Understanding the Value of Your Cloud Investments

As a technologist you might wonder what exactly your Finance department is thinking about when considering different payment options for Cloud Service Providers (CSP) committed use discounts like AWS’ Reserved Instances (RIs) or Savings Plans (SPs). In general, you could save more when you are willing to pay upfront a proportion of the commitment. So, it seems like a no brainer, right?!? If we are going to spend a certain amount in a specific technology anyway, why not prepay and take those additional savings to reinvest in our applications? So Finance Department, what gives? Well in the dynamic landscape of technology investments, making informed decisions about payment options for AWS RI/SP is akin to Application Rationalization. It’s crucial for optimizing costs, however, needs to be placed in the proper context of the business and its financial constraints. While these upfront commitments offer significant savings potential, there is a drain on the most important resource of a company, CASH (incoming satire: not you, don’t buy into the HR mantra). So understanding what are some of the tools your Finance & Accounting departments use to make their go-no-go decision, can help you frame the discussion or business case for the next purchase or your recommendation. I hope to unpack what is Net Present Value (NPV) and Weighted Average Cost of Capital (WACC) and how we use them in FinOps decisions. 

AWS Payment Options

AWS provides 3 different payment options. All Upfront, Partial Upfront, and No Upfront. The specific uptick in discount depends on the commitment itself including location, term, instance type, etc. So lets take a look at one example.

• Operating System = Linux
• Region = US East Ohio
• Instance Type = c5d.xlarge
• Tenancy = Shared
• Commitment Type = Savings Plan
• Term = 3year

Would Net:

• No Upfront = 51.6% Discount off On-Demand
• Partial Upfront = 55.2% Discount off On-Demand
• All Upfront = 56.3% Discount off On-Demand

In general, I have observed No Upfront to Partial Upfront (keep in mind that partial is 50% of the total commitment upfront, the rest monthly) to be an additional 4points higher discount, and Partial Upfront to All Upfront an additional 2 points higher discount. But it does really depend on the specifics.

There might be other circumstances where Finance & Accounting will consider making prepayments rather all or partial upfront, like expense the commitment this fiscal year while we have the budget. I wont dive into those issues much just make sure you have those matching principle and lease accounting discussions with your staff accountants.

So that leaves us with NPV and WACC.

Net Present Value (NPV)

NPV is the notion or theory that one should invest in something that has a present value greater than zero when you factor in all of the projected cash flows and you discount those by a certain rate. For accounting and finance, their ultimate goal is to increase shareholders wealth. So being "good" financial stewards of the company’s finances, they will only be approving or recommending decisions that will lead to positive outcomes for the enterprise. In the context of AWS RIs and SPs, NPV assesses the long-term benefits of these commitments versus using funds in a different capacity. By estimating the expected cost savings over the RI or SP term and discounting them to their present value, you can determine if the upfront payment is worthwhile. One confusing financial jargon that I keep bringing up is discounting. Discounting is essentially considering the expected rate of return that the company expects to get from an investment. We will dive into more of this in the next section, just remember it is a rate of return an enterprise expects.

NPV Calculation:

• Estimate future cash flows: Project the expected cost savings for each period of the RI or SP term. (1 or 3 years)
• Determine the discount rate: Use WACC (we will discuss next) as the discount rate.
• Calculate the present value of each cash flow: Divide each cash flow by (1 + discount rate)^n, where n is the number of periods.
• Sum the present values: Add up the present values of all cash flows.
• Subtract the initial investment: Subtract the cost of the RI or SP from the sum of present values.

If the NPV is positive, the investment is potentially advantageous for the organization. So the question is which option leads to a higher NPV? No Upfront, Partial Upfront, or All Upfront.

Weighted Average Cost of Capital (WACC)

WACC represents the average rate of return a company expects to pay to all its equity and debt holders. Taking one stepback, how does a company raise funds. Well it can raise funds from operations (selling stuff), getting a loan (debt) or issuing stock (equity). Your finance and accounting departments make it their goal to invest in areas that can at least net them a higher return than their debt and/or equity holders costs. By accurately determining your company's WACC, you can assess the financial viability of RIs and SPs in the context of your overall capital structure. So WACC calculate the cost or debt (interest over total debt) and cost of equity at their respective proportions.

WACC Calculation:

• Determine the market value of equity (E): This is the current market capitalization of your company.
• Determine the market value of debt (D): This is the total market value of your outstanding debt.
• Calculate the total value of capital (V): V = E + D
• Determine the cost of equity (Re): This can be calculated using the Capital Asset Pricing Model (CAPM) or Dividend Yield.
• Determine the cost of debt (Rd): This is the interest rate you pay on your debt. (check the income statement)
• Determine the tax rate (T): This is your company's corporate tax rate. (there are tax implications to interest payments)

WACC formula: WACC = (E/V * Re) + ((D/V * Rd) * (1 - T))

Combining NPV and WACC for Optimal Decision Making

By combining NPV and WACC, you can make data-driven decisions (sounds like a FinOps principle) about your AWS payment option:

1. Calculate WACC: Determine your company's WACC.
2. Estimate future cash flows: Project the expected cost savings from RIs or SPs.
3. Calculate NPV: Discount the future cash flows using WACC to determine the present value.
4. Compare options: Evaluate different RI and SP options based on their NPVs.
5. Optimize your strategy: Select the payment option with the highest positive NPV

Live Long and Prosper

Now that you have a basic understanding of the tools used to evaluate the different payment options, bake them into your business case on purchasing a RI or SP.