The assessment of the financial effectiveness of investments in IT technology serves to solve one of the basic problems related to the decision to participate in the process of technology development and transfer. The problem boils down to answering the question: Will the investment in IT technology pay off? The lack of an answer to this question practically closes the discussion of whether it is worthwhile, and if so why, to participate in a project that is not certain how it will end from an economic point of view. Despite the fact that a reliable and unambiguous assessment of investment in technology is very difficult, if at all possible, the requirements of risk rationalization related to the implementation of business ventures force a thorough analysis of their profitability.
In the analysis and evaluation of the profitability of IT investments, four basic indicators are used, namely:
- payback period, which indicates the length of the period after which the project's cash inflows return the expenditure incurred in the initial period,
- Net Present Value (NPV), based on the principle that the project is worth implementation if it generates revenues equal to at least the initial capital expenditure,
- Internal Rate of Return (IRR), which expresses the expected rate of income from the planned investment, which allows you to compare its profitability with other investment alternatives available on the market,
- the profitability index, which defines its effectiveness as the ratio of the results obtained from the investment in the assumed (required) period of return on capital to investment expenditures.
The ratios presented above are commonly known and do not differ from those used in the profitability analyses of typical investment projects. Their application in the assessment of IT technology investments is particularly difficult due to the uncertainty of the data on which the analyses are based.
The financial assessment of the effectiveness of investments in technology is carried out on the basis of planned economic values, such as the value of the investment, the value of net profit and, above all, the value of financial flows. The most difficult thing is to realistically and correctly prepare financial forecasts for the planned project. The problems that should be solved when assessing the profitability of undertaking the project relate to the issues that are presented below (based on P. Głodek, P. Pietras, Financing the commercialization of technology and knowledge-based innovative projects):
- Determining the period to be analyzed. It is determined individually for each project taking into account, inter alia, the estimated time of use of the fixed asset being the subject of the investment. In the case of the analysis of IT projects, the time horizon of their detailed analysis is typically 5-7 years.
- Preparation of a financial plan for the project, specifying the amount of investment expenditure, sources of financing and financial forecasts. The plan should be constructed on the basis of future, expected capital expenditures, revenues from the sale of products and costs of current operations, incurred as a result of the project implementation. When a project is implemented alongside an existing activity, it can sometimes be difficult to separate them from each other.
- Construction of the profit and loss account, requiring the planning of sales revenues and related costs. In an existing enterprise, based on historical data, it is quite easy to plan the costs of the following years. When an IT project develops on the basis of a completely new entity, the cost structure should be estimated on the basis of experience and market analysis.
- Determining the value of cash flows, and therefore the value of financial resources at a specific point in time at the company's hand. While it is relatively easy to plan investment flows (e.g. purchase of hardware devices) or financial flows (related to financing activities, e.g. from loans), it is difficult to plan operational flows related to current activities (purchase and sale of goods, services, etc.). And operating costs have a major impact on the need for working capital for planned operating activities.
Thus, investments in technology come with risks. Generally, the risk occurs in such main areas as (based on D.M. Trzmielak, W. B. Zehner, Methodology and organization of consulting in the field of technology transfer and commercialization):
- A market where the risk relates to the assessment of market events related to changes in the behaviour of buyers, purchase patterns, the size of market segments, market potential, demand and supply of funds for the development of new technologies or changes in regulations, but also the volatility of the entrepreneur's needs, willingness to pay for the granted license, the availability of competent service providers (further commissioned research), or misappraisal of the market and market trends resulting from their sudden change or lack of access to information.
- Business, characterized by the risk related to the fact that not every idea is accepted on the market, the expectations may not be met by testing the idea, prototype or interest in the target market, as well as the lack of economic value of market research results or the lack of patentability of solutions.
- R&D activities, where the risk concerns not achieving the assumed research successes, exceeding the budget, delaying the work schedule, not achieving the planned technology parameters, protecting intellectual property and ease of copying solutions, or changing government policy.
- Investments when the risk results from difficulties in achieving the intended investment parameters of the technology implementation, including the assessment of financial results obtained thanks to the implementation, assessment of the granted (purchased) license or obtaining income from funds invested in a new company.
- Other areas of risk, such as errors in assessing the development of substitutional solutions, assessing the sources of obtaining materials and components, or assessing changes in the legislative, social and political environment.
An important step towards risk in assessing the financial effectiveness of an investment in IT technology is to determine its sources and the method of measurement against the desired effects of the project. The risk assessment should be useful for the preparation of reserves and collateral, protecting the project against unprofitability or bankruptcy, in the form of a reserve of funds, collateral in the work schedule, alternative methods of action, etc.
We will talk about general risks that may occur in the implementation of technology transfer projects (in particular IT) in a separate article. Another interesting point or tool in the area is well-defined software request for proposal (RFP software development). We will discuss it aswell in a new article.