1. 14 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Principles of Capital Budgeting Project classifications Role of financial analysis Cash flow estimation Breakeven and profitability measures The post audit

2. 14 - 2 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is capital budgeting? Analysis of potential additions to a business’ fixed assets. Such decisions: Typically are long-term in nature. Often involve large expenditures. Usually define strategic direction. Thus, such decisions are very important to a business’ future.

3. 14 - 3 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Project Classifications For analysis purposes, projects are classified according to purpose and size. For example, Mandatory replacement Expansion of existing services Expansion into new services

4. 14 - 4 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Role of Financial Analysis For investor-owned firms, financial analysis identifies those projects that are expected to contribute to shareholder wealth. For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’ financial condition.

5. 14 - 5 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Overview of Capital Budgeting Financial Analysis 1. Estimate the capital outlay. 2. Forecast the cash inflows: Operating flows Terminal flows 3. Assess the project’s riskiness. 4. Estimate the cost of capital. 5. Measure the financial impact.

6. 14 - 6 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Key Concepts in Cash Flow Estimation Incremental cash flows: Inc. CF = CF (w/ project) - CF (w/o project). Cash flow versus accounting income Cash flow timing Project life

7. 14 - 7 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Key Concepts (Cont.) Sunk costs Opportunity costs: For capital For other resources Effects on other business lines Shipping and related costs

8. 14 - 8 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Key Concepts (Cont.) Working capital effects: Current assets Current liabilities Inflation effects Strategic value

9. 14 - 9 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cash Flow Estimation Example Assume Northwest Healthcare, a not- for-profit hospital, is evaluating a new piece of diagnostic equipment Cost: $200,000 purchase price $40,000 shipping and installation Expected life = 4 years. Salvage value = $140,000.

10. 14 - 10 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Utilization = 5,000 scans/year. Charge = $80 per scan. Variable cost = $40 per scan. Fixed costs = $100,000. Corporate cost of capital = 10%. Cash Flow Estimation Example (Cont.)

11. 14 - 11 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Time Line Setup 01234 OCF 1 OCF 2 OCF 3 OCF 4 Initial Costs (CF 0 ) + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4

12. 14 - 12 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equipment $200 Installation & Shipping40 Net investment outlay $240 Investment at t = 0 (000s)

13. 14 - 13 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Operating cash flows (000s) 1234 Revenues$400 Total VC200 Depreciation25 BT op. inc.$ 75 Taxes-- $ 75 Depreciation25 Net op. CF$100 AT op. inc. Fixed costs100

14. 14 - 14 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Should the CFs on the previous slide have included interest expense or dividends? No. Financial costs are accounted for by discounting the net cash flows at the 10% corporate cost of capital. Thus, deducting interest or dividends from the estimated cash flows would be “double counting” financing (capital) costs.

15. 14 - 15 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Terminal cash flows at t = 4 (000s) Salvage value $140 Tax on SV0 Net terminal CF$140  How are salvage value taxes determined for investor-owned firms?

16. 14 - 16 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Suppose $5,000 had been spent last year to improve the space for the new diagnostic equipment. Should this cost be included in the analysis? No. This is a sunk cost. The money has already been spent, so project acceptance would have no effect on that flow. Cash flows in the analysis must be incremental to the project.

17. 14 - 17 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Suppose the space could be leased out for $12,000 a year. Would this affect the project’s cash flows? Yes. Accepting the project means that Northwest Healthcare is foregoing a $12,000 cash inflow. This is an opportunity cost that should be charged to the project.

18. 14 - 18 Copyright © 1999 by the Foundation of the American College of Healthcare Executives If the new equipment would decrease patient utilization of existing services, would this affect the analysis? Yes. The effect on other CFs within the business is an “externality.” The net CF loss each year on other services would be a cost to this project. Externalities can be either positive or negative.

19. 14 - 19 Copyright © 1999 by the Foundation of the American College of Healthcare Executives 0 100 1 2 3 4 -240 140 240 Net cash flows (000s)

20. 14 - 20 Copyright © 1999 by the Foundation of the American College of Healthcare Executives If this were a replacement rather than a new (expansion) project, would the analysis change? The relevant operating CFs would be the difference between the CFs on the new and old equipment. Also, selling the old equipment would produce an immediate cash inflow, but the salvage value at the end of its original life is foregone.

