What is traditional financial modeling

When making decisions between two or more investment options it is important to understand the totality of the cash invested, cash received, timing of the cash flows, risk of the project, salvage value of the asset, inflation, weighted average cost of capital, and divestiture cost.  There are other factors depending on the specific industry, but are beyond the scope of this article.

Several tools exist for assisting with the decision making process, all have their strengths and weaknesses, and provide different lens’s to view the picture (though all are directionally correct).

Net Present Value (NPV)

Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment by comparing the present value of expected cash inflows to the present value of cash outflows over time. It considers the time value of money, meaning that money received today is worth more than the same amount in the future. A positive NPV indicates that an investment is likely to be profitable, while a negative NPV suggests it may result in a loss. NPV is essential for making informed capital budgeting decisions.

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is a financial metric used to evaluate the profitability of an investment. It represents the rate at which the net present value (NPV) of an investment equals zero, meaning the investment breaks even. IRR is the discount rate that makes the present value of expected cash inflows equal to the initial investment. A higher IRR indicates a more profitable investment, while a lower IRR suggests a less desirable investment. IRR is often used to compare the attractiveness of different investment opportunities and to determine whether an investment meets a company’s minimum required rate of return.

Return On Investment (ROI)

Return on Investment (ROI) is a financial metric used to evaluate the efficiency or profitability of an investment. It measures the gain or loss generated relative to the initial investment cost. ROI is expressed as a percentage, allowing for easy comparison between different investments. A positive ROI indicates that the investment has generated more profit than its cost, while a negative ROI suggests a loss. This metric is widely used by investors and businesses to assess the effectiveness of their investments and make informed decisions about future projects or expenditures.

Total Cost of Ownership (TCO)

Total Cost of Ownership (TCO) is a financial metric that represents the total cost of acquiring, operating, and maintaining an asset or investment over its entire lifespan. It encompasses not only the initial purchase price but also ongoing expenses such as maintenance, repairs, upgrades, and disposal costs.

TCO provides a comprehensive view of the costs associated with an investment, allowing businesses and individuals to make informed decisions about whether to acquire or retain an asset. By considering all costs, TCO helps to identify the most cost-effective options and minimize long-term expenses.

Discounted Payback Period (DPP)

Discounted Payback Period (DPP) calculates the time required for an investment to generate enough discounted cash flows to recover its initial cost. Unlike the simple Payback Period, DPP considers the time value of money by discounting future cash flows back to their present value. This makes it a more accurate measure of an investment’s profitability and risk.  DPP helps assess how quickly an investment will generate returns, taking into account that money received sooner is worth more than money received later.

Real Options Analysis (ROA)

Real Options Analysis (ROA) is a way of evaluating projects that considers the value of flexibility. Just like financial options give you the right, but not the obligation, to buy or sell a stock, real options give managers choices on how to proceed with a project. This could include delaying, expanding, or even abandoning a project based on how the future unfolds. By incorporating this flexibility, Real Options Analysis provides a more accurate picture of a project’s true worth, especially in uncertain environments. Traditional corporate finance gives us one metric—NPV—for evaluating projects, and only two possible actions: invest or don’t invest. In option space, we have NPV, two extra metrics, and six possible actions that reflect not only where a project is now but also the likelihood of it ending up somewhere better in the future.

How is technology modeling different? 

When comparing technology asset valuations to traditional asset valuations (like land and buildings), several key differences emerge, particularly influencing financial modeling for metrics like IRR, ROI, and NPV.

Traditional assets are often tangible, physical items with inherent value (e.g., land, buildings, machinery). Their value can be more easily assessed based on physical attributes and market comparables. Technology assets are frequently intangible (e.g., software, intellectual property, data). Their value is derived from their potential to generate future revenue, which can be highly uncertain.

Traditional assets depreciate gradually over time, often following predictable patterns. Technology assets can become obsolete rapidly due to technological advancements, making their lifespan and residual value highly unpredictable. This creates a much faster depreciation curve.

Additional differences include:

Liquidity

Traditional assets often have established markets with high liquidity, while technology assets may have more volatile markets with lower liquidity depending on the specific asset.

Disruption Potential

Technology assets can often represent disruptive innovations that may significantly impact established industries, making their future cash flow estimations more challenging.

End of Warranty (EOW)

End of Warranty (EOW) refers to the point at which a technology asset’s warranty coverage expires. During the warranty period, the manufacturer or seller typically covers repairs, replacements, and technical support for defects or malfunctions. After EOW, the owner assumes full responsibility for maintenance and repair costs. Understanding EOW is crucial for budgeting and planning for potential expenses related to asset upkeep, as well as for deciding whether to extend coverage through service contracts or warranties to mitigate future risks.

End of Support (EOS)

End of Support (EOS) refers to the point at which a technology asset, such as software or hardware, is no longer supported by the manufacturer or vendor. This means that no further updates, patches, or technical assistance will be provided, potentially exposing users to security vulnerabilities and compatibility issues. Understanding EOS is essential for organizations to plan for upgrades or replacements, ensuring continued functionality and security. Failing to address EOS can lead to increased risks and operational challenges as technology becomes outdated and unsupported.

End of Life (EOL)

End of Life (EOL) refers to the point at which a technology asset, such as hardware or software, is officially retired by the manufacturer or vendor. At EOL, the product is no longer produced, sold, or supported, meaning users will not receive updates, patches, or technical assistance. This status often necessitates planning for migration to newer solutions to maintain functionality and security. Understanding EOL is critical for organizations to avoid disruptions and ensure they are using supported technologies, as continuing to use EOL products can lead to increased risks and operational inefficiencies.

Performance issues

Servers lose 14% performance per year, 40% functional by fifth year
Routers lose 10-15% performance per year

Switches lose 5-10% performance per year

Access points lose 10-15% performance per year

Laptops lose 10-20% performance per year

Support/Maintenance Cost

Basic support contracts for IT hardware and software may include access to patches and updates.  The annual cost of Depending on the specific asset.

For enterprise servers, the average annual support and maintenance cost can range from 10% to 20% of the original purchase price.

For network devices, such as routers and switches, the average annual support and maintenance cost can range from 5% to 15% of the original purchase price.

For storage devices, the average annual support and maintenance cost can range from 5% to 10% of the original purchase price.

Other Considerations

Newer software and hardware may reduce Security Risks, Hardware Failure, & Compatibility Issues. In addition, they may have Intangible Benefits, Improved Security, Team Collaboration, & Higher Moral

Conclusion

No matter how much we might try to simplify it, the real world of IT investment is not just about quantifying the quantifiable and making a single decision at the start of a project.

It is about analyzing all of the relevant factors as well as the potential decision points throughout the system life-cycle.

NPV is a useful decision metric, but successful IT decision making requires a more sophisticated approach using all of the tools and the experience we have at our disposal to get to the “true NPV.”