Net Present Value (NPV) is defined as the sum of the present values of the individual cash flows.
Solely relying on NPV will not address the overall loss or gain of actually executing a technology initiative. Many times internal rate of return is used as a complement to NPV when attempting to better understand a percentage gain relative to the investments made for a project.
What about adjusting for risk by adding a premium to the discount rate? A bank may certainly charge a higher rate of interest for a riskier project, but that does not mean this is a valid NPV approach to adjusting for risk. If some risk is incurred leading to a loss, then a discount rate in the NPV will reduce the impact of the loss below its accurate financial cost. You might want to consider a risk approach that requires identifying and valuing risks explicitly and thus explicitly calculating the cost of financing any/all losses incurred.
What happens when the amount of cash (inflow minus outflow) is generally negative late in a project (e.g., a custom component(s) Service-Level Agreement is offered (and must be paid) just prior to project sign-off)? The company owes money, so a high discount rate is overly idealistic. A reasonable solution for consideration is to calculate the cost of financing a situation such as the one described above.
See below for a recent email exchange first between a Principal of an IT consulting firm and one of their prospective partners – and then the Principals of the consulting firm. Email communications start at the bottom of this post.
Principal #1: As we discussed last night – our employees need to know that we will go to the ends of the earth to protect them and our business. They are the real VALUE in the equation.
Principal #2: I am really proud of you and how you are handling all this.
Principal #1: I am staying involved to remind her that we have not yet come to a teaming agreement.
Principal #2: I am impressed that you’ve found someone so willing to just tell you how worthless you are. She treats you like a three year old.
Principal #1: I apologize. Too many high priority things to do yesterday just coming back from the Thanksgiving holiday.
I was surprised to hear from you about <consultant name withheld> as I thought you communicated during our last phone discussion that because <company and partner names withheld> had not come to an agreement, that you would not be presenting <consultant name withheld> resume to <client name withheld>.
I indicated yesterday that <consultant name withheld> has been resourced to a new project beginning 12/6 that will last 5-6 months.
We do have other resources – they are even more experienced than <consultant name withheld> – but their hourly rates are higher, but I certainly don’t want to “put the cart before the horse” as I think we are not yet close to coming to an agreement. The sticking point as I remember it is the specific project/task at hand vs. any/all future projects.
Prospect: I am very disappointed you didn’t tell me earlier in the day as I might have tried to reach out to someone else. I waited all day for your call.