Return on Investment Analysis for E-business Projects

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Return on Investment Analysis
for E-business Projects
Return on Investment Analysis
for E-business Projects
Mark Jeffery, Northwestern University
Introduction 1
The Information Paradox 2
Review of Basic Finance 4
The Time Value of Money 4
ROI, Internal Rate of Return (IRR),
and Payback Period 6
Calculating ROI for an E-business Project 6
Base Case 7
Incorporating the E-business Project 8
Incremental Cash Flows and IRR 10
Uncertainty, Risk, and ROI 11
Uncertainty 11
Sensitivity Analysis 11
Project and Technology Risks 12
Monte Carlo Analysis Applied to ROI 13
Executive Insights 14
The Important Questions to Ask When
Reviewing an ROI Analysis 14
A Framework for Synchronizing e-Business
Investments With Corporate Strategy 14
Beyond ROI: Trends for the Future 16
Acknowledgments 17
Glossary 17
Cross References 17
References 17
INTRODUCTION
As the late 1990s came to a close, many companies had
invested heavily in Internet, e-business, and information
technology. As the technology bubble burst in 2000 many
executives were asking “Where is the return on invest-
ment?” When capital to invest is scarce new e-business
and information technology (IT) projects must show a
good return on investment (ROI) in order to be funded.
This chapter will give the reader the key concepts neces-
sary to understand and calculate ROI for e-business and
IT projects. In addition, the limitations of calculating ROI,
best practices for incorporating uncertainty and risk into
ROI analysis, and the role ROI plays in synchronizing IT
investments with corporate strategy will be discussed.
What is ROI? One conceptual definition is that ROI is a
project’s net output (cost savings and/or new revenue that
results from a project less the total project costs), divided
by the project’s total inputs (total costs), and expressed as
a percentage. The inputs are all of the project costs such
as hardware, software, programmers’ time, external con-
sultants, and training. Therefore if a project has an ROI
of 100%, from this definition the cash benefits out of the
project will be twice as great as the original investment.
(In the section Review of Basic Finance we will discuss
how this definition of ROI, although qualitatively correct,
does not accurately include the time value of money, and
we will give a more accurate definition based upon inter-
nal rate of return [IRR].)
Should a manager invest a company’s money in an
e-business project if it has a projected ROI of 100%? There
are many factors one should consider when making an
investment decision. These factors include, but are not
limited to those listed below:
The assumptions underlying the costs of the project.
The assumptions underlying the potential benefits.
The ability to measure and quantify the costs and benefits.
The risk that the project will not be completed on time
and on budget and will not deliver the expected be-
nefits.
The strategic context of the firm; that is, does the project
fit with the corporate strategy?
The IT context of the project: that is, does the project align
with the IT objectives of the firm, and how does it fit
within the portfolio of all IT investments made by the
firm?
As discussed in the section Review of Basic Finance,
the simple definition of ROI given above is not rigorous
enough for good investment decision-making. In addition,
the assumptions underlying the model and risks associ-
ated with the IT project are key drivers of uncertainty in
any ROI analysis. Awareness of these uncertainties and
the impact of risks on ROI can significantly improve the
likelihood of successful investment decisions.
The return on investment for corporate information
technology investments has been the subject of consi-
derable research in the last decade. (For reviews see
Brynjolfsson & Hitt, 1998; Dehning & Richardson, 2002;
Strassmann, 1990.) The most recent research suggests
that investing in IT does on average produce significant
returns (Brynjolfsson & Hitt, 1996). See the next section,
The Information Paradox, for a discussion of this research.
Jeffery and Leliveld (2002) surveyed CIOs of the For-
tune 1000 and e-Business 500 companies: Of the 130 CIO
respondents, 59% reported that their firms regularly cal-
culated the ROI of IT projects prior to making an in-
vestment decision, and 45% of respondents reported that
ROI was an essential component of the decision-making
process. ROI is therefore an important component of
the information technology investment decisions made in
many large companies.
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