Create a Budget
Budget Development
Due Week 8 and worth 120 points
One of the tasks you face as a manager, especially if your organization makes frequent business transactions, is that of preparing a budget. A budget is a tool used for planning and controlling your financial resources. It is a guideline for your future plan of action, expressed in financial terms within a set period of time. A budget does not have to be complex. However, it should support the strategic plan for the organization. We will need resources to achieve our goals and objectives.
For this assignment, you will focus on the operating budget. An operating budget shows the company’s projected revenue and associated expenses for an upcoming period—usually the next year. An operating budget starts with revenue, and then shows each expense type. This includes variable costs, or the costs that vary with sales, such as the cost of raw materials and production labor. The operating budget includes fixed costs, such as the monthly rent on office space or the monthly payment for a photocopier lease. The budget also includes operating expenses, such as interest on business loans, and the non-cash expense of depreciation. These items enable the company to compute its projected net income and net profit percentage.
Imagine you are the healthcare administrator for an actual non-profit clinic, home health agency, or outpatient surgery center. Your first task is to locate either the strategic plan for that organization or determine its strategic direction through the vision statement, mission/purpose statement, and strategic priorities/goals. You will also need to locate the audited financial statements for the organization.
Using the information from your research, develop a one-year operating budget for the chosen entity, which will include operating revenues and expenses. Include a 1–2 page document to justify the approach you use in constructing the operating budget with the strategic plan or strategic direction.
· Upload the strategic plan or strategic direction and audited financial statements as an attachment or include the web link.
· Complete your operating budget using Excel.
· Support your work with at least 3 quality references, one being your course textbook.
The specific course learning outcome associated with this assignment is:
· Develop a budget for a department within a healthcare organization.
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CHAPTER |
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THE BASICS OF CAPITAL BUDGETING |
14 |
Learning Objectives
After studying this chapter, readers will be able to
· Explain how managers use project classifications and post-audits in the capital budgeting process.
· Discuss the role of financial analysis in health services capital budgeting decisions.
· Explain the key issues involved in cash flow estimation.
· Describe the usefulness and methods applied in breakeven and profitability analyses.
· Conduct basic capital budgeting analyses.
Introduction
This chapter focuses on long-term (fixed) asset acquisition decisions, which involve the expenditure of capital funds. Such decisions commonly are called capital budgeting decisions because the listing of all capital investments (projects) to be undertaken in the future is known as the capital budget. Capital budgeting decisions are among the most critical decisions that health services managers must make. First and most important, the results of capital budgeting decisions generally affect the business for an extended period. If a business invests too heavily in fixed assets, it will have too much capacity and its costs will be too high. On the other hand, a business that invests too little in fixed assets may face two problems: technological obsolescence and inadequate capacity. A healthcare provider without the latest in technology will lose patients to its more up-to-date competitors and, further, will deprive its patients of the best healthcare diagnostics and treatments available.
Effective capital budgeting procedures provide several benefits to businesses. A business that forecasts its needs for capital assets well in advance will have the opportunity to plan the acquisitions carefully and thus will be able to negotiate the highest-quality assets at the best prices. Additionally, asset expansion typically involves substantial expenditures, and because large amounts of funds are not usually at hand, they must be raised externally. Good capital budgeting practices permit a business to identify its financing needs and sources well in advance, which ensures both the lowest possible financing costs and the availability of funds as they are needed.
Capital budgeting decisions
The process of selecting a business’s capital (long-term asset) investments. The list of investments chosen constitutes a business’s capital budget.
Project Classifications
Although benefits can be gained from the careful analysis of capital investment proposals, such efforts can be costly. For certain projects, a detailed analysis may be warranted, along with senior management involvement; for others, simpler procedures should be used. Accordingly, healthcare businesses generally classify projects into categories, and by cost within each category, and then analyze each project on the basis of its category and cost. For example, Bayside Memorial Hospital uses the following classifications:
· Category 1: Mandatory replacement. Category 1 consists of expenditures necessary to replace worn-out or damaged equipment necessary to the operations of the hospital. Because these expenditures are mandatory, they are usually made with only limited analyses and decision processes.
