Appendices to Information Technology
Investments and Firm Value
Dehning,
B.,
Information and Management, Vol. 42,
Issue 7, Oct. 2005, pp. 989–1008.
Bruce Dehning
Phone: (714) 628-2702; Fax: (714) 532-6081
Email: bdehning@chapman.edu
Phone: (479) 575-6803; Fax: (479) 575-2863
Email: vrichardson@walton.uark.edu
Theophanis Stratopoulos
Phone: (519) 888-4567 ext. 35943
Email: tstratop@watarts.uwaterloo.cau
Table of
Contents
·
Both Appendices in a Word
document.
Numerical
Examples – COMPARATIVE STATIC ANALYSIS
Below are the numerical examples referred to in each section of the implications of the FVF for managers. As shown in equation (8), firm value is a function of six variables, IAE, FAE, n, d, re, and BV. In the following sections we examine the effect of a ceteris paribus change in each one of these variables on firm value.
Change in IAE,
Industry Abnormal Earnings
Ceteris paribus, a change in industry profitability changes firm value in the same direction. The effect of a change in the level of industry abnormal earnings on firm value can be shown with a simple numerical example. Assume that initially in an industry firms earn low abnormal earnings ($0.50/period). After industry-wide IT implementation firms earn high abnormal earnings ($2.00/period). Before and after implementation, companies have the same book value ($10.00), level of risk, and cost of equity capital (10%). Ceteris paribus, an increase in industry profitability leads to an increase in value. The following table summarizes firm value before and after the IT investments.
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Before IT Implementation, Low Abnormal Earnings |
After IT Implementation, High Abnormal Earnings |
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Change in FAE, Firm-Specific Abnormal
Earnings
We continue our numerical example in order to further demonstrate our findings. Consider a company from the example above with a value of $30.00 as follows.
If the company introduces new IT that increases its abnormal earnings
from $2 to $5 (FAE = 3) for
a period of 5 years (n = 5),
and the cost of equity capital stays the same, then new firm value is $41.37.
Change in n, the Duration of Competitive Advantage
We can demonstrate the impact of duration on firm value by examining different durations of competitive advantage when FAE > 0. Recall the company from the example above. The company implemented IT that led to an increase in abnormal earnings from $2 to $5 (FAE = 3) for a period of 5 years.
If the company is able to increase the duration of competitive advantage
for another four years, then the value of the company will increase to $47.28.
Change in re, the Cost of Equity Capital
Consider the change in risk and therefore the cost of equity capital, re, due to new investments in IT. Remember that the company in our example originally had a value of $30.00 based on a book value of $10.00, abnormal earnings of $2.00, and a cost of equity capital of 10%.
If the cost of equity capital increases to 13%, abnormal earnings decrease to $1.70, due to a higher charge for the cost of equity capital. In addition, future abnormal earnings are impounded into price at a decreased amount and the value of the company is only $23.08.
Timing of Abnormal Earnings
The effect of d
on firm value can be easily demonstrated by continuing the numerical example
from above. Remember that the company implemented IT that led to an increase in
abnormal earnings from $2 to $5 (FAE = 3)
for a period of 5 years.
If the increase in abnormal earnings from that
investment were delayed three years (d = 3),
the value would only be $38.54.
An opposite effect occurs when abnormal earnings are received earlier. Accelerating abnormal earnings increases firm value. There are two ways to capture this effect in the model, through a reduction in d, the opposite of the example presented above, or shortening n and increasing FAE as shown below. As shown above, the company in our example had a value of $41.37 based on IAE = $2.00, FAE = $3.00, and n = 5.
If the company is able to accelerate abnormal earnings from the last two years ($3.00 per year for 2 years, or $6.00) into the first three years (increasing firm-specific abnormal earnings in those years from $3.00 to $5.00), firm value increases to $42.43.
This demonstrates that the magnitude of competitive advantage is as equally important, if not more important than the duration of competitive advantage. Ceteris paribus a longer duration of competitive advantage leads to higher firm value. However, ceteris paribus a competitive advantage that is half as long but twice as large (e.g. FAE = 4, n = 3) increases firm value more than a competitive advantage twice as long but half as large (e.g. FAE = 2, n = 6).
Change
We will start this example with an IT investment that results in $15.00 of income over three years. After three years we will assume that competitors duplicate the investment and competitive forces drive abnormal profits to zero. In the example, beginning book value is $5.00 and the cost of equity capital is 10%. Assume that no dividends are paid, so the increase in book value is equal to the reported profits for the period. The profits are evenly distributed over the three years, resulting in firm value of $15.03 as follows:
Now assume that initial IT expenditures are expensed in the first year, driving first year profits to zero. Despite the overly conservative accounting method chosen, firm value remains at $15.03:
This example shows that regardless if IT-related expenditures are initially capitalized and shown as assets or written off, firm value does not change. It is the benefits of the IT that increase firm value, not the choice of accounting for the IT investment.
Numerical
Examples – DYNAMIC ANALYSIS
A Delay in Abnormal Earnings Offset by an
Increase in FAE
Consider a company with industry abnormal earnings of
$2 that is considering an IT investment that will increase abnormal earnings
immediately by $1 for 3 years. In this case the value of the firm would increase
slightly to $32.49.
However, if by
delaying the investment by 2 years and they are able to increase abnormal
earnings by $2, then firm value increases to $34.11.
A Change to a More Profitable
Industry Offset by a Decrease in FAE
The management of a company might observe a higher level of abnormal earnings in another industry and believe that a way to increase firm value would be to operate in that industry. In order to do so the company must invest heavily in IT. However, due to a lack of technical IT skills and managerial IT skills necessary to successfully implement and manage the necessary IT, the move is accompanied by a negative FAE of $2.50 that lasts for ten years until the adequate capabilities are developed. Under this scenario, the value of the company after moving to the new industry is $14.64, less than the value of the company when they operated in the industry with lower industry level of abnormal profits. The original value is given as:
After moving into the new industry, there is an increase in IAE but firm value drops due to negative FAE that last for ten years.
IT Leads to Increase in FAE that is Offset by an Increase in re
This numerical example demonstrates the importance of managing risk when implementing new IT. Remember the earlier example of a company that increased its abnormal earnings from $2 to $5 (FAE = 3) for a period of 5 years and had a new value of $41.37.
But if an increase in risk (Dre = 4%) accompanies the increase in the company’s abnormal earnings, firm value is $30.35, not a substantial change from the original value of $30.00.
Only by managing the risks associated with the new IT will the firm realize a significant increase in value.