Information Technology Investments

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Information Systems Frontiers 5:3, 289–301, 2003

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2003 Kluwer Academic Publishers. Manufactured in The Netherlands.

Information Technology Investments: Characteristics,Choices, Market Risk and Value

Brian L. Dos Santos

∗

Department of Computer Information Systems, College of Business & Public Administration, University of Louisville, Louisville, KY 40292, USA E-mail: briandossantos@iitbombay.org Abstract.

The decisions confronting information technology (IT)managers have changed a great deal since the early 1970s. Thekey decisions three decades ago were related to the management of application development projects and operations centers. To-day, the key decisions are quite different. What level of serviceshould the firm provide end-users? Should IT services, devel-opment projects and the ownership and management of opera-tions centers be outsourced? IT investments attempt to satisfyspecific needs. Because of environmental differences and differ-ences in the cost structure and benefits of alternative ways inwhich these needs can be met, the answers to these questionsmay differ across firms. Modern financial analysis can provideinsights to help managers deal with many of the problems theycurrently face. We use modern financial theory to show how thevalue of IT investments can be affected by some of the choicesmade by managers. We show how the market risk of demand and the market risk of costs affect the market risk and value of IT investments. We consider three types of investment decisions:outsourcingversusin-houseservices;investmentsininterorgani- zationalsystems;anddeterminingtheoptimallevelofITservicesthat should be provided. Our analysis indicates that: (1) as themarket risk of demand for operations decreases, firms are lesslikely to outsource operations; (2) the value of an investment in an interorganizational system increases as the market risk of costs increases; and (3) the optimal level of user service is in-versely related to service demand risk and is directly related tothe market risk of service costs.

1. Introduction

Firms are spending billions of dollars on computersystems. However, there have been claims that firmsfail to benefit from these investments and suggestionsthat firms are making poor information technology(IT)investmentdecisions(BrynjolfssonandHitt,1996;Dos Santos, Peffers and Mauer, 1993; Benaroch andKauffman, 1999). Information technology investmentdecisions are often based on intuition, fear and follow-ing what other firms have done. Only infrequently arethesedecisionsbasedonfinancialanalysis(DosSantos,1991;Keen,1981).AlthoughexantefinancialanalysisofITinvestmentspresentsproblemsthathavebeendis-cussed by many authors (Kauffman and Kriebel, 1988;Strassman, 1988; DeLone and McLean, 1992), suchanalysis can provide useful insights to managers facedwith investment choices.ThekeyproblemsfacingITmanagershavechangedover time. Thirty years ago, key problems faced byIT managers stemmed from the management of de-velopment projects and operations centers. Today, thekey decisions are quite different. What level of serviceshould the firm provide end-users? Should IT services,development projects and the ownership and manage-ment of operations centers be outsourced? IT invest-ments attempt to satisfy specific needs. Because firmsface different environments and the cost structure andbenefits of the investment choices available to firmsdiffer, the answers to such questions may differ acrossfirms.Widespread adoption of Internet standards is mak-ing it easier for firms to develop interorganizationalsystems. Today, systems that link a firm to its cus-tomers and suppliers are fairly common. Firms invest-ing in interorganizational systems are faced with manydecisions that affect the cost and benefit structures of thesesystems.Forexample,firmsmustdecidewhethercharges for these systems are based on use, a fixed fee,or whether charges are built into the price of the goods

∗

I would like to thank D.C. Mauer for his help on key aspects of thispaper.

289

290

Dos Santos

and services provided. These decisions affect the coststructure and bene

ﬁ

ts of the system and thereby affectthe market risk and value of the system. Market risk is the risk to a project

’

s returns that result from ad-verse movements in the level or volatility of markets.Investors cannot eliminate market risks by holding adiversi

ﬁ

ed portfolio. The market risk of an investmentshould be re

ﬂ

ected in the rate used to discount cash

ﬂ

ows from the investment. Hence, market risks affectthe projected value of an investment. Managers mustunderstand how alternative ways of meeting needs af-fect the market risk and value of a system in order tomake sound investment decisions.An increasingly important IT management decisioninvolves determination of the level of IT services thatthe

ﬁ

rm must provide. For example, IT services aimedat educating end-users and helping them deal withproblems that they encounter are important, makingit necessary to determine the level of support for theseservices. The optimal service level is affected by thecharacteristics of a

