparisons Using Financial Terms
I developed a MathCad program to compare and plot two projects based on several financial terms. The MathCad equations can be used if you already have this math package. Download the MathCad template [tbd]
If you prefer to use Microsoft’s Excel, an open source office package, or google’s hosted office suite, then you can use the equations I develop here to handle the calculations.
In this Mathcad example, two projects with the same basic financial data are compared. Project A is a typical project with estimated sales (as a result of project completion) that builds up over time. Project B is not typical, but is a good test case. Project B uses equal payback amounts over time – similar to an annuity.
Define Initial Data for Two Projects
Time, N (in years)
Initial Investment, IV, in $ dollars
Interest Rate, Rate, in % percent
Cash Flow, CF, in $ dollars
Define Equations
Net Present Value, NPV, in $ dollars
Present Value, PV, in $ dollars
Coefficient of Variation, CV
Return On Investment, ROI
Compare Results for the Two Projects
Results for project A
Results for project B
Plot of Projects Over a Span of Rates
Discussion
The plot of NPV vs. Rate shows that if the Rate is zero, the NPV for both projects are the same. The plot also shows that the hurdle rate must be set much lower for Project A to be approved by a firm’s finance team in comparison to project B (looking at NPV equal to zero in the graph). Yet project B is not a likely outcome either because the sales forecasts aren’t realistic. Therefore the features and benefits of project A could be re-evaluated such that estimated sales over time increases enough to outweigh the initial lag in projected sales – to make up for the time-cost of money burden.
ROI Example: Evaluating an Infrastructure Project
I like this example even though it is far from embedded device projects. It provides a solution to the comparison between project choices that go beyond just simple cash flow. It points out that the process of getting to an ROI number can be more important to the success of some projects than the number itself.
Beyond ROI … Justifying a Business Intelligence Initiative, Digital Review Magazine, January 2004, Thomas Groh
ROI Example: The Original Design Manufacturer
An ODM is a good reference point for engineers and executives alike in the embedded systems industry. An ODM is a design to manufacture house, often located in Taiwan, People’s Republic of China (PRC), or Singapore. These companies work with their local silicon vendors and other regional suppliers to keep themselves informed of what tools, application frameworks, middleware, and silicon that may work together for various projects they are considering. To be clear, these local component vendors are integral partners for the ODM – right where the parts are often made. The ODM then has many advantages with respect to cash flow and its associate time-cost of money: lowest possible cost for parts, improved supply chain advantage without the need to pre-purchase in bulk, lower cost of knowledge, and cheaper labor costs. The ODM also focuses on the engineering effort rather than the marketing, brand recognition, and product sales efforts that their OEM (original equipment manufacturer) clients face. The goal of the ODM is to design cool stuff and manufacture all or part of the final product for its OEM client.
Figure 2: Sample Financial Spreadsheet
In Figure 2 above, I show a sample spreadsheet that would be a typical tool used by an ODM and its OEM client. How much should an ODM project cost? Take a look at the bottom line. For this project, the ODM figures on a shared IRR of 43% over an 8 year time line (only 5 of the 8 years are shown in Figure 2) using this set of numbers. A rate of return higher than most any hurdle rate. As a result, the OEM client may find funding this project to be attractive (remember that the OEM will have to factor in brand, marketing, and sales costs). The 8-year time line in this example may be too long for some projects. You can download a working copy of this cash-flow spreadsheet or their task-based budget spreadsheet from Bird Foundation’s web site and use any time-line you like for your next project.
Take a look at lines D, for development expenses, and C, for capital expenses. These two lines are where the operating system, development tool, and component vendors live. The cost of engineering and project management charged by the ODM lives here too.
The Bird Foundation
It is interesting to take note of the software tools and operating system choices available to the ODM. These are some of the only components that are not designed and built in or near the ODM’s location. Does Microsoft Windows CE make a better choice, or Wind River’s VxWorks, or should an embedded Linux version be the bases for development tools on this project? Well it all depends. Flexing the financial estimates for these two lines D and C are often a point of significant debate for a sales team or a roll-your-own internal engineering team. In this case, startup and recurring costs are important. Time to market is another point of consideration – here again the time-cost of your firm’s monetary assets will come into play. I invite sales and engineering teams to study the other numbers on this sample spreadsheet and envision how their product or service value might affect the final calculation of IRR. There can be further discussion on the effect of each financial component with respect to your position – there is likely no single right or wrong answer. One ROI strategy for embedded components and tools software vendors is to consider building more relationships with an ODM’s trusted local hardware component suppliers.
