The Case for IT

Chapter 4

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Announcements

• Quiz return after class

• Three people still need to form project team– See me after class

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Today’s Outline

• Economic Measures

• Justifying expenditure on IT– As infrastructure cost– As profit driver– As proprietary advantage

• Three examples– SABRE– IBM– MedCo

• Building a Business Case

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Important Financial Measures

• Return on Investment / Rate of Return

• Return on Equity

• Return on Assets

• Internal Rate of Return

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Return on Investment

• Also known as rate of return• = ratio of money gained/lost to investment

amount

• Eg. – Invest $1,000 at start, – end with $1,075

– Return on investment = 75/1000 = 7.5%

• Often annualized ROI is used

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Return on Equity

• = Return on net worth

• Measures the return to common stockholders

• ROE = Net Income / Average stockholder’s equity

= (net income/sales) * (sales/total assets) * (total assets/avg stockholders equity)

(known as DuPont Formula)

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Return on Assets

• ROA = Net Income / Total Assets

• = (Net Income / Sales) * (Sales / Assets )

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Time Value of Money

• The present value of something its value in today’s dollars

• Eg. Having $110 a year from now is equivalent to having $100 if the bank is giving 10% return

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Net Present Value

• Value of cash flows in today’s dollars

Where

t - the time of the cash flow

n - the total time of the project

r - the discount rate

Ct - the net cash flow (the amount of cash) at time t.

C0 - the capital outlay at the beginning of the investment time ( t = 0 )

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Internal Rate of Return

• Annualized effective compounded return rate

• = Discount rate that results in net present value of zero from series of cash flows

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Comparison with financial options

• Security option:– The right to buy a security at a fixed, predetermined

price (called the exercise price) on or before a fixed date (called the maturity date)

• Eg. The right to buy (up to) ten Google Stock, one year from today for $450 each

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This week’s case:IT Doesn’t matter

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Main Ideas

• Competitive Advantage from IT is possible, but challenging

• ‘IT Doesn’t matter’ responses

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Chapter 4: Making the Case for IT

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Table 4.1: IT Investment Categories

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Business Case for IT

• Investments in reusable, value-enabling infrastructure lower costs, improve asset efficiency and create strategic options for future growth

• Investments in value-creating IT applications drive profitable growth through further cost reductions and revenue generation

• Value-sustaining IT applications and infrastructure provide strategic differentiation and proprietary advantage

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SABRE

1957 • IBM and American Airlines team up to form SABRE, the Semi-

Automatic Business Research Environment. It's based on SAGE, the Semi-Automatic Ground Environment -- the first major system to use interactive, real-time computing -- which IBM helped develop for the military.

1960 • The first Sabre reservation system is installed in Briarcliff

Manor, N.Y., on two IBM 7090 computers. It processes 84,000 telephone calls per day.

1964 • The Sabre system, and its nationwide network, is completed at

a cost of $40 million and becomes the largest commercial real-time data-processing system in the world. It saves American Airlines 30% on labor costs.

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SABRE

1972 • The Sabre system is upgraded to IBM S/360 and moved to a

new consolidated computer center in Tulsa, Okla. It is used for all of American Airlines' data processing facilities.

1976 • The Sabre system is installed in a travel agency for the first

time, triggering a wave of travel automation. By the end of the year, 130 locations have the system.

1984 • Sabre introduces BargainFinder, the industry's first automated

low-fare search capability. Competitors sue American Airlines, saying its Sabre system unfairly gives its flights priority on the displays seen by travel agents. American agrees to discontinue any preferential treatment of its flights.

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SABRE

1985 • Sabre introduces easySabre, allowing consumers with PCs to tap into the

Sabre system to make airline, hotel and car rental reservations. 1989 • On May 12, the ultrareliable Sabre system goes down for 12 hours. The

cause: a latent bug in disk-drive software that destroys file addresses. 1996 • Sabre launches Travelocity.com. 2000 • AMR Corp., the parent of American Airlines, spins off The Sabre Group as

an independent company. 2001 • Sabre Holdings Corp. begins migrating its massive, 25-year-old mainframe

system for air-travel shopping and pricing to HP NonStop servers and Linux servers.

