CHAPTER 9 Capital Investment Decision Basics Project classifications Role of financial analysis Time value of money Project evaluation measures Payback NPV IRR Project scoring Post audit Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Capital Investment Basics Capital investment decisions (capital budgeting) involve the process of analyzing proposed new investments in land, buildings, and equipment. Such decisions: Typically are long-term in nature Often involve large expenditures Usually define strategic direction Thus, these decisions are very important to businesses. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Project Classifications Proposed investments (projects) are classified according to purpose and size. For example, Mandatory replacement Expansion of existing services Less than $1 million $1 million or more Expansion into new services How are such classifications used? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Role of Financial Analysis For investor-owned businesses, financial analysis identifies those projects that are expected to contribute to owners’ wealth. For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’s financial condition. Why is this important? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Overview of Capital Investment Financial Analysis Estimate the project’s cash flows. 2. Assess the project’s riskiness. 3. Estimate the project cost of capital (opportunity cost of capital or discount rate). 4. Measure the financial impact. In this chapter, we focus on Step 4 (measuring the financial impact). The first three steps will be covered in Chapter 10. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Capital Budgeting Example Assume that Midtown Clinic is evaluating the purchase of a x-ray machine. Cost = $240,000. Expected life = 4 years. Corporate cost of capital = 10%. The expected cash flows from buying and operating the equipment are listed on the next slide.                 Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Project Cash Flows (in thousands) 1 2 3 4 ($240) $100 $105 $110 $141 Note that the cash flows have been laid out on a time line. Also, the cash flows are merely estimates based on volume, reimbursement rate, and operating cost assumptions. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Breakeven Analysis It is very difficult to make judgments about the financial attractiveness of a project by looking at its cash flows. Breakeven analysis is one way to help interpret the information embedded in the cash flows. We will focus on time breakeven, which is measured by payback (payback period). Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Payback Illustration Cumulative CFs: 1 2 3 4 ($240) $100 $105 $110 1 2 3 4 ($240) $100 $105 $110 $141 Cumulative CFs: ($240) ($140) ($ 35) $ 75 $216 Payback = 2 + $35 / $110 = 2.3 years. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Advantages of Payback: 1. Easy to calculate and understand. 2. Provides an indication of a project’s risk and liquidity. Disadvantages of Payback: 1. Ignores time value (discussed next). 2. Ignores all cash flows that occur after the payback period. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Time value analysis is necessary because money has time value. Time Value of Money Time value analysis is necessary because money has time value. A dollar in hand today is worth more than a dollar to be received in the future. Why? Because of time value, the values of future dollars must be adjusted before they can be compared to current dollars. Discounted cash flow (DCF) analysis is the name given to techniques that account for the time value of money. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

What is the FV after 3 years of a $100 lump sum invested at 10%? 1 2 3 10% -$100 FV = ? Finding future values (moving to the right along the time line) is called compounding. For ease, assume interest is paid annually. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

= PV × (1 + I) × (1 + I) = PV × (1 + I)2 = $100 × (1.10)2 = $121.00. After 1 year: FV1 = PV + INT1 = PV + (PV × I) = PV × (1 + I) = $100 × 1.10 = $110.00. After 2 years: FV2 = FV1 + INT2 = FV1 + (FV1 × I) = FV1 × (1 + I) = PV × (1 + I) × (1 + I) = PV × (1 + I)2 = $100 × (1.10)2 = $121.00. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

After 3 years: FV3 = FV2 + I3 = PV x (1 + I)3 = 100 x (1.10)3 = $133.10. In general, FVN = PV x (1 + I)N . Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Three Primary Methods to Find FVs Solve the FV equation using a regular (non-financial) calculator. Use a financial calculator; that is, one with financial functions. Use a computer with a spreadsheet program such as Excel. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Non-Financial Calculator Solution 1 2 3 10% -$100 $110.00 $121.00 $133.10 $100 x 1.10 x 1.10 x 1.10 = $133.10. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Financial Calculator Solution INPUTS 3 10 -100 0 N I/YR PV PMT FV 133.10 OUTPUT Notes: (1) Set your calculator on P/YR = 1, END. (2) For lump sums, the PMT key is not used. Either clear the calculator before you start or enter PMT = 0. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Financial Calculator Solution Spreadsheet Solution (Optional Slide) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

