A Financial Approach to Evaluating Data, Analytics and AI Investments Using NPV, IRR, and WACC
Guest Contributors: Varun Vemula and Zain Raza Nayani
Introduction
Extracting tangible business benefits from data and analytics projects, including those involving AI, has proven challenging for most enterprises. In 2019, VentureBeat reported that 87% of data and analytics (D&A) projects failed to reach production [1]. In 2022, Gartner found that only 20% of insights derived from analytics translated into business outcomes [2]. Despite various reasons for this low success rate, many firms struggle to build a compelling business case to secure investment in data and analytics initiatives. So, how can one effectively use the right KPIs to showcase the business benefits of these D&A projects?
While there are many finances related KPIs and concepts, there are three foundational concepts that can be used to demonstrate the business benefits from D&A projects.
- Net Present Value (NPV): A dollar today is worth more than a dollar tomorrow and this is reflected in the term NPV. NPV is the difference between the present value of the investment and the present value of cash inflows over a period generated from the investment.
- Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of a project zero. In other words, IRR is the expected compound annual rate of return that will be earned on a project or investment. (NOTE: Closely related to IRR is ROIC - Return on Invested Capital. IRR is for evaluating project-specific investment opportunities and ROIC is comparing the efficiency of different companies or business units).
- The Weighted Average Cost of Capital (WACC). WACC represents the company’s average cost of financing from both debt and equity. It serves as the minimum acceptable return that firm can expect from the D&A investments.
Figure 1: Framework for Evaluating Data, Analytics, and AI Investments
Case Study
Here’s a case study illustrating the application of the metrics in evaluating an investment in a D&A project. A mid-sized logistics company, enjoying steady growth, seeks to maintain its competitive edge by investing in a D&A initiative. This D&A project is designed to optimize inventory management, predict customer purchasing behaviors, and refine pricing strategies to boost profitability. The business goals are to increase sales, reduce costs, and elevate customer satisfaction. To assess the feasibility of the D&A investment, we utilized three key financial metrics: NPV, IRR, and WACC.
Step 1: Calculate the expected cash flows for a given time horizon
The upfront cost of investing in D&A project was about $235,000 including labour and technology investments. The projected benefits over a five-year period include improved operational efficiencies such as reduced rework, better decisions, improved data quality, enhanced collaboration and communication, and more generated from the project and it was calculated as follows:
- Year 1: $54,000
- Year 2: $70,000
- Year 3: $83,000
- Year 4: $96,000
- Year 5: $106,000
Step 2: Calculate the NPV
Net Present Value (NPV) assists in evaluating whether a project will generate value for the company by comparing the present value of cash inflows with the initial investment cost. NPV can be calculated as follows:
The NPV calculation is based on the WACC, which reflects the company’s average cost of financing from debt and equity. For this firm, the WACC was 10%, and it is used to discount the project’s future cash flows. We calculated the present values of the projected cash flows for years 1 through 5 and subtracted the initial investment of $235,000. The resulting NPV is $65,688.23, as detailed below.
Essentially, a positive NPV indicates that a project is likely to generate business value, as the returns surpass the investment. Conversely, a negative NPV suggests that the D&A project will fall short of the required return and may not be justified. In our scenario, the NPV is positive at $65,688.23, indicating that the firm can validate the investment in the D&A project.
Step 3: Calculate the IRR
NPV alone cannot be used to decide the investment as we must compare if the positive NPV with the cost of capital the firm in incurring. In this regard, IRR calculates the rate of return on a specific investment or project, often used to evaluate the attractiveness of new investments. IRR is an absolute return measure, helpful for deciding whether a particular investment meets a required rate of return or comparing the profitability of multiple projects. The formula for IRR is shown below [3].
Using the above cashflows, Excel gives IRR value of 19.23% as shown below.
NOTE: The IRR is often tied to the payback period. The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. However, the main issue is that the time value of money is not factored in the calculation of the payback period.
Decision
If the project’s IRR significantly exceeds the WACC, the project is creating value. Mathematically, if NPV > 0 and IRR > WACC, the firm should proceed with the project as it will likely generate sufficient returns to justify the investment. If not, the company may need to rethink the investment or consider alternative projects that provide a better IRR. In this case, the NPV value is $65,688.23 and is greater than zero and the IRR value of 19.26% is greater than the WACC value of 10%. This case study demonstrates how the logistics firm used NPV, IRR, and WACC to assess the value of a D&A project, providing a structured financial approach to making informed investment decisions.
Conclusion
Overall, companies that are data-driven demonstrate improved business performance. McKinsey says that D&A can provide EBITDA (earnings before interest, taxes, depreciation, and amortization) increases of up to 25% [4]. According to MIT, digitally mature firms are 26% more profitable than their peers [5]. Forrester research found that organizations using D&A are three times more likely to achieve double-digit growth [6]. In our experience, D&A projects have yielded 3%-9% increase in net income and up to 15%-30% IRR.
CFO.University’s Capital Investment Analysis Request Form evaluates the financial merits of capital projects, including your investments in AI. With a few inputs from you it calculates Payback, NPV and IRR. This template can be easily amended to reflect your capital spending policy.
References
- https://venturebeat.com/ai/why-do-87-of-data-science-projects-never-make-it-into-production/
- https://www.datascience-pm.com/project-failures/
- https://www.investopedia.com/terms/i/irr.asp#:~:text=What%20Is%20IRR%3F,a%20discounted%20cash%20flow%20analysis.
- https://www.mckinsey.com/capabilities/growth-marketing-and-sales/our-insights/insights-to-impact-creating-and-sustaining-data-driven-commercial-growth
- https://ide.mit.edu/insights/digitally-mature-firms-are-26-more-profitable-than-their-peers/
- Evelson, Boris, “Insights Investments Produce Tangible Benefits — Yes, They Do”, https://www.forrester.com/blogs/data-analytics-and-insights-investments-produce-tangible-benefits-yes-they-do/, May 2020
About Our Guest Contributors
Varun Vemula, MS, is the Managing Partner and VP of Digital and AI at Aztra, a data engineering, analytics and AI firm based in US. He brings over 20 years of expertise in advanced data solutions, and leads Aztra in delivering transformative business insights, streamlining operations, and fostering digital innovation. An MBA candidate at Northwestern’s Kellogg School of Management, he combines technical acumen with strategic vision to drive impactful, data-driven outcomes.
Zain Raza Nayani, ACA, serves as Group Head of Finance at Bin Yousef Group of Companies, a leading firm in Qatar. In this role, he oversees financial operations across multiple divisions, applying his extensive expertise in financial management and strategic planning. Zain’s leadership focuses on establishing robust financial planning, budgeting, and risk management frameworks, all aimed at driving profitability and enhancing operational efficiency for the organization. Zain’s ability to simplify complex financial data into strategic insights makes him invaluable in driving business growth.
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