So where can you get more information on this spreadsheet? The answer can be found with the Bird Foundation. A grant giving organization that focuses on building engineering relationships between Israeli companies and OEM companies in United States – who in-turn may include an ODM partner. The spreadsheet example in Figure 2 comes right out of their guidelines for financial and project management (see Proposal Preparation Guidelines page 28). I invite you to learn more about this foundation, how it may work in developing technical partnerships with international companies you can leverage; and their great guidelines offered on the Bird foundation web site. Indeed this is a great example of using ROI as an ethical framework between partner companies from a global perspective.
References
This section under construction as of 12/8/07
Internal Rate of Return
Perils of the Internal Rate of Return
http://hspm.sph.sc.edu/COURSES/ECON/invest/invest.html
Text Books
Research Papers
Return on Investment Analysis for E-business Projects
by Dr. Mark Jeffery, Northwestern University
The old reference section below
An overview of ROI from a sales and marketing perspective – a rich alternative perspective from the financial content on this blog post:
Customer Centric Thinking and ROI (turn your speakers on)
The Bird Foundation project guidelines, and project spreadsheets, can be reviewed and downloaded from here:
www.birdf.com/Index.asp?ArticleID=57&CategoryID=77&Page=1
A great Windows calculator (see Figure 3 below) for most of your engineering and financial needs can be downloaded from here:
www.hp41.org/LibView.cfm?Command=View&ItemID=458
The original HP financial support software module works within this simulated HP41 programmable calculator and can also be downloaded from the same site, here:
www.hp41.org/LibView.cfm?Command=View&ItemID=3
The original HP How To manual for financial decision making can be downloaded or read from this the site as well, from here:
www.hp41.org/LibView.cfm?Command=View&ItemID=445
Figure 3: The HP41 Calculator Emulated on a Windows Desktop
Next steps…
I invite you to use this blog post’s comment facility to share your experience as an engineer, innovator, sales manager, marketer, or executive. Do you think a financial vocabulary can be used to build an effective (and ethical) balance for your team between consensus and innovation?
Technorati Tags: Ron Fredericks, Engineer, project, requirements, executive, invest, budget, financial management, Return On Investment, Six Sigma, CMMI, Dr. Thomas J. Buckholtz, cash flow, Net Present Value, Internal Rate of Return, Hurdle Rate, NPV, coefficient of variation, standard deviation, mean, embedded device, Thomas Groh, Original Design Manufacturer, ODM, embedded systems, tools, application framework, middleware, silicon, OEM, original equipment manufacturer, IRR, hurdle rate, Windows CE, VxWorks, embedded Linux, development tools, Bird Foundation, project management, ROI, marketing, team, consensus, innovation, Ethics, Business, United States, Israel, China, Singapore
October 26th, 2007 at 2:41 pm
Amazing comment.
I guess you’ll read my blog..
See ya
October 29th, 2007 at 4:08 am
Hello, very nice site, keep up good job!
Admin good, very good.
November 28th, 2007 at 12:23 am
Amazing post.
I know you’ll surf on my page..
Ciao
November 28th, 2007 at 12:27 am
Nice job in covering so many key concepts in a fairly short blog post. I especially liked your examples around embedded Linux, Bird Foundation, and the foreign ODM designers.
But I think there are a few problems with figure #1 – the NPV formula:
1) Your value for time is not a function. It should be t(k), not just k
2) Your interest rate, R, should always be an annual rate – but even then – interest rate is changing all the time and is not predictable.
For these two reasons I don’t think NPV is a good function for financial work in general. So I question why you would even try and make it the “heart” of your ethics for engineering manifesto?
Best regards,
The Master Financeer
November 28th, 2007 at 9:35 am
I applaud Ron for providing perspective whereby people doing engineering work and people doing financial-management work can better coordinate.
Permit me to comment on his material. My advice includes the following.
• Know what decisions you are trying to make and what intent you are trying to convey.
• Decide to what extent you need make financial estimates (or provide financial history).
• Select appropriate financial calculation tools.
• To the extent you use NPV (net present value) and the formula Ron provides, consider the following.
• Decide on a time-frame, T, for interest rates, such as R. Consider that many people will – unless otherwise advised – think “per year” and that using “per year” may prove appropriate. In any event, state the timeframe – “per year” (T = 1 year), “per month” (T = 1 month), or whatever.