What is the PV of $100 due in 3 years if I = 10%? 1 2 3 10% PV = ? $100 Finding present values (moving to the left along the time line) is called discounting. The interest rate applied is called the discount rate. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Solve FVN = PV x (1 + I )N for PV PV = FVN ÷ (1 + I )N. PV = $100 ÷ (1.10)3 = $100 × 0.7513 = $75.13. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Time Line Solution 1 2 3 $75.13 $82.64 $90.91 $100 1 2 3 10% $75.13 $82.64 $90.91 $100 $100  1.10  1.10  1.10 = $75.13. Note that the calculated present value ($75.13), when invested at 10 percent for 3 years, will produce the starting future value ($100). Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Financial Calculator Solution 3 10 0 100 -75.13 INPUTS N I/YR PV PMT FV OUTPUT Either PV or FV must be negative on most calculators. Here, PV = -75.13. Put in $75.13 today, take out $100 after 3 years. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Financial Calculator Solution Spreadsheet Solution (Optional Slide) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

On the present value illustration we needed to apply a discount rate. Opportunity Cost Rate On the present value illustration we needed to apply a discount rate. The appropriate discount rate is the opportunity cost rate or opportunity cost of capital. It is the rate that could be earned on alternative investments of similar risk. In capital investment analyses, the corporate cost of capital typically is used as the benchmark discount rate. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Profitability (ROI) Analysis Return on investment (ROI) analysis focuses on a project’s financial return. Financial returns can be measured either in dollar terms or in rate of return (percentage) terms. Net present value (NPV) measures a project’s time value adjusted dollar return. Internal rate of return (IRR) measures a project’s rate of (percentage) return. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Net Present Value (NPV) NPV measures return on investment (ROI) in dollar terms. NPV is merely the sum of the present values of the project’s cash flows. The discount rate used in project analysis is called the project cost of capital. If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Net Present Value (NPV) Calculation 1 2 3 4 10% ($240.00) $100 $105 $110 $141 90.91 86.78 82.64 96.30 $116.63 Thus, the project’s NPV is about $117,000. Note that financial calculators have functions that perform capital investment analyses. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Spreadsheet Solution (Optional Slide) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Interpretation of the NPV NPV is the excess dollar contribution of the project to the value of the business. A positive NPV signifies that the project will enhance the financial condition of the business. The greater the NPV, the more attractive the project financially. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

What is the meaning of an NPV of $0? Discussion Item What is the meaning of an NPV of $0? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Internal Rate of Return (IRR) IRR measures ROI in percentage (rate of return) terms. It is the discount rate that forces the PV of the inflows to equal the cost of the project. (In other words, it is the discount rate that forces the project’s NPV to equal $0.) IRR is the project’s expected rate of return. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

IRR Calculation (Cont.) 1 2 3 4 29.7% ($240.00) $100 $105 $110 $141 77.11 62.46 50.48 49.95 $240.00 $ 0 = NPV. Thus, the project’s IRR is 29.7%. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Spreadsheet Solution (Optional Slide) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Interpretation of the IRR If a project’s IRR is greater than its cost of capital, then there is an “excess” return that contributes to the equity value of the business. In our example, IRR = 29.7% and the project cost of capital is 10%, so the project is expected to enhance Midtown Clinic’s financial condition. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

What is the meaning of an IRR of 0%? Of an IRR of 10%? Discussion Items What is the meaning of an IRR of 0%? Of an IRR of 10%? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Some Thoughts on Project Analysis Although NPV and IRR generally are perfect substitutes, there are yet other ROI measures that can be used; i.e., the Profitability Index. A thorough analysis will consider all profitability measures, plus examine input variable breakevens. However, the key to effective project analysis is the ability to forecast the cash flows with some confidence. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Project measures thus far have focused on financial value. Project Scoring Project measures thus far have focused on financial value. Other factors can be incorporated into the analysis by using project scoring, which is a matrix that considers factors such as patient, staff, and physician value in addition to financial value. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

It has several purposes: Post Audit The post audit is a formal process for monitoring a project’s performance over time. It has several purposes: Improve forecasts Develop historical risk data Improve operations Reduce losses Copyright © 2013 by the Foundation of the American College of Healthcare Executives

Do you have any questions? Conclusion This concludes our discussion of Chapter 9 (Capital Investment Decision Basics). Although not all concepts were discussed in class, you are responsible for all of the material in the text. Do you have any questions? Copyright © 2013 by the Foundation of the American College of Healthcare Executives