(Answered)-The Approach to do Valuation Now a days organizations are - (2025 Updated Original AI-Free Solution

Question

???????????????????????? ????????The Approach to do Valuation

Now a days organizations are interested to know the future value of the investment in Information Technology, the return on investment on Information Technology and contribution of a specific IT project in company?s income statement and dividend to shareholders. Very few IT vendors have realized that and started giving guidance on IT valuation and IT strategy to its customers. Developing a frame work to do this exercise and give solution to customers will be a very good differentiator.

In every IT project there are some cost involved and some revenue expectation. The first task is to identify the IT cost over a period of time. These include the software licensing cost, hardware cost, fee of consultants, cost of capital equipment, production support cost and maintenance cost over a period of time. The revenue estimation part is very important. Usually a company saves cost or generates extra revenue from increased availability of product, rightsizing of workforce, reduction of holding cost through reduction of leadtime and improved management decision through greater visibility.

Cash expenditure is estimated for at least five years. After second year it is generally the production support and maintenance support cost. Future cash flow is also estimated for five years based on estimated revenue. Net cash flow is estimated after summing up both the cash flows. DCF (Discounted Cash Flow) approach is applied to get the NPV of the IT project. After a certain period a terminal value is calculated to reasonably assume the future cash flow over a longer period of time. A positive NPV always advocates for validity of IT project. This NPV is the valuation of IT project and is termed as V _system .Generally the discount is given on opportunity cost of capital. That is the risk free rate of interest the company could have earned by investing the capital using other options. In another way using the same DCF technique we can calculate IRR (Internal rate of Return). This IRR should be higher than the direct cost of capital or opportunity cost of capital to establish the validity of an IT project. This IRR can be treated as ROI of the IT project as well.

The next step is to do corporate valuation. The corporate valuation can be done in various ways. There are DCF approach, market value approach etc. But DCF approach is most popular approach in doing corporate valuation. The future projected cash flow is discounted at the rate of WACC (Weighted Average Cost of Capital) with a proper terminal value. The NPV of the outcome is the valuation of corporation as of date. This is termed as V _{corporate .}

We can now compare the effect of the IT project in the intrinsic value of company?s share.?

From V _system we can negate the amount we are supposed to pay the debt holders and others. We can say that E _{system =} V _{system ?} D_.? D is amount paid to debt holders

Similarly, E _corporate = V _corporate ? D.

The new intrinsic value of share can be calculated as (E _corporate / S)?? + (E _system / S) where the old value is (E _corporate / S).

This way the change in intrinsic value of share of a company due to an IT project can be measured with reasonable assumptions.??

?????????????????????????? Information Technology Cost Modeling

We will take a real life case to estimate the cost of an ERP project. Let us take up the Whirlpool case ?of Harvard Business School to do the cost estimation. The typical areas of spending are capital equipment, software licenses, charge for consultants, internal cost for engaging employees of the company and cost for production support. The typical areas of cost savings are more availability of products, less headcount of staff, reduction in storage time and storage space, reduced lead time and improved inventory turn over ratio.

Total Cost of the project starting year 1999 to 2002.? All facts and figures are from case.

The cost of capital of the money which is going to be used for ERP implementation is 9%.?

?????????????????????? ?Information Technology Revenue Modeling

Let us calculate the total savings in this project.

From the case it can be observed that the company is saving money in working capital reduction, high chance of availability of product, increase in margin and right sizing the company.? By considering the margin increase and increase in availability of the product it can be calculated that increase in profit should be something mentioned below in the table. Other cost savings are there is the case.

To calculate the return on investment we need to calculate the net cash flow for every year starting from 1999. The production support expense and software license upgrade expense should be a constant expense for subsequent years.

It can be observed that after few years the net cash increase will be constant. We can use terminal value which is 163 M USD to make an end to this.

???????????????? ??Information Technology Project ROI Estimation

Using DCF (Discounted Cash Flow) the IRR is 48%. There is DCF software which can calculate the value of IRR. It calculates for what interest rate we can discount the cash flow so that the net present value becomes zero. This IRR is nothing but ROI. This is higher than 9% which is the cost of capital used for ERP implementation Project. So we can say that the implementation project is feasible.

The mathematical equation for this calculation is like this:-

-11.25? - 5 /(1+IRR) + 2/(1+IRR)² ?+ 7/(1+IRR)³ + 15.6 / (1+IRR)⁴ + 21/ (1+IRR)⁵ + 21 / (1+IRR)⁶ + 21 / (1+IRR)⁷ + 21 /(1+IRR)⁸ ?= 0

We can get IRR = 0.48 which is ROI.

?????????? ????????????????????????Information Technology Valuation

The valuation of the ERP project at Whirlpool can be done in the following way. We can again use DCF for this. The direct cost of capital which was used in the ERP project was 9%. We can discount the DCF with this interest rate. The NPV of the outcome may be the value for the project.

NPV =? -11.25? - 5 /(1+0.09) + 2/(1+0.09)² ?+ 7/(1+0.09)³ + 15.6 / (1+0.09)⁴ + 21/ (1+0.09)⁵ + 21 / (1+0.09)⁶ + 21 / (1+0.09)⁷ + 21 /(1+0.09)⁸ ?

NPV = -11.25 ? 4.58 + 1.68 + 5.40 + 11.06 + 13.72 +? 12.57 + 11.53 + 10.55

50.68

We can infer that the valuation of the ERP project at Whirlpool is 50.68 Million USD. This value is termed as V _system.

Adequate data is not there in the case based on which we can do corporate valuation. Unless we do the corporate valuation, we can not estimate the change in intrinsic value of share of the company. But we have methodology and valuation technique which we can use to do the remaining part in any real life case.

evaluate the followings:-

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1. What are the main issues in this case?

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?2. What are the Project Risks?

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?3. How these risks can be mitigated?