· Category 2: Discretionary replacement. This category includes expenditures needed to replace serviceable but obsolete equipment. The purpose of these projects generally is to lower costs or to provide more clinically effective services. Because Category 2 projects are not mandatory, a more detailed decision process is generally required to support the expenditure than that needed for Category 1 projects.
· Category 3: Expansion of existing services or markets. Expenditures to increase capacity, or to expand within markets currently being served by the hospital, are included here. These decisions are more complex, so still more detailed analysis is required, and the final decision is made at a higher level within the organization.
· Category 4: Expansion into new services or markets. These are projects necessary to provide new services or to expand into geographic areas not currently being served. Such projects involve strategic decisions that could change the fundamental nature of the hospital, and they normally require the expenditure of large sums of money over long periods of time. Invariably, a particularly detailed analysis is required, and the board of trustees generally makes the final decision as part of the hospital’s strategic plan.
· Category 5: Environmental projects. This category consists of expenditures necessary to comply with government orders, labor agreements, accreditation requirements, and so on. Unless the expenditures are large, Category 5 expenditures are treated like Category 1 expenditures.
· Category 6: Other. This category is a catchall for projects that do not fit neatly into another category. The primary determinant of how Category 6 projects are evaluated is the amount of funds required.
In general, relatively simple analyses and only a few supporting documents are required for replacement decisions and safety/environmental projects, especially those that are mandatory. A more detailed analysis is required for expansion and other projects.
Note that, within each category, projects are classified by size: Larger projects require increasingly detailed analyses and approval at a higher level within the hospital. For example, department heads can authorize spending up to $25,000 on discretionary replacement projects, while the full board of directors must approve expansion projects that cost more than $5 million.
The Role of Financial Analysis in Healthcare Capital Budgeting
For investor-owned businesses, with owner wealth maximization as the primary goal, the role of financial analysis in capital investment decisions is clear. Those projects that contribute to owners’ wealth should be undertaken, while those that do not should be ignored. However, what about not-for-profit businesses, which do not have wealth maximization as a goal? In such businesses, the appropriate goal is providing high-quality, cost-effective service to the communities served. (A strong argument could be made that this should also be the goal of investor-owned businesses in the health services industry.) In this situation, capital budgeting decisions must consider many factors besides a project’s financial implications. For example, the needs of the medical staff and the good of the community must be taken into account. Indeed, in many instances, noneconomic factors will outweigh financial considerations.
Nevertheless, good decision making and the future viability of healthcare businesses require that the financial impact of capital investments be fully recognized. If a healthcare provider takes on a series of highly unprofitable projects that meet nonfinancial goals, and such projects are not offset by profitable ones, the firm’s financial condition will deteriorate. If this situation persists over time, the provider will eventually lose its financial viability and could even be forced into bankruptcy and closure. Of course, not-for-profit businesses can offset some project losses with contributions and grants. However, long-run financial sustainability is best ensured by striving for operating profitability rather than depending on less reliable sources.
Because bankrupt firms cannot meet a community’s needs, even managers of not-for-profit businesses must consider a project’s potential impact on the firm’s financial condition. Managers may make a conscious decision to accept a project with a poor financial prognosis because of its nonfinancial virtues, but it is important that managers know the financial impact up front, rather than be surprised when the project drains the firm’s financial resources. Financial analysis provides managers with the relevant information about a project’s financial impact and helps managers make better decisions, including those decisions based primarily on nonfinancial considerations.
Overview of Capital Budgeting Financial Analysis
The financial analysis of capital investment proposals typically involves the following four steps:
1. Estimate the project’s expected cash flows, which consist of the following:
a. The capital outlay, or cost
b. The operating cash flows
c. The terminal (ending) cash flow
Cash flow estimation is discussed in the next section.
2. Assess the riskiness of the estimated cash flows. Risk assessment is discussed in
Chapter 15
.
