Table Of Content

FINANCE FOR IT DECISION MAKERS BCS, THE CHARTERED INSTITUTE FOR IT Our mission as BCS, The Chartered Institute for IT, is to enable the information society. We promote wider social and economic progress through the advancement of information technology science and practice. We bring together industry, academics, practitioners and government to share knowledge, promote new thinking, inform the design of new curricula, shape public policy and inform the public. Our vision is to be a world-class organisation for IT. Our 70,000 strong membership includes practitioners, businesses, academics and students in the UK and internationally. We deliver a range of professional development tools for practitioners and employees. A leading IT qualification body, we offer a range of widely recognised qualifications. Further Information BCS The Chartered Institute for IT, First Floor, Block D, North Star House, North Star Avenue, Swindon, SN2 1FA, United Kingdom. T +44 (0) 1793 417 424 F +44 (0) 1793 417 444 www.bcs.org/contact FINANCE FOR IT DECISION MAKERS A practical handbook Third edition Michael Blackstaff © 2012 Michael Blackstaff Second edition published by The British Computer Society 2006 First edition published by Springer Verlag 1999 All rights reserved. Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted by the Copyright Designs and Patents Act 1988, no part of this publication may be reproduced, stored or transmitted in any form or by any means, except with the prior permission in writing of the publisher, or in the case of reprographic reproduction, in accordance with the terms of the licences issued by the Copyright Licensing Agency. Enquiries for permission to reproduce material outside those terms should be directed to the publisher. All trade marks, registered names etc. acknowledged in this publication are the property of their respective own- ers. BCS and the BCS logo are the registered trade marks of the British Computer Society charity number 292786 (BCS). Published by BCS Learning & Development Ltd, a wholly owned subsidiary of BCS The Chartered Institute for IT, First Floor, Block D, North Star House, North Star Avenue, Swindon, SN2 1FA, UK. www.bcs.org ISBN: 978-1-780171-22-7 PDF ISBN: 978-1-780171-23-4 ePUB ISBN: 978-1-780171-24-1 Kindle ISBN: 978-1-780171-25-8 British Cataloguing in Publication Data. A CIP catalogue record for this book is available at the British Library. Disclaimer: The views expressed in this book are of the author(s) and do not necessarily reflect the views of the Institute or BCS Learning & Development Ltd except where explicitly stated as such. Although every care has been taken by the authors and BCS Learning & Development Ltd in the preparation of the publication, no warranty is given by the authors or BCS Learning & Development Ltd as publisher as to the accuracy or completeness of the information contained within it and neither the authors nor BCS Learning & Development Ltd shall be responsible or liable for any loss or damage whatsoever arising by virtue of such information or any instructions or advice contained within this publication or by any of the aforementioned. Typeset by Lapiz Digital services, Chennai, India. Printed at CPI Antony Rowe Ltd, Chippenham, UK. iv CONTENTS Figures and tables x Authors xiii Foreword xiv Acknowledgements xv Abbreviations xvi Preface xvii 1 FINANCE AND ACCOUNTS: THE BASICS 1 Objectives 1 The purpose of business 2 Companies or corporations 2 How a business works 4 Example 1.1 Part 1: How transactions affect the statement of financial position 7 Example 1.1 Part 2: Typical adjustments 12 Example 1.1 Part 3: The income statement 15 Example 1.1 Part 4: The statement of cash flows 17 Relating cash flow to profit 18 Published accounts 19 Planning and management accounting 22 Cash flow forecasting 22 Non-business organisations 23 Summary 24 2 DECISIONS, DECISIONS... 