In this Toolkit Part, you learned how to use payback analysis, ROI, and NPV to assess IT projects. Could these tools also be used in your personal life? Give an example of how you might use each one to help you make a financial decision.
What will be an ideal response?
In payback analysis, the key question is how long it takes for something to pay for itself. When people make decisions about products and services, they often must consider payback analysis. For example, suppose you have a home heating or air conditioning system that is relatively inefficient and subject to breakdowns. Should you replace it with a new unit, which might be quite expensive? The answer is, “it depends.” A payback analysis would reveal how long it takes for the new system to pay for itself with reduced operating costs and the avoidance of repair costs.
Now consider ROI, using the same fact situation. Suppose you constructed a spreadsheet showing the lifetime costs and benefits for the new unit. The costs would be the initial purchase, plus operational costs over a reasonable life expectancy, such as 10 or 15 years. The cost-reduction benefits would reflect the avoidance of repair and operating costs that the old system would incur. Using ROI, you could estimate the return on your investment in terms of reduced costs. If you had only a limited budget, you could use ROI to select the maintenance and repair strategies that would be most attractive.
What about NPV, and how could it be useful to our hypothetical homeowner? Using the same fact situation, suppose a new system could be purchased outright at an attractive discount, or at a higher price that could be paid over several years. Also suppose that inflation was about six percent. Because of the time value of money, it would be more desirable to pay for the system with future dollars, using the discount factor, but only if that was less expensive compared to the discount available with an outright purchase. In this situation, NPV would be an ideal tool to help our homeowner make a decision.
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