Accordingly, firms generally categorize projects and then analyze those in each category somewhat differently:
1. Replacement: maintenance of business. Replacement of worn-out or damaged equipment is necessary if the firm is to continue in business.
The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? If the answers are yes, maintenance decisions are normally made without an elaborate decision process.
2. Replacement: cost reduction. These projects lower the costs of labor, materials, and other inputs such as electricity by replacing serviceable but less efficient equipment. These decisions are discretionary, and require a detailed analysis.
3. Expansion of existing products or markets. Expenditures to increase capacity or output of existing systems in markets now being served are included here.
These decisions are more complex because they require an explicit forecast of growth in demand, so a more detailed analysis is required. (The Intuit story presented above falls into this category.) Also, the final decision is generally made at a higher level within the firm.
4. Expansion into new products or markets. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums with delayed paybacks.
Invariably, a detailed analysis is required, and the final decision is generally made at the very top—by the board of directors as a part of the firm’s strategic plan.
5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms are called mandatory investments, and they often involve non-revenue producing projects. How they are handled depends on their size, with small ones being treated much like the category 1 projects described above.
6. Research and development. The expected cash flows from R&D are often too uncertain to warrant a standard discounted cash flow (DCF) analysis. (Please see my article on Developer.com for a detailed discussion of DCF).
Instead, decision tree analysis and the real options approach are often used. (Please see my article on Developer.com for a detailed discussion of decision tree analysis and the real options.)
7. Long-term contracts. Companies often make long-term contractual arrangements to provide products or services to specific customers. For example, IBM has signed agreements to handle computer services for other companies for periods of five-to-10 years.
There may or may not be much up-front investment, but costs and revenues will accrue over multiple years, and a DCF analysis should be performed before the contract is signed.
The Cost of Capital
The cost of capital is affected by a number of factors. Some are beyond the firm’s control, but others are influenced by its financing and investment policies.
The three most important factors that are beyond a firm’s direct control are: (1) the level of interest rates, (2) the market risk premium, and (3) tax rates.
A firm can control its cost of capital through: (1) its capital structure policy, (2) its dividend policy, and (3) its investment (capital budgeting) policy.
The cost of capital is beyond the scope of this article and beyond the responsibility of the CIO. At the same time, understanding the operational consequences of under-investing or unnecessarily investing in the firm’s IT infrastructure can only be estimated by the CIO and his/her staff.
Thus, the level of IT capital investment needs to be based on the judgments of both the CIO and his/her finance counterpart.
Marcia Gulesian has served as software developer, project manager, CTO, and CIO over an eighteen-year career. She is author of well more than 100 feature articles on IT, its economics, and its management, many of which appear on CIO Update.