3. Given the riskiness of the project, estimate the project’s cost of capital (opportunity cost or discount rate). As discussed in
Chapter 13
, the corporate cost of capital reflects the aggregate risk of the business’s assets—that is, the riskiness inherent in the average project. If the project being evaluated does not have average risk, the corporate cost of capital must be adjusted to reflect the risk differential. Risk incorporation is also discussed in
Chapter 15
.
4. Finally, assess the financial impact of the project. Several measures can be used for this purpose; we discuss four in this chapter.
Cash Flow Estimation
The most critical as well as most difficult step in evaluating capital investment proposals is cash flow estimation. This step involves estimating the investment outlays, the annual net operating flows expected when the project goes into operation, and the cash flows associated with project termination. Many variables are involved in cash flow estimation, and many individuals and departments participate in the process. Making accurate projections of the costs and revenues associated with a large, complex project is difficult, so forecast errors can be quite large. Thus, it is essential that risk analyses be performed on prospective projects.
Have a Laugh
Principles of Cash Flow Estimation
To emphasize the difficulties involved in capital budgeting cash flow estimation, one manager with a good sense of humor developed the following principles of cash flow estimation:
· It is difficult to forecast cash flows, especially those that occur in the future.
· Those who live by the crystal ball soon learn how to eat ground glass.
· The moment someone forecasts cash flows, he knows that they are wrong—he just doesn’t know by how much and in what direction.
· If someone makes a correct forecast, never let the boss forget.
· An expert in cash flow estimation is someone who has been right at least once.
What do you think? Is there any truth in these “principles”? Can you think of any “principles” to add to this list?
Neither the difficulty nor the importance of cash flow estimation can be overstated. However, if the concepts discussed in the next sections are observed, errors that often arise can be minimized.
Incremental Cash Flows
The relevant cash flows to consider when evaluating a new capital investment are the project’s incremental cash flows, which are defined as the business’s cash flows in each period if the project is undertaken minus the cash flows if the project is not undertaken:
Incremental CFt = CFt(Business with project) − CFt(Business without project).
Here the subscript t specifies a time period—often years. CF0 is the incremental cash flow during Year 0, which is generally assumed to end when the first cash flow occurs; CF1 is the incremental cash flow during the first year; CF2 is the incremental cash flow during Year 2; and so on. In practice, the early incremental cash flows, and Year 0 in particular, are usually cash outflows—the costs associated with getting the project up and running. As the project begins to generate revenues, the incremental cash flows normally turn positive.
In practice, it typically is not feasible to forecast the cash flows of a business with and without a new project. Thus, the actual estimation process focuses on the cash flows unique to the project being evaluated. However, if a doubt ever arises as to whether or not a particular cash flow is relevant to the analysis, it is often useful to fall back on the basic definition given above.
Incremental cash flow
A cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis.
Cash Flow Versus Accounting Income
As discussed in chapters
3
and
4
, accounting income statements define revenues and costs in terms that do not necessarily reflect the actual movement of cash. In capital investment decisions, the decision must be based on the actual dollars that flow into and out of the business that are a direct result of the project being evaluated. A firm’s true profitability, and hence its future financial condition, depends more on its cash flows than on income as reported in accordance with GAAP.
Cash Flow Timing
Capital budgeting analysts must be careful to account properly for the timing of cash flows. Accounting income statements are for periods such as years or quarters, so they do not reflect exactly when during the period any revenues and expenses occur. In theory, capital budgeting cash flows should be analyzed exactly as they are expected to occur. Of course, there must be a compromise between accuracy and practicality. A time line with daily cash flows would in theory provide the most accuracy, but daily cash flows would be costly to estimate, unwieldy to use, and probably no more accurate than annual cash flows. Thus, in most cases, analysts simply assume that all cash flows occur at the end of each year. However, for projects with regular, easy-to-forecast cash flows, it may be more appropriate to assume that the flows occur every six months or quarterly or even monthly.
