CAPITAL BUDGETING TECHNIQUES

Appraising the Application of Traditional Capital Budgeting Techniques

Appraising the Application of Traditional Capital Budgeting Techniques

Introduction

In this chapter we examine various ways of measuring the business value provided by information systems, describing both financial and nonfinancial models. We then examine the role of change management in successful system implementation. Finally, we present strategies for reducing the risks in systems projects and improving project management.

Understanding the Business Value of Information Systems

Information systems can have several different values for business firms. A consistently strong information technology infrastructure can, over the long term, play an important strategic role in the life of the firm. Looked at less grandly, information systems can permit firms simply to survive.          It is important also to realize that systems can have value but that the firm may not capture all or even some of the value. Although system projects can result in firm benefits such as profitability and productivity, some or all of the benefit can go directly to the consumer in the form of lower prices or more reliable services and products (Callon & Lare´do, 1992). Society can reward firms that enhance consumer surplus by allowing them to survive or by rewarding them with increases in business revenues. Competitors who fail to enrich consumers will not survive. Benefits from information technology investments can also be reduced if firms do not consider the costs of organizational change associated with new systems and make these changes effectively. (Burchell & Clubb, 1980: 5). But from a management point of view, the challenge is to retain as much of the benefit of systems investments as is feasible in current market conditions.           The value of systems from a financial view comes down to one question: Does a particular IS an investment produce sufficient return to justify its costs? There are many problems with this approach, not the least of which is how to estimate benefits and count the costs.Traditional Capital Budgeting Models

Capital budgeting models are one of several techniques used to measure the value of investing in long-term capital investment projects. The process of analyzing and selecting various proposals for capital expenditures is called capital budgeting. Firms invest in capital projects to expand production, to meet anticipated demand or to modernize production equipment to reduce costs. Firms also invest in capital projects for many noneconomic reasons, such as to install pollution control equipment or to convert to a human resources database to meet some government regulations. Information systems are considered long-term capital investment projects. Six capital budgeting models are used to evaluate capital projects (Burchell & Clubb, 1985: 381):

The payback method

The accounting rate of return on investment (ROI)

The cost-benefit ratio

The net present value

The profitability index

The internal rate of return (IRR)

Capital budgeting

The process of analyzing and selecting various proposals for capital expenditures. All capital budgeting methods rely on measures of cash flows into and out of the firm. The investment cost is an immediate cash outflow caused by the purchase of the capital ...