Return on Investment and E-Business - Coursework Example

Introduction While the internet and e-commerce have greatly revolutionized the business environment, the business expenditures on the e-business have also been seeing an increase. The other side of the matter, however, is that the business organizations have to apply economic criteria in their justification of spending on IT-related decisions. Time value of money is a very important aspect of any investment decision made and hence the firms not only consider the impact of internet to their business but they also look at the implications of the decisions they make to invest in the IT-related ventures. As business faced the turn of the century, spending in the information technology increased by about nine per cent while the following year saw a further increase in the spending by eleven per cent in 2000 (Pisello and Strassmann 2003). Pisello and Strassmann (2003) elaborate further pointing out that those businesses which under- spend on internet-related ventures are no better performers while those that invest more on the IT-related ventures perform better. In addition, spending on internet-related investments calls for even more spending as there is more expenditure required to ensure that the venture is well maintained and well managed for efficiency and effectiveness. Because an investment venture may be beneficial to a business or organization in one of the two ways; cost saving or additional revenue, the paper will attempt to critically analyze ROI in relation to e-business while considering of the two aspects (Pisello 2003). The graph below shows how US businesses’ expenditure on IT –related ventures rose steadily from mid nineties to 2001. The tremendous increase in the spending between 1999 and 2001 is significant. US Business IT spending from 1995 to 2001 As it can be seen from the graph, investment in the internet, IT and e-business intensified particularly towards the close of the century. However, the underpinning economic conditions do not allow for funding without considering whether the investment would have a good return on investment or if it would have a detrimental effect on growth, expansion and survival of the business entity. The economy continues to be volatile and the capital that can be invested in any new venture continues to be scarce as well. This is not withstanding the fact despite all these, spending in e-business by business organizations now clocks trillion of dollars. Businesses have to justify these investment decisions. There are a number of things that a business, while justifying its investment decision, must put into account. First of all, the prevailing uncertainty in business environment must be slotted in. risk is also involved in any decision and hence the businesses attempt to weigh their capabilities to handle the risk that comes with any business investment they make. After that they have to carry out a sensitivity analysis. Though Return on investment is widely used by businesses as a standard justification for their investment in the internet ventures, the assumptions they make are widely varied. The Time Value of Money If we took an example of two investment options in e-business which we would assume to have the same cost; such that the first venture brings a cost saving benefit or has new revenue amounting to five million dollars for each year for the subsequent 5 years. Assuming that the second project will generate benefits amounting to eleven million dollars at the end of year one and year two of the investment after which it generates nothing and there is capital limitation limiting us to invest only in one particular project out of the two. Jeffery (2000) notes that in this case we would most probably go for the first option since it would be more appealing than project 2 given that it (project 1) may be argued to have cash flows of $25 M and the second project has only $ 22 M cash flows. Moreover, we must bear in mind that a dollar today is more than a dollar in the future since it can be used in an investment venture to generate extra interest. Therefore, the rates must be discounted to get the present value of a dollar earned in the future and the future value of a dollar earned today. Hence if we had a series of cash flows, we would discount them to get the present value of the whole cash flow using the equation below. PV = A1/(1 + r ) + A2/(1 + r )2 + A3/(1 + r )3 + · · · + An/(1 + r )n. Since our equation incorporates the interest that accrues to each part of the series of our cash flow, we would get our Net Present Value (NPV) of the cash flow by subtracting the interest (I) from the equation such that: NPV = PV - I Accounting rate of return Companies may use the accounting profits from their financial statements to justify or assess the viability of e-business investment options or proposals (Anfield, Jeffery, and Ritters 2009). The decision criteria here is for the companies to accept the e-business ventures whose ARR is greater than the one that has been set by the management. In case the management has not set any benchmark, the bank rate can be used as the benchmark. Where the decision involved is of mutually exclusive ventures, the e-business venture to be selected is that which has the highest ARR. The projects may be ranked in order of their levels of ARR; if they are many so that independent decisions are achieved by choosing all the projects that have a higher ARR than that set by the management. Though this method of justifying the expenditure in e-business ventures due to the fact that it is computed from the business’s accounting data that is readily available in the financial statements and the fact that it analyzes the returns on the investments on the basis of all the profits generated it has short-falls which present difficulties for taking it as a sole mode of justifying an investment venture. Though it is in consistency with the profitability objective of most business organizations, it