A Comparison of Approaches to Investment Analysis John Favaro Proc. Fourth International Conference on Software Reuse, 1996, IEEE Computer Press, p

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 =  C t / (1 + k t ) t C t : future cash flow in period t k t : discount rate in period t NPV = Net Present Value add the initial investment as a negative value NPV = C 0 + 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: –N 0 = E / (1-b) –E = relative cost of developing a component for reuse –b = relative cost of integrating the component –N 0 = 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 C 0 =  C t / (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