Monday, March 28, 2005

How Interest rate hikes affect ROI

As interest rates keep inching higher, HR professionals often have trouble with creating ROI presentations that are meaningful to financial executives. This week, Greenspan announced that there is some inflation risk in the economy, meaning that interest rates may rise even faster in the upcoming months. As you will see in the following conversation, as interest rates increase, ROI will be much more difficult to find as you try to justify your software purchases.

So why do interest rates impact an ROI? Well, a standard ROI will project cost savings for various processes over a period of time, often 3, 5 or 10 years. As you (an HR practitioner) project these costs over time, a financial executive will want to understand what these costs are in relation to the “Net Present Value” or NPV. For a ROI novice, a simple ROI might mean that a $10K implementation with a $5K/year savings has a 2 year payback. In reality, year 2’s $5K savings are not worth $5K in today’s dollars because of interest and inflation. What is a 2 year payback to the ROI novice is a 2+ year payback to a financial executive. While this does not seem significant, if we use 5-10 years, a simplified (non-NPV) ROI might return a positive dollar value, but a NPV ROI might show that the investment will never produce a financial return.

So what is NPV? NPV is a means of identifying what the current cost of a future investment is worth. NPV uses interest rate assumptions based on the current cost of capital that the CFO uses to borrow money. In other words, if the $10K implementation we used earlier was borrowed money at 14% interest, you can see why it takes more than 2 years to pay off that implementation.

14%??? Yes, 14%. Most CFO’s use their base cost of capital plus a minimum required ROI. So a loan of 7% + minimum ROI of 7% gives you 14%. This is a good thing. Because the CFO uses 14% (most are somewhere between 14-18%), if you can get a ROI of $0 savings using the NPV ROI method, you have achieved the CFO’s minimum ROI requirements. If you need more help, here's a good site.