I got around to reading a back copy of the Harvard Business Review and an article caught my eye again. Innovation Killers – How financial tools destroy your capacity to do new things. I skim read it back in January this year and made a mental note to spend a little time giving it more attention. Now is a great time for me to review whilst I am in the midst of developing the business case for an (expensive and critical) major IT transformation.

The article talks about the misapplication of three key financial analysis tools:

Lets start with Net Present Value and Discounted Cash Flow calculations for IT Investments. Perhaps I should explain first that NPV is the inverse of DCF. NPV is the value that an investor would give to a promised stream of payments over a period of time. Typically this value is less that the sum of all of the payments allowing for interest and risk payments.

NPV and DCF are great tools for making investment decisions on types of investment where the decision not to make the investment will not materially affect cash flows coming from existing business activities. In many IT related investments this is patently not true as running with older software and systems is highly likely to impact existing profitability of a business unit as competitors move to overtake us.

Moving on to fixed and sunk costs for IT Investments, our CFO is encouraged to discount the net flows to the present. This approach assumes again that the do nothing choice will result in no damage to existing cash flows. As for DCF, this is patently untrue for many IT Investments. Also knowing that the equity markets will punish managers for early asset write offs can cause delays in making the right decision. Startup businesses are not subject to the same constraints and this is often a key driver that enables upstarts to make enormous inroads into mature markets.

Short term focus on earnings per share as the primary driver of share price and thereby executive reward is another critical factor. Investments that do not make an immediate and positive EBITDA impact are less likely to gain approval for investment. This is one of the reasons that Private Equity has been so successful in restructuring businesses across the world.

So what are the lessons to be learnt and how do we explain this to our CFO? Simply this, that in the fast moving world of technical innovation that drives competitive advantage the simple investment assessment tools do not work straight out of the box.

We must take into account that the do nothing option does not necessarily mean that existing cash flows hold up. Do nothing often means a diminution of return on the existing business as competitors move to become more efficient.