• Replace the exponent-use of k with t(k)/T, where t denotes the elapsed time from “now” and k denotes the “number of the transaction.” Transactions (payments and receipts of moneys) often do not occur on a completely regular schedule.
• Pay attention to – and (be prepared to) discuss – the accuracy of the NPVs you announce. For example, you might …
• Consider that each CF and t(k) may be an estimate.
• Consider that R may be 1-number an estimate of a quantity that, in reality, varies over time.
• Consider that, with all other parameters fixed, NPV varies with choice of T.
November 29th, 2007 at 2:09 am
In response to Thomas J. Buckholtz and MasterFinanceer comments above:
I am using NPV, equation 1 in this blog post, as a financial framework for comparing two or more engineering projects. I believe it to be useful for making accept/reject project change proposals by engineers and business managers alike.
I agree that R may not always be a simple constant, but may be a different value for each increment of cash flow. With that variability in mind, the incremental cash flow should indeed use a variable interest rate assigned to each cash flow increment. The interest rate R, would then simply be R(k). This doesn’t change the nature of the equation. See the plot comparing NPV and a variable interest rate spanning 0.01 to 99 percent for a visual expression of just how sensitive R is to the NPV equation – one of the draw-backs to using NPV in the first place. Meanwhile, for comparing two projects, R is often defined as the hurdle rate. Where the hurdle rate is the minimum rate of return needed before any given project proposal becomes attractive as a financial investment. In this case, a simple constant works great.
The notion of time is already expressed within the NPV equation, without using an explicit variable like t(k). Instead, time’s behavior on expenses and incomes during the life of a project is built into the incremental cash flows summed together. When looking at the merits of a single project, a reasonable interest rate R or R(k) may be used. Just as there is a unique cash flow value, CF(k), for each period of time, so too a unique R value, R(k), could be included in any NPV calculation when R is estimated to change predictably over the life of a project. It is the lack of predictability in future R values that make the hurdle rate so useful as a simple constant set just high enough to make investment worthwhile as a financial investment.
In summary, NPV remains the heart of my engineering ethics proposal. Asymmetric cash flows and variable interest rates may be useful to make project accept/reject decisions. For an initial common sense framework, consider the basic behavior that the NPV equation promotes. Strive to promote new projects that have lower initial expenses and higher payback values sooner during the life of your intended product development project – that is the heart of an ethical framework for engineers that in turn makes investors happy too. Yet as Thomas J. Buckholtz and MasterFinanceer are saying, the NPV equation is in fact not very good at comparing projects when one project is either more strategic or expected to be more disruptive in the marketplace.
I hope this comment helps to simplify an otherwise complex NPV equation. Simple enough for engineers, marketers, and executives to use as a common framework for decision making and team consensus. Future blog posts may indeed explore the nuance of a more complex numerical example.
Best regards,
Ron
December 3rd, 2007 at 9:32 pm
I thought my readers would be interested in this blog post too…
On Recurrent computation of NPV (net present value) of a cashflow
I wrote about finding IRR of a cashflow. This time I’m going to write about two ways of recurrent NPV computation, one of which is numerically unstable…. click link above for complete post…
December 4th, 2007 at 7:57 am
Ron
there are several issues with your post in PV/NPV/CV
computation parts. For example, your ROI computation
for proj A is a bit strange. Your investment is
100000, so your ROI must be based off of this value
somehow. The easiest way is to get the yield (aka
IRR).
You have to look at cash outflows and inflows.
Outflows are your investments, inflows are returns.
In your case you get ROI = NPV/PV. Think of this: you
divide by the present value of future cashflows
outflows. So your base is not your investment, but
rather returns, then why do you call this ROI (return
on _investment_)?
You could do ROI=NPV/IV, but that’s not good either,
because NPV has taken into account your RRR (required
rate of return). Why dont you simply get IRR? It has
its own issues too, and finance professors usually
prefer NPV approach to proj financing.
sorry, for being a bit harsh with critique. however, I
find your approach interesting, especially the
relation to “ethics”. that’s unusual 🙂
thanks
argyn
December 4th, 2007 at 12:58 pm
Thanks argyn:
I agree that my sample test case comparing two projects is too mundane. It was meant to be simple so others can follow. What may be needed as a follow on post is a real-life example on how to effectively move NPV and IRR out of the financial domain and into engineering due diligence. This might include market attractiveness, time to market, and cash flows that bundle a mix of income and expense.
Many text books and financial preso’s conclude that ROI does equal cumulative NPV/PV.
