A Comparison of Approaches to Investment Analysis

1. A Comparison of Approaches to Investment Analysis John Favaro Proc. Fourth International Conference on Software Reuse, 1996, IEEE Computer Press, p. 136-145

2. Software reuse economics • Three kinds of activities: • Reuse metrics • the measurement of reuse-related characteristics of software • Cost estimation • the estimation of cost and benefits associated with reusable software development • Reuse investment analysis • the evaluation of investment decisions

3. The investment analysis • Is in the domain of the financial corporate analyst • Different perspective from the software engineer • reuse is only one alternative for investment • is concerned with the best way to allocate capital and human resources • There is always an alternative to reuse investment • equivalent investment in the capital market that provides some yearly rate of return • reuse-oriented investment should be compared with this • Capital investments are analysed with respect to periods of time, and the same approach should be used for reuse investment analysis

4. Cost estimation and cash flow • Cost estimation = cash flow analysis • Estimation of cost/benefit • Candidate reuse projects has potential cash flows • positive (e.g.. savings by avoiding work) • negative (e.g.. work to generalize a component) • Techniques for quantifying economic benefits are emerging. • Cash flows are forecast over a suitable time horizon • Time period must be neutral estimate, not a desired characteristic • Cash flow analysis is an activity prior to investment analysis

5. Comparison of approaches • Desirable characteristics • depend as much as possible only on forecast cash flow • have a quantifiable acceptance rule to guide the investment decision • suitable for comparing and ranking candidate projects • be able to deal with arbitrarily large or small projects • be able to handle projects of arbitrarily long or short duration

6. Net present value • PV = Present Value • PV = S Ct / (1 + kt)t • Ct : future cash flow in period t • kt : discount rate in period t • NPV = Net Present Value • add the initial investment as a negative value • NPV = C0 + PV

7. NPV characteristics • Acceptance rule is based on the value of NPV • positive : accept • Permits realistic comparison with alternative capital investment possibilities • Does not depend on arbitrary factors (e.g.. managers instincts) • Values are additive, can be ranked, and are sensitive to scale • Large and small alternative can be compared and combined

8. Payback • The time or number of uses required to recover the cost of an investment • The payoff threshold value: • N0 = E / (1-b) • E = relative cost of developing a component for reuse • b = relative cost of integrating the component • N0 = number of times a component must be used before its cost is recovered

9. Payback characteristics • Acceptance is based on cost recovery within a cut-off date • Intuitively appealing but problematic • cut-off date is arbitrarily and subjective • payback is not sensitive to patterns of cash flow • problem of scale: the true value (long term) is not taken into account • choice of cut-off period affects whether short or long lived projects are accepted, tends to penalize forward looking reuse programs • Ad-hoc approach useful for communicating the result of an investment analysis

10. Average return on book value • Software as a capital asset • An amortization schedule for the investment for reusable work products is agreed upon (deducted as appropriate from future cash flows from those work products) • The book rate of return (of an investment) is calculated by: • dividing the avg. profits from predicted cash flows by the avg. net book value of the investment

11. Avg. return on book valuecharacteristics • Acceptance rule is based on the book rate of return meet some target set by the analyst e.g.. • companies current book rate of return • of the industry as a whole • The approach is entirely insensitive to a variable cash flow pattern • The calculation is depending on the choice of amortization schedule • Choice of target book rate is arbitrary and subjective • Not satisfactory approach

12. Internal rate of return • A way of defining the rate of return of a long lived asset • IRR is related to NPV • IRR is the discount rate which makes NPV equal to zero • C0 = S Ct / (1 + IRR)t

13. IRR characteristics • Acceptance rule: • accept a project if its IRR is greater than the opportunity costs of the project • Can be used to produce results equivalent to NPV • Proper use of IRR is more difficult • Can be undermined by certain patterns of cash flow in a project • Exhibits problems with respect to the scale of projects

14. Profitability Index • Examines the ratio of benefits to costs • Conceptually closest to NPV • Numerous variations • ROI (return of investment) • Q (Quality of investment) • CDCF (Cumulative discounted cash flow) • Values are note additive

15. Summary / conclusion • Table on page 143 of the article