Project Life
Perhaps the first decision that must be made in forecasting a project’s cash flows is the life of the project. Does the cash flow forecast need to be for 20 years, or is five years sufficient? Many projects, such as a new hospital or ambulatory care clinic, have long productive lives. In theory, a cash flow forecast should extend for the full life of a project, yet most managers would have little confidence in any cash flow forecasts beyond the near term. Thus, most organizations set an arbitrary limit on the project life assumed in capital budgeting analyses—often five or ten years. If the forecasted life is less than the arbitrary limit, the forecasted life is used to develop the cash flows, but if the forecasted life exceeds the limit, project life is truncated and the operating cash flows beyond the limit are ignored.
Although cash flow truncation is a practical solution to a difficult problem, it does create another problem: The value inherent in the cash flows beyond the truncation point is lost to the project. This problem can be addressed either objectively or subjectively. The standard procedure at some organizations is to estimate the project’s terminal value, which is the estimated value of the cash flows beyond the truncation point. Sometimes, the terminal value is estimated as the liquidation value of the project at that point in time. If the terminal value is too difficult to estimate, the fact that some portion of the project’s cash flow value is being ignored should, at a minimum, be subjectively recognized by decision makers. The saving grace in all of this is that cash flows forecasted to occur well into the future typically contribute a small amount to a project’s initial profitability estimate. For example, a $100,000 terminal value projected ten years in the future contributes only about $38,500 to the project’s value when the project cost of capital (discount rate) is 10 percent.
Some projects have short lives, and hence the analysis can extend over the project’s entire life. In such situations, the assets associated with the project may still have some value remaining when the project is terminated. The cash flow expected to be realized from selling the project’s assets at termination is called salvage value. Even if a project is being terminated for “old age,” any cash flow that will arise by virtue of scrap value must be included in the project’s cash flow estimates. For investor-owned businesses, such asset sales typically will trigger tax consequences, which are discussed in the cash flow estimation example presented in the next major section.
Terminal value
When a project’s cash flows are arbitrarily truncated, an estimate of the value of the cash flows beyond the truncation point.
Salvage value
The expected market value of an asset (project) at the end of its useful life.
Sunk Costs
A sunk cost refers to an outlay that has already occurred or has been irrevocably committed, so it is an outlay that is unaffected by the current decision to accept or reject a project. To illustrate, suppose that in 2016 Bayside Memorial Hospital is evaluating the purchase of a lithotripter system. To help in the decision, the hospital hired and paid $10,000 to a consultant in 2015 to conduct a marketing study. This cash flow is not relevant to the capital investment decision; Bayside cannot recover it whether or not the lithotripter is purchased. Cash flows that are not relevant to the analysis are called nonincremental cash flows. Sometimes a project appears to be unprofitable when all of its associated costs, including sunk costs, are considered. However, on an incremental basis, the project may be profitable and should be undertaken. Thus, the correct treatment of sunk costs may be critical to the decision.
Sunk cost
A cost that has already occurred or is irrevocably committed. Sunk costs are nonincremental to project analyses and hence should not be included.
Nonincremental cash flow
A cash flow that does not stem solely from a project that is being evaluated. Nonincremental cash flows are not included in a project analysis.
Opportunity Costs
All relevant opportunity costs must be included in a capital investment analysis. To illustrate, one opportunity cost involves the use of the funds required to finance the project. If a business uses its capital to invest in Project A, it cannot use the capital to invest in Project B or for any other purpose. The opportunity cost associated with capital use is accounted for in the project cost of capital, which represents the return that the business could earn by investing in alternative investments of similar risk. The mathematics of the discounting process forces the opportunity cost of capital to be considered in the analysis.
In addition to the opportunity cost of capital, there are other types of opportunity costs that arise in capital budgeting analyses. For example, assume that Bayside’s lithotripter would be installed in a freestanding facility and that the hospital currently owns the land on which the facility would be constructed. In fact, the hospital purchased the land ten years ago at a cost of $50,000, but the current market value of the property is $130,000, after deducting both legal and real estate fees. When evaluating the lithotripter, the value of the land cannot be disregarded merely because no cash outlay is necessary. There is an opportunity cost inherent in the use of the property because using the property for the lithotripter facility deprives Bayside of its use for other purposes. The property might be used for a walk-in clinic, an ambulatory surgery center, or a parking garage rather than sold, but the best measure of its value to Bayside, and hence the opportunity cost inherent in its use, is the amount that could be realized from selling the property.