Here is one such preso (see slide 28):
Role of a Systems Analyst
by Rich Schlesinger
http://science.kennesaw.edu/~rschlesi/3600fa07/Session%203_project%20initiation.ppt
From a purely MathCad style perspective, I am interested in taking the NPV equation (figure #1 in this blog post) to its natural limit of N := infinity. Move the equation into the domain of a calculus boundary value problem. This may lend itself to some automation with less of a need for special case consideration for a more uniform ethics discussion between engineers and business stake holders.
Thanks for the positive interest in bridging the conversation gap between naturally self-interested engineers and equally naturally self-interested business managers. I have seen the problem time and again where it can be hard to weigh the advice of several engineering options with the nagging thunder of “just get it done as soon as possible” by the business team. Using a financial equation seems like a neat solution to me because it covers both the time issues and the money issues in an ethical or fair way that helps even the playing field between those that understand the technology and those that understand the financial risks. I will ping you before crafting such a post and if you have future ideas please let me know.
Best regards,
Ron
December 4th, 2007 at 7:28 pm
Ron
I’m trying to help you sort out issues with financial computations.
You mentioned this ppt:
Role of a Systems Analyst
by Rich Schlesinger
http://science.kennesaw.edu/~rschlesi/3600fa07/Session%203_project%20initiation.ppt
it’s screwed up 🙂
Look at slide 17. It says
NPV = PV / (1+rate)^n
This is plainly misleading. It should be:
PV = FV / (1+rate)^n
You discount the future value and get the present value. This is a fundamental equation of finance, time value of money.
NPV concept is different. It’s “Net”, meaning that you add all cash inflows and outflows. In the example on slide 17 $100,000 is a future value, it’s 5 years from now. Today it’s worth 95,242.63 at a given discount rate of 5% annual with annual compunding. That’s the PV. IF this was the only cash exchange, then this is also NPV. If there were other cash exchanges, then you add them up.
On the other hand, look at slide 27 and 28. It says that you compute “cumulative” NPV, i.e. “costs and benefits”; then divide it by PV of COSTS.
In you case A, if you’d follow the slides, then PV of costs is equal the face value, i.e. $100,000. why? because you invest NOW, this means period ZERO, there’s no discounting. NPV remains the same, then you divide it by $100,000, your costs.
Actually, I dont like this approach too. The issue is that NPV in numerator is already accounting for interest rate. Now when you compute ROI it’s going to be already discounted. So you get a rate which has another rate inside. In this particular case I would simply get IRR or compare NPVs but in a different way.
This is all standard financial stuff, look for “project financing”, dont read anything written for “engineers by engineers” on this subject. Grab any book written for finance professionals.
cheers
argyn
December 5th, 2007 at 2:12 am
Hi argyn:
I really appreciate your taking the time to add value to this discussion. Reading through the slide set I picked at the top of a google search is time well spent for my readers. It has a high rank on google because it may be a popular reference.
You are absolutely correct. Rich’s slide 17 does have a potential “typo” in using Present Value (PV) instead of Future Value (FV). I say “typo” in quotes because he only uses the equation in slides 27 and 28 with words that very well could be considered future value (“total cost” and “total benefit”) – as such slide 17 may simply be a typing error. Let’s ask him and see? At UC Berkeley I was required to buy my professor’s notes in a binder while he/she used our class participation to correct the notes we had to buy. These notes would often have many errors and typo’s. To Rich’s credit, he posts his notes for public use and for his students to use at no cost. So having some typos, like PV instead of FV, does not take away from his over all concepts.
Your summary of my project A example using the PV set to $100,000 is fine. Using PV at year zero vs. NPV at year 4 all seem consistent – no news here. But I am glad that you restated it here using some different language for my readers.
Meanwhile, I used my MathCad template on Rich’s detailed ROI example data on slide 21, just as I did in my example:
ROI Example: Simple Project Comparisons Using NPV
http://www.embeddedcomponents.com/2007/09/roi-as-an-effective-communications-tool-for-engineers/#NPV
I added an annual interest rate, R, of 7% and come out with an ROI number of 29% – just as Rich did using his alternate ROI method. So I think my ROI equation for these simple periodic cash flows works just fine – the same ROI equation Rich uses on slide 28. See my attached PDF report of the MathCad exercise here:
ROI using Rich Schlesinger’s ppt slide 21
The finance book I studied for my MBA program is the same resource I used to extract my equations for this blog post in the first place:
Financial Management, Principles and Practice
By Timothy J. Gallagher and Joseph D. Andrew, Jr.
