Johnson Controls - Research Paper Example

Information systems are also considered long-term capital investment projects. The following are some of the traditional capital budgeting models used to evaluate capital projects: The payback method The accounting rate of return on investment (ROI) The net present value The cost-benefit ratio The profitability index The internal rate of return (IRR) These methods rely on measures of cash flows into and out of the firm. Capital projects generate cash flows into and out of the firm. The investment cost is an immediate cash outflow caused by the purchase of the capital equipment (capital outlay).

In subsequent periods, the investment may cause additional cash outflows related to repair and maintenance that will be balanced by cash inflows resulting from the investment. Cash inflows take the form of increased revenues generated from the improved facilities or reduced costs in production and operations. The difference between cash outflows and cash inflows (net cash flows) is used for calculating the financial worth of an investment. Once the cash flows have been established, several alternative methods are available for comparing different projects and deciding about the investment.

Financial models assume that all relevant alternatives have been examined, that all costs and benefits are known, and that these costs and benefits can be expressed in a monetary terms. When one has to choose among many complex alternatives, these assumptions are rarely met in the real world, although they may be approximated (Aggarwal, 2002). Tangible benefits can be quantified and assigned a monetary value. Intangible benefits, such as more efficient customer service or enhanced employee goodwill, cannot be immediately quantified but may lead to quantifiable gains in the long run.

Shim and Siegel (2008) argue that traditional capital budgeting has a number of challenges. The models do not express the risks and uncertainty of their own costs and benefits estimates; cash flows are uncertain; inflation may affect costs and benefits differently; technology—especially information technology—can change during the course of the project, causing estimates to vary greatly; intangible benefits are difficult to quantify. These factors wreak havoc with financial models. The difficulties of measuring intangible benefits give financial models an application bias.

Traditional approaches to valuing information systems investments tend to assess the profitability of individual systems projects for specific business functions. Theses approaches do not adequately address investments in IT infrastructure, testing new business models, or other enterprise-wide capabilities that could benefit the organization as a whole (Gregory, 1999). The traditional focus on the financial and technical aspects of an information system tends to overlook the social and organizational dimensions of information systems that may affect the true costs and benefits of the investment.

However, there are other modern methods that can be used as alternatives to the traditional methods. One of the approaches is the option pricing or real options theory recognizes the interactions among option holders’ optimizing behavior, asset uncertainty, and market disciplines. Recently, the option pricing theory has been applied in the evaluation of nonfinancial assets or ‘