By considering the property’s current market value, Bayside is letting market forces assign the value for the land’s best alternative use. Thus, the lithotripter project should have a $130,000 opportunity cost charged against it. The opportunity cost is the property’s $130,000 net market value, irrespective of whether the property was acquired for $50,000 or $200,000.
Effects on Existing Business Lines
Capital budgeting analyses must consider the effects of the project under consideration on the firm’s existing business lines. Such effects can be either positive or negative; when negative, it is often called cannibalization. To illustrate, assume that some of the patients who are expected to use Bayside’s new lithotripter would have been treated surgically at Bayside, so these surgical revenues will be lost if the lithotripter facility goes into operation. Thus, the incremental cash flows to Bayside are the flows attributable to the lithotripter, less those lost from forgone surgery services.
On the other hand, new patients who use the lithotripter may use ancillary services provided by the hospital. In this situation, the incremental net cash flows generated by the lithotripter patients’ utilization of other services should be credited to the lithotripter project. If possible, both positive and negative effects on other projects should be quantified, but at a minimum they should be noted so that these effects are subjectively considered when the final decision regarding the project is made.
Shipping, Installation, and Related Costs
When a business acquires new equipment, it often incurs substantial costs for shipping and installation or for other related activities. These charges must be added to the invoice price of the equipment to determine the overall cost of the project. Also, the full cost of the equipment, including such costs, typically is used as the basis for calculating depreciation charges. Thus, if Bayside Memorial Hospital purchases intensive care monitoring equipment that costs $800,000, but another $200,000 is required for shipping and installation, the full cost of the equipment would be $1 million, and this amount would be the starting point for both tax (when applicable) and book depreciation calculations.
Changes in Current Accounts
Normally, expansion projects require additional inventories, and expanded patient volumes also lead to additional accounts receivable. The increase in these current assets must be financed, just as an increase in fixed assets must be financed. (Increases on the asset side of the balance sheet must be offset by matching increases on the liabilities and equity side.) However, accounts payable and accruals will probably also increase as a result of the expansion, and these current liability funds will reduce the net cash needed to finance the increase in inventories and receivables.
The impact of such changes in current accounts must be recognized in a capital budgeting analysis. If the increase in current assets exceeds the increase in current liabilities, this amount is as much a cash cost to the project as is the dollar cost of the asset itself. Such projects must be charged an additional amount above the dollar cost of the new fixed asset to reflect the net financing needed for current asset accounts. Alternatively, if the increase in current liabilities assets exceeds the increase in current assets, the project is generating a positive cash flow. In this situation, the increase in liabilities exceeds the project’s current asset requirements, and this cash flow partially offsets the cost of the asset being acquired.
As the project approaches termination, inventories will be sold off and not replaced, and receivables will be converted to cash without new receivables being created. In effect, the business will recover its change in current accounts when the project is terminated. This will result in a cash flow that is equal but opposite in sign to the cash flow that arises at the beginning of a project.
For healthcare providers, where inventories often represent a very small part of the investment in new projects, the change in current accounts often can be ignored without materially affecting the results of the analysis. However, when a project requires a large positive change in current accounts (current assets increase a much greater amount than current liabilities), failure to consider the net change will result in an overstatement of the project’s profitability.
Inflation Effects
Because inflation effects can have a considerable influence on a project’s profitability, inflation must be considered in any sound capital budgeting analysis. As we discussed in
Chapter 13
, a firm’s corporate cost of capital is a weighted average of its costs of debt and equity. These costs are estimated on the basis of investors’ required rates of return, and investors incorporate an inflation premium into such estimates. For example, a debt investor might require a 5 percent return on a ten-year bond in the absence of inflation. However, if inflation is expected to average 4 percent over the coming ten years, the investor would require a 9 percent return. Thus, both equity and debt investors add an inflation premium to their required rates of return to help protect them against the loss of purchasing power that stems from inflation.
