A Comparison of Approaches to Investment Analysis

John Favaro Proc. Fourth International Conference on Software Reuse, 1996, IEEE Computer Press, p. 136-145

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

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

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

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

Net present value

PV = Present Value PV = 7 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

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

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

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

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

Avg. return on book value characteristics

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

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 = 7 Ct / (1 + IRR)t

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

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

Summary / conclusion
Table on page 143 of the article