Copyright 1997, Prentice-Hall, Inc.
ISBN 0-02-340271-7
I can tell from your own blog posts that IRR is a favored technique. I agree that IRR is useful too. In fact, I use the IRR method in my blog post too. See “figure 2 – sample financial spreadsheet” in section “ROI Example: Evaluating an Infrastructure Project” above.
Lastly, you bring out a very important point for engineers to consider when using my proposed ROI methods (NPV and IRR) to make ethical project decisions. The dichotomy between engineers, business professionals, and executives alike will not be solved just because an engineer tries to bridge the conversation gap by adopting a financial ROI approach. All team members must actually want to find the best solution between them. The tools you and I presented here – around time’s effect on a project’s cash flows – may still be one very promising ethical approach.
Best regards,
Ron
December 5th, 2007 at 6:36 am
Ron
“ROI using Rich Schlesinger’s ppt slide 21”
http://www.embeddedcomponents.com/wp-content/uploads/2007/12/mathcad-npv2_slide21.pdf
This slide again uses a wrong formula. NPV of proj A is computed correcly, it’s 4.8139e+005. However its ROI is not good. It divides NPV by present value of future cash flows from investment. It doesnt make any sense. It has to divide it by -IV, i.e. $1180083.
You invested IV, you are trying to compute a return on your investment, then divide by -IV.
You’d get “ROI”=40.79%.
check out this presentation: http://leeds-faculty.colorado.edu/zender/MBAC6060-Eve/L-Notes/Rules-Nt.ppt
It gives a brief overview of capital budgeting techniques.
What you call “ROI” is there under Profitability Index method description.
Your proj A IRR is 23.39%. I dont prefer IRR over other methods, it’s just one of the methods of comparison.
cheers
argyn
December 6th, 2007 at 12:46 am
Hi argyn:
Some corrections are in order…
Wow! I think I see the light. You have had to be patient in your comments above to get me to this point. I do now see a flaw in my use of PV for calculating ROI. I also agree with you that my ROI equation can be corrected using your improved equation:
ROI = NPV[CF(k), R] / (- IV)
If I were to add more reality to my MathCad template, I should consider changing my Cash Flow terms, CF(k), to periodic incomes and expenses, then a new ROI equation may be used:
ROI = NPV[(income(k) – expense(k)), R] / [ (- IV) + PV[(expense(k)), R] ]
By including PV (present value) in the ROI equation, we can measure time’s effect on expenses more effectively. Expenses deferred to a later time in the life of a project, where possible, could yield a more effective use of capital. So the deferred expense should also reflect an improved ROI value.
IV is still the initial investment at period 0.
k is the cash flow count from 1 to N, where N is the total number of periods.
R does not have to be only defined as the annual interest rate. It could also be repurposed as the weighted average cost of capital (WACC). A value of 15% seems typical for a Web or network information technology project. A value should be chosen that includes enough risk for projects undertaken in specific market sectors. A web site IT project may have lower risk (WACC of 15% for R) than an embedded system development project (WACC of 20% for R), for example. See my reference below to Dr. Jeffery’s “Return on Investment Analysis for E-Business Projects” article below.
Note the difference in the type of cash flow used for NPV and PV: income – expense vs. just expense. This was a significant part of the error I now see in my first draft.
I plan to update my MathCad template to reflect these corrections in PV, ROI, along with a project example with periodic incomes and expenses. I need to add an IRR equation, and a PI equation too, as these make good alternative ROI calculations.
