Mar 1, 2014

First Level Requirements

We devise systems to bring about a new, better situation, a better tomorrow. This better tomorrow can be an alleviated problem, a realised vision, or a captured opportunity.

Unfortunately, many systems are built with only a passing familiarity with what the mission is.  Without a rigorous understanding and clarity of what is being sought, the result will be unsatisfactory.  Systems are expensive to build.  They cost money, use up time, extract effort.  We can do things more effectively. How?

First, one must have a clear understanding of the current situation.  What is it that’s causing pain, causing dissatisfaction?  The examples are myriad: foreign aircraft are able to cross our boundaries at will; our payroll system is too slow and making the staff spend too much time using it; our operating costs are too expensive compared to the industry for the same services, and so on.

Then we analyse the situation, and identify what changes need to occur in the problem domain for the problem to be alleviated.  For example, a change might be to have the ability to detect, intercept, and if necessary shoot down unwelcome aircraft; vastly reduced payroll processing time; reduced operating costs by at least 15%.

These changes are what the solution systems needs to ‘effect.’  A solution system that provides the ability to sink ships; run a payroll program on Unix; improve morale do not address the changes required.  They would not exhibit the necessary effects on the problem domain.

Some solutions will be more effective than others. A solution may be able to track 10 planes at a time while another can track 100;  A solution may reduce payroll processing time by 5 hours while another by 1 hour.  A solution may reduce operating costs by 20% and another by 25%.

The difference in their level of effect is the measure of effectiveness. All things equal, we want more effective solutions than less effective solutions.

The changes required on the problem domain map to the effects required from the solution system. 

Jan 12, 2014

Impact of the Risky Situation on Present Value

 An investment that is more risky must offer higher returns (if only potential), than safer investments.  If it did not, why would anyone invest in it? 

One impact on the present value is that the the required interest rate will be increased by the ‘risk premium’, which is the additional rate on top of the risk-free rate.  If the risk free rate was for example 2%, and the risky investment offers a risk premium of for example, 8%, then the total interest rate of the investment would be 2% + 8% = 10%.

The simple formula for present value:

CV = PV (1 + i)^t

needs to be adjusted to include the risk premium:

CV = PV (1 + i + rp)^t

Where:

CV = cash value in the future 
PV = cash value in the present (most commonly known as present cash value) 
i = interest rate of a given time period (for example, the interest rate for 1 year) 
rp = risk premium 
t = the number of time periods to consider

Example: What is the present value of an investment that will give us $12,000 one year from now, if the risk-free interest rate was 2% and the risk premium was 8%?

CV = PV (1 + i + rp)^t 
12,000 = PV (1 + 0.02 + 0.08)^1 
PV = 12,000 / (1.10) 
PV = $10,909

What does $10,909 mean?

  1. $10,909 today, if invested for one year at the combined risk-free and risk premium rate would return $12,000 in one year.
  2. $12,000 one year from now is worth $10,909 today if a comparable investment is available today.

For the sake of comparison, what is the present value of $12,000 -- to be received one year from now -- without the risk premium?

CV = PV (1 + i + rp)^t 
12,000 = PV (1 + 0.2 + 0.0)^1 
PV = 12,000 / (1.02) 
PV = $11,534

Jan 11, 2014

Present Value of Future Cash in a Risky Situation

The most basic way of determining the present value of a future cash flow considers only 3 things:

  1. How much cash are we talking about?
  2. What is the interest rate that you could invest the cash in if you had it today instead of in the future?
  3. How long is the future?  1 year?  2 years?

Why would you be receiving that future cash flow anyway?  Sometimes it’s cash that came from you.  Sometimes it’s cash as payment for services you rendered.  Consider the following three scenarios:

  1. You put in $10,000 in a term deposit.
  2. You lend $10,000 by buying a corporate bond.
  3. You provide a service to a company which now owes you $10,000

In each case, the other party has an obligation to pay you back your money.  Is the chance that you will get paid the same?  It’s almost certain you will get your money back from the term deposit.  Even if the bank collapses, the $10,000 is most certainly covered by insurance.

The corporate bond is at risk if the company that issued the bond goes bankrupt.  How likely this is depends on who the company is.  A bond issued by an IBM is less risky than one issued by a smaller startup.

The company who owes you $10,000 may decide not to pay you at all.

Since the risk of not being paid in these scenarios is not different, there are two key things to note:

  1. The value of the future cash flow should not be the same. 
  2. You would normally want to be compensated for taking more risk.

The most basic means of computing the future cash flow, as outlined above, is not adequate for computing future cash flows that have a certain amount of risk in them.  The formula needs to incorporate the risk factor.