ﬁ

’

s products and services, andits operations. The nature of a

ﬁ

’

s products (or ser-vices) may determine how demand for (i.e., use of)these support services is affected by general economicconditions. The sales of some products are more sen-sitive to economic conditions than are others, and thissensitivity can affect the demand for IT services. Otherservice-related decisions also require such consider-ation. For example, how should priorities be set fordifferent groups of users of a centralized resource or anetwork environment?We use modern

ﬁ

nance theory to show how differ-ent choices available to managers making certain ITinvestment decisions affect the market risk and valueoftheseinvestments.Ouranalysisfocusesonthreedif-ferent IT investment decisions. We begin our analysiswith a decision involving a choice between outsourc-ing the operations function and housing this functionwithin the

ﬁ

rm. We show that outsourcing the opera-tions function is a more viable option as the marketrisk of demand for the services provided by the op-erations function increases. Next, we consider someof the issues that must be addressed when developingan interorganizational system. Firms that are develop-ing an interorganizational system have to make manydecisions during the development and implementationphases that affect the cost structure and bene

ﬁ

ts of thesystem. The variable costs and bene

ﬁ

ts if such systemsmay not be related to demand (i.e., use). We show thatthevalueofsuchsystemsincreasesasthemarketriskof variable costs of the system increase. Finally, we con-sider service level decisions. We show that the optimalservice level is inversely related to demand risk and di-rectly related to the market risk of periodic

ﬁ

xed costs.The paper is organized as follows: Section 2 pro-vides a very brief characterization of related researchand provides a discussion of different types of busi-ness risk as it relates to IT investment decisions. InSection 3 we develop, analyze and interpret models forthree types of IT investment decisions. A brief sum-mary and conclusions is presented in Section 4.

2. Background

Ex ante analysis of IT investments has been studied forover two decades by information system (IS) practi-tionersandacademics(KingandSchrems,1978;Keen,1981; Dos Santos, 1991; Benaroch and Kauffman,1999; Campbell, 2002). The problems encounteredwhen trying to determine the value of IT investmentsare widely discussed in the literature (Keen, 1981;Benaroch and Kauffman, 1999; Brynjolfsson, 1994).Thestandardmethodtoevaluatepotentialcorporatein-vestmentsisdiscountedcash

ﬂ

ow(DCF)analysis.DCFanalysis determines the value of an investment by dis-counting the expected value of each period

’

s cash

ﬂ

owbyarisk-adjusteddiscountrate.TouseDCF,itisneces-sary to obtain unbiased estimates of the expected cash

ﬂ

ows attributable to the investment (project) and a dis-countratethatadjustsforthemarketriskoftheproject.Recently, many authors have suggested that real op-tions analysis may be a better way to evaluate potentialIT investments if the current investment could providesigni

ﬁ

cant investment opportunities in the future andthese future investment opportunities can be identi

ﬁ

edinadvance(DosSantos,1991;Kambil,Henderson,andMohsenzadeh, 1993; Benaroch and Kauffman, 2000;Campbell, 2002). Many IT investments, however, donot meet these conditions. Our experience at two verylarge

ﬁ

rmsintheUnitedStatessuggeststhatmany

ﬁ

rmsrequire DCF analysis for IT investments.The analysis in this paper is based on the DCF ap-proach. The cash

ﬂ

ows from IT projects are affectedby numerous factors: the quality of the system, conver-sion effectiveness, economic conditions, interest ratesandactionstakenbythe

ﬁ

rmanditscompetitors.Thesefactorsmakethecostsandbene

ﬁ

tsofaprojectrisky.ITproject risks are of two types:

market risks

and

uniquerisks

. Market risks stem from the fact that there are

Information Technology Investments

291

economy-wide perils that threaten all businesses. Forexample, government regulations, general economicactivity and the events of September 11th affect cash

ﬂ

ows of all businesses to some extent. Market risk istherisktoaproject

’

ﬁ

nancialconditionresultingfromadverse movements in the level or volatility of mar-kets. Market risks are not directly related to a speci

ﬁ

cproject; yet they affect a project

’

s cash

ﬂ

ows. Uniquerisks include

project-speci

ﬁ

risks that are unique tothe project, and

ﬁ

rm-speci

ﬁ

risks that are unique tothe

ﬁ

rm or the industry.The information systems (IS) literature has primar-ily focused on project-speci