21. 14 - 21 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Breakeven Analysis There are many different approaches to breakeven in project analysis: Time breakeven Input variable breakeven Utilization Charge We will focus on payback (or payback period), a measure of time breakeven.

22. 14 - 22 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is the project’s payback? 0 100 1 2 3 240 4 -240 Cumulative CFs: 60-240-40-140300 Payback = 2 + 40 / 100 = 2.4 years.

23. 14 - 23 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Strengths of Payback: 1.Provides an indication of a project’s risk and liquidity. 2.Easy to calculate and understand. Weaknesses of Payback: 1.Ignores time value. 2.Ignores all CFs occurring after the payback period.

24. 14 - 24 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Profitability Analysis Profitability analysis focuses on a project’s return. As with any investment, returns can be measured either in dollar terms or in rate of return (percentage) terms. Net present value (NPV) measures a project’s dollar return. Internal rate of return (IRR) measures a project’s rate of return.

25. 14 - 25 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net Present Value (NPV) NPV is merely the sum of the present values of the project’s net cash flows. The discount rate used 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%.

26. 14 - 26 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is the project’s NPV? 0 100 1 2 3 240 4 -240.00 10% 90.91 82.64 75.13 163.93 172.61 = NPV

27. 14 - 27 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Financial Calculator Solution Enter in CF j registers: -240 100 240 CF 0 CF 1 NPV CF 2 CF 3 I Then: = 10 And solve for: CF 4 = 172.61

28. 14 - 28 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Interpretation of the NPV NPV is the dollar contribution of the project to the equity 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.

29. 14 - 29 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Internal Rate of Return (IRR) IRR measures a project’s percentage (rate of) return. 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.

30. 14 - 30 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is the project’s IRR? 0 100 1 2 3 240 4 -240.00 ? ? ? ? 0.00 = NPV IRR = ?

31. 14 - 31 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is the project’s IRR? (Cont.) 0 100 1 2 3 240 4 -240.00 73.84 54.53 40.27 71.36 0.00 = NPV IRR = 35.4% Therefore, IRR = 35.4%.

32. 14 - 32 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Calculator Solution Enter in CF j registers: -240 100 240 CF 0 CF 1 IRR CF 2 CF 3 And solve for: CF 4 = 35.4%

33. 14 - 33 Copyright © 1999 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 = 35.4% and the project cost of capital is 10%, so the project is expected to enhance Northwest’s financial condition.

34. 14 - 34 Copyright © 1999 by the Foundation of the American College of Healthcare Executives k > IRR and NPV < 0. Value is decreased. NPV ($) Cost of Capital (%) IRR IRR > k and NPV > 0. Value is increased. Comparison of NPV and IRR Here, k = project cost of capital.

35. 14 - 35 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Budget Decision Making Responsibility resides with: Senior-level management/GB for expansion-type capital projects Mid-level management for replacement- type capital projects Decision criteria summary Strategic importance of project “Appropriate” project returns anticipated “Manageable” level of project risk

36. 14 - 36 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Budget Decision Making Evaluating projects with unequal lives Mutually exclusive projects having different useful life periods Comparing apples to oranges Evaluation methods Replacement chain analysis method “Force” projects to have equal lives by allowing unlimited replication Assumes that cash flow projections and cost of capital won’t change upon replication Difficulty in finding “lowest common denominator” for similar project lives (5 vs. 6)

37. 14 - 37 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Budget Decision Making Equivalent Annual Annuity Method Given projected project NPV, estimate “implied” annuity (PMT) associated with stream of cash flows Enter NPV as PV in calculator, cost of capital as ‘I’, and # of years as N, find PMT Project with highest estimated EAA is preferred Like RCA method, assumes that projects can be costlessly replicated indefinitely.

38. 14 - 38 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Budgeting in NFP Businesses Measures thus far have focused on the financial impact of a project. Presumably, NFPs have important goals besides financial ones. Other considerations can be incorporated into the analysis by using: The net present social value (NPSV) model.

39. 14 - 39 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Budgeting in NFP Businesses TNPV = NPV (fin.) + NPSV (social) Preferred projects have high TNPV No investments in projects where NPSV < 0 (regardless of NPV) Average TNPV for all projects = 0 Estimation of NPSV -- willingness to pay methodology (conceptual) The “social” cost of capital

40. 14 - 40 Copyright © 1999 by the Foundation of the American College of Healthcare Executives 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