ROI is uniquely qualified to level a group into a team
Meanwhile, after reading your great Colorado MBA preso in your previous comment, I realize that finance people don’t actually use the term ROI at all. My finance book does not have a single equation that uses the term ROI. I think it is considered too vague an expression. I found an out of print book with some sample pages online that captured the problem in using the term ROI for finance nicely:
The Internet Encyclopedia
3 volume set
Edited By Hossein Bidgoli
Published 2004
John Wiley and Sons
ISBN 0471222046
Specifically, volume 3 pp 211 to 227
“Return on Investment Analysis for E-Business Projects”
By Mark Jeffery, Northwestern University
Where Dr. Jeffery offers a few options for ROI calculation. Now this 3 volume set sells for as much as $900+ on Amazon.com and is unavailable most other places. But Dr. Jeffery’s full article is online here:
Return on Investment Analysis for E-Business Projects
Dr. Jeffery suggests three separate methods for predicting ROI:
IRR, equation 7, page 6:
NPV[(income(k) – expense(k)), IRR] = 0
Profitability Index (as you have already suggested), equation 5, page 5:
Profitability Index = NPV / Investment
An ROI equation similar to the one I present above, equation 6, page 6:
ROI = 100% x (Project Outputs – Project Inputs) / (Project Inputs)
In summary, I really appreciate your patience following along with me to identify these problems and in participating within this new ROI framework with me as a way to stay focused on improving the framework itself. There is an additional lesson I learned as a result of our discussion, argyn. ROI is a term less used by financial experts but often used to make business decisions. Yet ROI requires effective use of financial equations. And, the team discussion to decide whether to invest in one of two or more technology projects requires careful engineering consideration too. All combined, ROI indeed can make a good framework for ethical discussion because no one expert likely can dominate an ROI investigation – all three professional classes of experts have an equal but separate place within this ROI Framework for effective communications.
To be clear, I believe the: (a) engineer, (b) finance professional, and (c) business executive, can work effectively together using ROI as an ethical framework for conversations that lead to high quality decisions as a team of equals.
What I have learned…
Each participant in an ROI-based project review naturally wants the best decision to be made. Yet, each of the members on the team may feel a little embarrassed at one point or another, as I too have during this blog conversation thread, when I realized how patiently argyn has been in getting me to realize my PV usage mistake. Why embarrassed? Well know that I understand argyn’s point, I read over my original references used to craft this blog post in the first place, and the correct PV usage was there all along. I just didn’t understand it. In my case: a reference to PV (Costs), for example, is not the same thing as just PV (Anything). Yet I am here to tell my readers now that the potential for a small embarrassment leads to an even greater feeling of reward in finding answers only a team conversation can yield. What kind of reward? To understand a point being missed, allows me know to apply this new gained knowledge in many related areas. A reward well earned by putting forth new ideas for discussion in the first place. So I say to you, try to make your best effort in a team participation, don’t be defensive, don’t give in to every “nattering nabob of negativity” either. Be patient and expect patience from others. But in the end, learn to more quickly accept other points of view that can be demonstrated to be correct. Just another positive result from ethical team conversation, I suppose.
Thanks again and best regards,
Ron
December 7th, 2007 at 9:59 am
Ron
I don’t think that you need WACC at this level of discussion. It’s for debt vs equity financing.
I also saw some people looking at IT projects as real options.
argyn
December 7th, 2007 at 10:13 am
Ron
another issue is with this statement:
“NPV and IRR are related to each other:
(1) If NPV = 0
(2) Then IRR = Cost of Capital”
IRR is not CC. IRR concept is a bit involved, I wont get into details. In capital budgeting one of the project acceptance criteria is IRR > CC.
December 7th, 2007 at 2:30 pm
Hi argyn:
I agree with your WACC comment. I would need to add further discussion around equity to use this term correctly. I think I will revert back to using “hurdle rate”. But the new value add taken from Dr. Jeffery’s reference related to assignment of a higher rate for more risky projects still seems both valid and useful.
Yes to your second point too. What follows are notes to incorporate into an updated blog post. I think I could rephrase the relationship between NPV and IRR as follows…
NPV and IRR are related to each other:
(1) If NPV(CF,R) = 0
Then R = IRR
(2) For any set of cash flows estimated for a prospective project
There is only one value for NPV
But, the same project model can result in several IRR values,
where NPV = 0
(3) If IRR > Cost of Capital
Then a prospective project may make
an acceptable investment
(4) If IRR >> Cost of Capital i.e. significantly greater than
Then a prospective project may carry too much risk
(5) The Cost of Capital can be replaced with a hurdle rate
Where Hurdle Rate includes both a
minimum desired rate of return for a project and
a threshold representing risk
(5-a) A typical Hurdle Rate for an E-Business project
might be 15%
(5-b) A typical Hurdle Rate for an embedded systems project
might be 18%
(5-c) Embedded Components, Inc. is focused on lowering risk
for its members by promoting the re-use of pre-existing
components through its online marketplace training centers
for embedded device manufacturers and their communities
(6) In general seek to maximize NPV, not IRR
(7) Yet, if two projects have NPV curves that cross over each other
Then the interest R where the curves cross is called
the Crossover Point
(6-a) If the Crossover Point > IRR
Then accept the project with higher NPV
(6-b) If the Crossover Point < IRR Then accept the project with higher IRR Best regards, Ron
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