ﬁ

c risks, for example, therisksemanatingfromuncertaintiesinthedevelopment,implementation and use of the system are project-speci

ﬁ

c risks (Kambil, Henderson, and Mohsenzadeh,1993; Mukhopadhyay, Barua, and Kriebel, 1995). Willthesystembecompletedontime,asbudgetedandwiththe features that are anticipated when the investmentdecision is made? Will the completed system be ashelpful to users as anticipated and will it be as usefulas expected? Risks that affect completion of the devel-opment effort, features that will be available and use-fulnessofthesystemtousersareprimarilyafunctionof the characteristics of the project, individuals involvedin the development effort, end users and methods usedto develop the system. Although project-speci

ﬁ

c riskscan be high for many IT investments, they are of noconcern to a shareholder who holds a diversi

ﬁ

ed port-folioofinvestments.Indeed,oneofthecentraltenetsof modern

ﬁ

nance theory is that investors will not requirethat a discount rate for a project contain a premiumfor project-speci

ﬁ

c risks. Project-speci

ﬁ

c risks are ac-counted for in estimates of project value by adjustinga project

’

s cash

ﬂ

ows for the risk involved. In general,the greater the project-speci

ﬁ

c risks that reduce futurebene

ﬁ

ts and/or increase cost, the lower the estimate of future expected cash

ﬂ

ows.Other IT investment risks are speci

ﬁ

c to a

ﬁ

rm. Forexample, the actions taken by a

ﬁ

rm in the future canaffect the costs or bene

ﬁ

ts of a project. Consider thesituation where a

ﬁ

rm decides to increase promotionof its products after an IT project that reduces order-processing costs has been developed and is in use. Asa result of the promotion, there may be an increasein orders, which would lead to an increase in the cash

ﬂ

owfromtheITproject.Otheruniquerisksareindustryrelated. For example, the actions taken by competitorsmay affect a project

’

s cash

ﬂ

ow, or prices of certaincommodities may affect cash

ﬂ

ow as a result of theirimpact on the prices of the

ﬁ

’

s products. Risks thatare

ﬁ

rm or industry speci

ﬁ

c also can be eliminated byinvestors through portfolio diversi

ﬁ

cation and shouldnot affect the discount rate for a project. These risksshould be re

ﬂ

ected in estimates of the project

’

s cash

ﬂ

ows.Although market risks affect the costs and bene-

ﬁ

ts of IT projects, they have received little attentionin the IT investment valuation literature (Dos Santos,1991). Market risks, to varying degrees, in

ﬂ

uence thebene

ﬁ

tsandcostsofallinvestments.Forexample,

ﬂ

uc-tuations in economic activity will generally affect thecostsandbene

ﬁ

tsofaproject.Thisispainfullyevidentright now; for many

ﬁ

rms, the return on recently com-pleted IT investments has been negatively affected bythe downturn in the economy. Consider for example,a

ﬁ

rm that recently invested in an information systemthatwasexpectedtoreduceorder-processingcosts.Thenumber of orders that the system processes drives thebene

ﬁ

ts of this system. The number of orders the

ﬁ

rmreceivesmaybenegativelyaffectedbythedownturninthe economy. An expanding economy may lead to anincrease in sales and thereby increase the value of suchaninvestment.Thenumberofordersprocessedmaybelarger when the economy is growing fast and smallerwhen the economy is shrinking. Cash

ﬂ

ows from suchan IT investment will have a positive covariance withthe return on the market. As such, the discount ratefor the IT investment should re

ﬂ

ect this risk. Modern

ﬁ

nance theory suggests that projects with cash

ﬂ

owsthat co-vary with general market conditions require ahigherdiscountratethanprojectsthatarelesssensitiveto such conditions.The underlying question addressed here is: how dothe decisions that are made during the pre-productionstages (i.e., before the system is in use) of a projectaffect its value? To answer this question, we need todetermine how the alternatives that are available affectthemarketriskoftheprojectandthevalueoftheinvest-ment.Inthenextsection,wedevelopmodelsthatallowus to determine how development and implementationdecisions and project characteristics affect market risk andthevalueoftheinvestmentforthreedifferenttypesof IT investment decisions.

3. Project Risk and Value

The underlying assumptions for our analysis are thatthe

ﬁ

rm making the investment has publicly traded

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