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Table 4.2: Leveraging Infrastructure at IBM: IT Operations

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Table 4.3: IBM: Enterprise Support Processes

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Arguments for IT

• New applications give competitive advantages

• Open standards, reliable infrastructure give rise to more innovation

• IT can give both operating efficiencies and business insight

• Reusable modules, shared middleware, common interfaces get around traditional pitfalls

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Role of infrastructure

• Examples of traditional infrastructure– What value do they create?– How do businesses account for them?

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Role of infrastructure

• IT infrastructure– Specific IT operations (data center, network, call

centers)– Support for enterprise processes (procurement,

ERP, finance, HR)

• Value creation– Efficiency– Speed to market– Flexibility

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Proprietary Advantage

• More than just cost-cutting!

• Must change competitive positioning– Successful entry into growing market or exit from

shrinking one– Achieving top position in attractive industry and

sustaining it– Attracting loyal investors

• Very few competitive advantages are sustainable!

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Table 4.4: Driving Profitable Growth at IBM

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Table 4.5: Creating Proprietary Advantage at IBM

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Differences of IT vs. other infrastructure costs

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Questions, Break, Presentation

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MedCo IT option

• Business plan to launch internet-enabled remote patient monitoring business

• Patients with pacemakers place device over pacemaker to collect data on rhythm, blood pressure, etc.

• Data sent from patient’s home by internet to physician, family, health care providers

• Cash flow expectations suggest:– $300 million investment over 5 years to develop– Positive cash flow in 5 years– $2 billion in revenues by year 10– … but there are risks– See curve in fig 4.3(a)

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Figure 4.3(a) Three Cash flow scenarios for MedCo Patient Monitoring Investments

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Alternative investment strategies

MedCo A:• 2 years and $150 million spent developing databases,

networks, call centers• Next 18 months, proprietary remote monitoring business

applications and user interface built for $25 million• Final 18 months $125 million custom installations, networking

patients etc.• What if this leads to $600 million cash flow from year 13MedCo B:• Leverage existing IT infrastructure (databases, networks, call

centers in 2 years for $25 million• Minimizes custom integration, rollout time• Proprietary advantage only lasts 3 years• Cash flow approach $1.5billion

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Figure 4.3(b) MedCo A and MedCo B Patient Monitoring Investments

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MedCo B options

• MedCo B can also use existing infrastructure for other income generating products– Other diseases– Charging family members for service

• These options are available because of initial investment

• They do not have to be exercised if the market changes

• Therefore give a lower risk

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Figure 4.3(c) MedCo B Leverages Infrastructure and Exercises Options

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Figure 4.3(d) the Value of Leveraging Infrastructure and Exercising Options

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Writing a Business Plan

• Two different scenarios:– A plan written for the purpose of attaining venture

capital funds– A plan for reorganizing the financial structure within

a company

• Both require excellent writing, clear objectives and positive projections

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Business Plan Success

• Personal Introduction, visit• Find out objectives of VC• Tell story• Negotiate• Treat all interactions as part of proposal• Executive summary is key• Be careful with writing, formatting, packaging• Maintain momentum• Don’t count cash till you have it• Expect mostly no answers and move on!

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What Investors look for

• People/management that can get the job done

• Innovative technology that can be commercialized

• Large, rapidly expanding market

• Strategy to gain “unfair advantage”

• Attractive per price share

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Business Plan Components

• Executive Summary

• Customer Need and Business Opportunity

• Business Strategy and Key Milestones

• Marketing Plan

• Operations Plan

• Management and Key Personnel

• Financial Projections

• Appendices

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Business Plan Components

• Executive Summary– Business opportunity, technology, product, market,

management– Proposed financing

• Amount• Use of proceeds

– Five-year income summary and requirements

• Customer Need and Business Opportunity– Product and technology description, uses

• Business Strategy and Key Milestones– Cumulative cash need and head count at each

milestone

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Business Plan Components

• Marketing Plan– Customer need– Market segmentation– Channels of distribution– Sales strategy and plans– Five-year sales forecast– Competition and positioning

• Operations Plan– Engineering plan– Manufacturing plan– Facilities and administration plan

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Business Plan Components

• Management and Key Personnel– Incentive compensation program– Detailed resumes– Organization– Staffing plan and headcount projections

• Financial Projections– Assumptions– Five-year pro forma forecasts– Income statement– Balance sheet– Cash flow statement

• Appendices– (If needed)

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Reminder

• Project Team – after class if you don’t have team yet