ignores the time value of money. The method also falls prey to the subjective elements of business profits including the accounting conventions and the accounting and financial standards. Hence the fact that it uses the accounting profits rather than the cash flows presents a difficulty since businesses treat same items using different methods (Dehning and Richardson 2002). The method also fails to put into consideration the timing of cost recovery and therefore it is biased at the expense of the creditors. Lastly, the method ignores the fact that profits generated by a business from its e-business may still be re-invested so that it generates more profit which would then change the overall computation of the ARR. Payback Period The businesses that wish to assess the viability of investment in internet or IT-related ventures would look at the cash inflows and the cash outflows over time to ascertain how soon or when the investment would be expected to pay back the initial cost. This method is used bearing in mind two perspectives in relation to the cash inflows: uniform cash inflows and non-uniform cash inflows. In the case where the business venture or investment generates uniform cash inflows then the payback period would be arrived at as follows: Under conditions of non-uniform cash inflows, the PBP would be computed as follows: The decision criterion in this method is to accept all the e-business investments whose payback period is less than the company’s benchmark (Dehning and Richardson 2002). Projects whose payback period exceeds the company’s benchmark are therefore rejected. Assuming that we have an e-business investment estimated to cost $80, 000 and which generates cash inflows for the next five years as shown in the table below and we need to make a decision to invest in this e-business. Year Cash inflows ($) 1 10, 000 2 30, 000 3 15, 000 4 20, 000 5 30, 000 Now if we assume further that the business benchmark payback period is two and half years, we would then have the following solution to our payback period: Time period Cash inflows Cumulative cash flows 0 (80, 000) (80, 000) 1 10, 000 (70, 000) 2 30, 000 (40, 000) 3 15, 000 (25, 000) 4 20, 000 (5, 000) 5 30, 000 25, 000 PBP = 4yrs + [5, 000 / 30, 000] = 4yrs 2 months to recover the initial investment of $80, 000. The decision would be to reject the project since the payback period exceeds the company’s benchmark of two and half years. ROI and Internal Rate of Return (IRR) for E-Business Project Return on investment (ROI) can be defined by the following formula: The project outputs comprise all the benefits which accrue from the project and which have been put in terms of revenues generated and costs saved. However, the approach in the above formula fails on two counts. First, it does not incorporate the time value for money. Secondly, it does not consider the fact that the cash flows may vary from time to time hence the benefits too. Using the internal rate of return for assessing the viability of the investment decision, the businesses find a rate that can equate a net present value (NPV) of zero. This means that the business organization has to know or estimate the cash flows (expected cash inflows and outflows), select an appropriate rate of discount and use it to calculate the NPV, determine IRR through interpolation using two rates selected and then apply the calculated IRR to make the appropriate investment decision in the identified e-business venture. The decision criterion for this method is that the projects whose calculated IRR’s are greater than the benchmark rate are selected. The cost of capital or the real rate of return may be used as the benchmark rates. Where the decision involves mutually exclusive e-business projects, the project that exhibits the highest IRR is selected as long as it satisfied the first criterion (Dehning and Richardson 2002). If the projects are independent projects, all the projects whose IRRs are greater than the benchmark rate are selected. Nevertheless, if the options are defined by capital limitation also, the project that satisfies the above criteria and satisfies the capital availability should be chosen. The approach has some factors which make it a better method for making investment decisions or for capital budgeting decisions. It puts into account the time value of money and it also considers all the cash flows (inflows and outflows) generated by the e-business venture. As such, it tends to gauge the profitability of the business more precisely. Lastly, it indicates the minimum rate of return that would be required to break even. However, the tedious computations involved in arriving at the decision could be more involving especially if the projects being assessed have longer duration of useful life and the where the decision involves many projects. The method also fails to give the time duration which a project will be expected to recover the initial cost. For such disadvantages of the method other methods must be put into consideration along it to arrive at a more concrete investment decision (Jeffery 2006). Hence, other methods like profitability index and discounted payback period are also used in addition to the ones discussed to further justify any decision made to invest in the e-business and assess how viable the available options are. Works Cited Anfield, J., Jeffery, M., and Ritters, T., “B&K distributors: Calculating return on investment for a Web based customer portal.” Retrieved August 6, 2009, from http://www.kellogg.northwestern.edu/faculty/jeffery/htm/ITPortfolioCasePage.htm Dehning, B., & Richardson, V. “Returns on investment in information technology: A research synthesis.” Journal of Information Systems, 2002: 16(1), 7–30. Pisello, T. and Strassmann P. "IT Value Chain Management" NY USA.2003 Pisello, T. “U.S. firms smarter IT spenders than E.U. peers” SearchCIO.com, April 17, 2003. Jeffery M. “Return on Investment Analysis for E-business Projects” Northwestern University: 2006 Read More