25 Objectives 25 What is cash flow? 25 A financial case 25 What is discounted cash flow? 30 The cost of money 31 Present value 32 Net present value (NPV) 35 Interpreting present values 37 Opportunity cost 37 ‘Financial cash flows’ 38 Inflation 38 Summary 41 v CONTENTS 3 FINANCIAL CASES AND BUSINESS CASES 42 Objectives 42 Cost cases 42 Financial cases 43 Business cases 44 What is a benefit? 45 Cash flow and profit 46 A basis for investment decision-making 50 Summary 51 4 WHEN IS A BENEFIT NOT A BENEFIT? 52 Objectives 52 How to build an IT financial case 52 Example 4.1: Description 53 Example 4.1: Solution 57 Example 4.1: Explanations 57 What cash flows are relevant? 67 Is it a worthwhile investment? 70 Summary 70 5 HOW FINANCIAL CASES ARE EVALUATED: PART 1 71 Objectives 71 Present value revisited 71 The cost of capital 72 Weighted average cost of capital (WACC) 73 Applying present values 74 The NPV decision rule 77 Profitability index 77 Internal rate of return (IRR) 78 The IRR decision rule 82 NPV, IRR and risk 83 Summary 87 6 HOW FINANCIAL CASES ARE EVALUATED: PART 2 88 Objectives 88 Payback 88 Payback and risk 90 Discounted payback 92 Return on investment (ROI) 94 ROI and risk 99 Shareholder value added (SVA) 101 Example 6.1: SVA 102 The methods compared 105 Summary 107 7 THE EFFECTS OF TAXATION 108 Objectives 108 Business tax 108 ‘Depreciation allowances’ 110 How does tax affect an IT financial case? 113 vi CONTENTS After-tax evaluation of an investment 116 The results compared 118 Taxation and leasing 119 Summary 121 8 DEPRECIATION OF IT ASSETS 122 Objectives 122 Depreciation of IT assets 122 Straight-line depreciation 123 Reducing balance depreciation 123 Loss on disposal 123 Frequency of depreciation charge 124 Depreciation of upgradable assets 125 Summary 126 9 IT FINANCING AND LEASING 127 Objectives 127 Introduction 127 What is a lease? 128 Lease definitions 130 Finance leases 131 How are finance leases accounted for? 132 Sale and lease-back 133 Leasing and financial cases 134 Operating leases 136 Residual value (RV) 136 How are operating leases accounted for? 140 Risk and reward 141 Variations on the leasing theme 143 Exchange leases 144 Rental 144 International financing 145 ‘Small ticket’ leasing 146 The leasing contract 146 The future 147 Summary 147 10 OUTSOURCING: FINANCIAL ASPECTS 148 Objectives 148 What is outsourcing? 148 Outsourcing in personal life 150 Outsourcing in business 151 Financial characteristics of outsourcing 152 Risk and service levels 152 Financial evaluation methods 153 Service enhancements 154 Inflation 155 How to build an outsourcing financial case 156 A worked example 157 Example 10.1: Description 157 vii CONTENTS Step by step to the solution 162 The tables 162 Example 10.1: Explanations 164 Example 10.1: Summary 184 Outsourcing decision criteria 185 Managing the process 186 Summary 186 11 BUDGETING, COSTING AND PRICING: THE BASICS 188 Objectives 188 Budgeting 188 Departmentalised businesses 189 Cost centres and profit centres 190 Charge-out 190 Responsibility accounting 191 The importance of operating profit 191 Capital expenditure 192 Revenue expenditure or ‘expense’ 193 Budgets and leasing 194 Costing and pricing 196 Variable costs 197 Fixed costs 198 Contribution 199 Price/volume calculations 201 Costing in manufacturing 203 Art versus science 206 Summary 207 12 FINANCIAL ANALYSIS: THE BASICS 208 Objectives 208 Financial analysis 208 Example 12.1: A sample company 210 Profitability ratios 214 Activity (or capital productivity) ratios 216 Liquidity (or cash management) ratios 220 Gearing or leverage ratios 221 Stock market ratios 222 Other ratios 223 Shareholder value added 223 Summary 225 APPENDICES 227 A1 DISCOUNT TABLES 229 The present value of a lump sum 229 The present value of an annuity 229 Annual equivalent annuity 232 viii