Investment Analysis: Principles and Tools October 10, 2003

2 Ray ReillyHCLI-LDP Investment Analysis Analytical Process Steps/Decision Determine the scope (boundaries) and range (time) for the business activity to be evaluated Specify alternative ways of accomplishing the activity and determine cases to be evaluated Forecast net cash flows for each case Determine the appropriate risk-adjusted cost of capital for each case Calculate Net Present Value Consider factors beyond the basic quantitative analysis Determine a course of action

3 Ray ReillyHCLI-LDP Investment Analysis Net Present Value Net Present Value of a project is the expected change in wealth of the investor in the project NNCF t P N NPV = ∑ + t=0(1+K) t (1+K) N NPV =net present value of the project NCF t =net cash flow in period t K=risk adjusted cost of capital N=planning horizon for the project P N =terminal value of the project at the end of the planning horizon

4 Ray ReillyHCLI-LDP Investment Analysis Internal Rate Of Return NNCF t P N 0 = ∑ + t=0(1+r) t (1+r) N NCF t =net cash flow in period t r=internal rate of return N=planning horizon for the project P N =terminal value of the project at the end of the planning horizon

5 Ray ReillyHCLI-LDP Investment Analysis Project Acceptability Chart Net Present Value (calculated using K)Internal Rate of Return Accept Project+r > K Indifferent0r = K Reject Project–r < K r= Internal Rate of Return K = Risk-Adjusted Cost of Capital

6 Ray ReillyHCLI-LDP Investment Analysis Development Of The Cash Flow For Valuation Analysis REVENUE –Expense (excluding Depreciation) –Depreciation Earnings before tax –Income tax Earnings after tax +Depreciation Operating cash flow –Investment –Increase in net working capital Net cash flow Note:Financial charges including interest, principal repayment, dividends, and stock repurchases are not included in the net cash flow computation. The cost of financing is reflected in the discount rate used to compute the present value of the cash flows.

7 Ray ReillyHCLI-LDP Investment Analysis Relevant Cash Flow Engineering, R&D, test market costs Product costs (material, labor, overhead) Erosion/enhancement Taxes Investment Inflation Salvage & other terminal value considerations Working capital Currency exchange Real options

8 Ray ReillyHCLI-LDP Investment Analysis Risk-Adjusted Cost of Capital Weighted Average* Cost of Capital Risk-Free Return* Risk-Adjusted Cost of Capital * Risk Class of the Firm Risk Rate of Return

9 Ray ReillyHCLI-LDP Investment Analysis Discount Rates Used by Other Healthcare Organizations Trinity/St. Joe’s11.8% Duke11.42% University of Chicago6.00% or 8.00%* Northwestern Memorial8.00% University of Michigan12.00% * Depends on whether they plan to use debt or equity financing

10 Ray ReillyHCLI-LDP Investment Analysis Sample Investment Analysis Cardiovascular Center University of Michigan Hospitals and Health Centers Financial Overview

11 Ray ReillyHCLI-LDP Investment Analysis HHC Project Cost $millions CVC building and equipment$171 Parking deck15 CFOB demolition1 Roadway improvements1 Utility upgrades10 Project cost$198

12 Ray ReillyHCLI-LDP Investment Analysis Cardiovascular Center – UMHS Summary Activity ActualProj.Estimated Incremental% Increase Cardiovascular Center ActivityFY01FY06FY07FY08FY09FY10FY11From FY01 Non-procedure clinic visits33,71139,0002,5004,7007,2009,70012,40052% Invasive procedures7,48310, ,2001,9002,6003,30082% Non-invasive procedures78,04089,90011,60017,40023,40029,90036,70062% CVC surgical cases1,6952, % CVC Discharges5,6936, ,2501,7002,20056% UM Main operating room backfill cases7,1477, ,000 23%

13 Ray ReillyHCLI-LDP Investment Analysis Cardiovascular Center – UMHS Summary Incremental Financials ActualEstimated Incremental Numbers in millionsFY01 Start-upFY07FY08FY09FY10FY11 Net Revenue Outpatient-CVC-HHC$0$10$13$18$22$27 Inpatient –CVC-HHC$0$14$28$44$61$80 Main OR Backfill – HHC$0$7$15$23$24$25 Professional$0$16$19$22$25 Total Net Revenue$127$0$47$75$107$132$157 Expenses Cash operating expenses - HHC$3$25$42$63$78$96 Cash operating expenses - Pro$0$12$15$18$20 Depreciation - HHC$0$13 Total Expenses110$3$50$70$94$111$129 Margin$17($3) $5$13$21$28 Margin %13%-6%7%12%16%18% Note: Medical School revenues and expenses are from September 2001.

14 Ray ReillyHCLI-LDP Investment Analysis Cardiovascular Center – UMHS Summary NPV Analysis $ millions012345Term. Value Margin($3) $5$13$21$28 Depreciation$0$13 Capital Investment($198)$0 Working Capital$0($2) ($3)($2) Cash Flow($201)$8$16$23$32$38$300 Discount Factor PV Cash Flow($201)$7$13$17$22$24$169 NPV-UMHS$52 Note: Medical School revenues and expenses are from September 2001.

15 Ray ReillyHCLI-LDP Investment Analysis Ideas from the Cardiovascular Center Analysis Project cost Incremental activity (revenue, expenses) Margin NPV analysis Cash flow –Depreciation, working capital, discount factor) Terminal value NPV - UMHS Do you understand the structure? Do you understand the Terminology? Do you understand the Analysis? Do you understand the Result?

16 Ray ReillyHCLI-LDP Investment Analysis Management Issues in Investment Decisions Is the investment process linked to the overall strategy? Is all investment subject to value-based management? If all value-creating investments cannot be funded at present, what are the bases for prioritization? Are any organizational rules-of-thumb used in the investment process? Are they valid? Are there any sacred cows in the investment arena? Is there a process for project evaluation and audit for control and learning purposes? Is the organization willing to reconsider an ongoing activity in light of changes that have taken place since the original decision?