Your Risk/Return Profile
Decision Research
Hubbard
The Applied Information Economics Company
Objectives
• Review Findings-to-date for ERDMS
and Desktop Replacement
• Capture the initial “Risk/Return
Profile” to be used to evaluate the
investments
Decision Research
Hubbard
The Applied Information Economics Company
Initial Desktop Risk/Return
Chance of a negative IRR
Desktop risk plots
30%
3
25%
20%
1
15%
10%
2
5%
0%
0%
20%
40%
60%
80%
100%
7 Year Expected IRR
1.
2.
3.
3 year replacement cycle; $29 million
4 year replacement cycle; $11 million
Initially accelerated “catch-up” followed by 4 year
replacement cycle; $49 million
Decision Research
Hubbard
The Applied Information Economics Company
Initial ERDMS Risk/Return
Chance of a negative IRR
ERDMS risk plots
60%
50%
40%
1
30%
20%
10%
0%
0%
20%
40%
60%
80%
100%
7 Year Expected IRR
1.
2.
Full ERDMS; $67 million
Various ERDMS Light options are a negative return, but will
probably have a viable risk/return position when the
information value of a pilot is considered
Decision Research
Hubbard
The Applied Information Economics Company
Distribution-based ROI
Inputs
Administrative Cost
Reduction
5%
10%
10%
20%
15
%
% Improvement in
Customer Retention
30
%
Total Project Cost
$2 million
$4 million
$6
million
ROI
-50%
Decision Research
Hubbard
The Applied Information Economics Company
0%
50%
100
%
Analyzing the Distribution
ROI = 0%
“Expected” ROI
Risk of
Negative
ROI
Probability of Positive ROI
The
“cancellation
hump”
-25%
0%
25%
50%
75%
Return on Investment (ROI)
Decision Research
Hubbard
The Applied Information Economics Company
100% 125%
Various Risks & Returns
Low Expected Return
High
Risk
Low
Risk
High Expected Return
-100%
0%
100%
200%
-100%
0%
100%
200%
-100%
0%
100%
200%
-100%
0%
100%
200%
Decision Research
Hubbard
The Applied Information Economics Company
Quantifying Risk Aversion
Probability of a negative ROI
• Your level of “risk aversion” is captured in a
risk/return profile chart
Risk
Investment Region
40%
30%
Acceptable Risk/Return
Boundary
20%
10%
Return
10% 20% 30% 40% 50% 60%
Decision Research
Hubbard
The Applied Information Economics Company
How Risk Averse are You?
Example profiles from 7 actual decision makers
Chance of a negative IRR
50%
Region of
Unacceptable
Investments
40%
Risk Boundaries for IT investments in
the range of $2-3 Million (initial outlay)
30%
20%
Region of Acceptable
Investments
10%
0%
0%
50%
100%
150%
200%
250%
300%
Expected IRR over 5 years
•
•
Decision makers seem to “catch on” to this right away
The risk/return boundaries are consistent with non-IT investors
Decision Research
Hubbard
The Applied Information Economics Company
Example of Risk Effects
Chance of a negative IRR
50%
Region of
Unacceptable
Investments
40%
30%
20%
Region of
Acceptable
Investments
10%
0%
0%
50%
100%
150%
Expected IRR over 5 years
Decision Research
Hubbard
The Applied Information Economics Company
200%
• These are real
IT investments of
$2M-$3M plotted
against a client’s
investment
boundary
• The 27% ROI
investment is
actually preferred
to the 83% ROI
investment
Defining Return
• The “Objective Function” may be defined as
ROI, NPV, EVA, Shareholder value or any
other measure you think is relevant
•
The Internal Rate of Return (IRR) method
for computing return is common
• We need to specify the timeframe to
compute this value (5 years is common)
Decision Research
Hubbard
The Applied Information Economics Company
Define Risk
• The definition(s) of risk used by AIE are much
closer to what actuaries mean by risk than other
methods
• We should define a risk as: A certain probability of
a specific undesirable outcome (loss)
• The exact “undesirable outcome” can be unique to
the organization - the important thing is to be
precise and consistent (so all investments can be
compared on the same basis).
Decision Research
Hubbard
The Applied Information Economics Company
Example Risk Definitions:
• “The percent chance of receiving a negative return
on investment (ROI).”
•
“The chance of losing more than $1,000,000.”
•
“The chance of receiving an internal rate of return
(IRR) below the ‘risk-free’ return.”
Decision Research
Hubbard
The Applied Information Economics Company