Because inflation effects are already embedded in the corporate cost of capital, and because this cost will be used as the starting point to discount the cash flows in the profitability measures, inflation effects must also be built into the project’s estimated cash flows. If cash flow estimates do not include inflation effects, but a discount rate is used that includes inflation effects, the profitability of the project will be understated.
The most effective way to deal with inflation is to apply inflation effects to each cash flow component using the best available information about how each component will be affected. Because it is impossible to estimate future inflation rates with much precision, errors will probably be made. Often, inflation is assumed to be neutral (i.e., it is assumed to affect all revenue and cost components, except depreciation, equally). However, at certain times it is common for costs to be rising faster than revenues or vice versa. Thus, in general, it is better to apply different inflation rates to each cash flow component. For example, net revenues might be expected to increase at a 3 percent rate, while labor costs might be expected to increase at a 5 percent rate. Inflation adds to the uncertainty and risk of a project under consideration as well as to the complexity of the capital budgeting analysis. Fortunately, computers and spreadsheet programs can easily handle the mechanics of inflation analysis.
Strategic Value
Sometimes a project will have value in addition to that inherent in its cash flows. Strategic value is a major source of hidden value that stems from future investment opportunities that can be undertaken only if the project currently under consideration is accepted.
To illustrate this concept, consider a hospital management company that is analyzing a management contract for a hospital in Hungary, which is its first move into Eastern Europe. On a stand-alone basis, this project might be unprofitable, but the project might provide entry into the Eastern European market, which could unlock the door to a whole range of highly profitable new projects. Or consider Bayside Memorial Hospital’s decision to start a kidney transplantation program. The financial analysis of this project showed the program to be unprofitable, but Bayside’s managers considered kidney transplants to be the first step in an aggressive transplantation program that would not only be profitable in itself but would enhance the hospital’s reputation for technological and clinical excellence and thus would contribute to the hospital’s overall profitability.
In theory, the best approach to dealing with strategic value is to forecast the cash flows from the follow-on projects, estimate their probabilities of occurrence, and then add the expected cash flows from the follow-on projects to the cash flows of the project under consideration. In practice, this is usually impossible to do because either the follow-on cash flows are too nebulous to forecast or the potential follow-on projects are too numerous to quantify. At a minimum, decision makers must recognize that some projects have strategic value, and this value should be qualitatively considered when making capital budgeting decisions.
SELF-TEST QUESTIONS
1. Briefly discuss the following concepts associated with cash flow estimation:
· Incremental cash flow
· Cash flow versus accounting income
· Cash flow timing
· Project life
· Terminal value
· Salvage value
· Sunk costs
· Opportunity costs
· Effects on current business lines
· Shipping and installation costs
· Changes in current accounts
· Inflation effects
· Strategic value
2. Evaluate the following statement: “Ignoring inflation effects and strategic value can result in overstating a project’s financial attractiveness.”
Strategic value
The value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted.
Cash Flow Estimation Example
Up to this point, several critical aspects of cash flow estimation have been discussed. In this section, we illustrate some of the concepts already covered and introduce several others that are important to good cash flow estimation.
The Basic Data
Consider the situation faced by Bayside Memorial Hospital in its evaluation of a new MRI system. The system costs $1.5 million, and the not-for-profit hospital would have to spend another $1 million for site preparation and installation. Because the system would be installed in the hospital, the space to be used has a low, or zero, market value to outsiders. Furthermore, its value to Bayside for other projects is difficult to estimate, so no opportunity cost has been assigned to account for the value of the site.
For Your Consideration
Cash Flow Estimation Bias
As you know, cash flow estimation is the most critical and most difficult part of the capital budgeting process. Cash flows often must be forecasted many years into the future, and estimation errors (some of which may be large) are bound to occur. However, as long as cash flow estimates are unbiased and the errors are random, they will tend to offset one another if many projects are being considered. Thus, in the aggregate, realized profitability will be close to that expected.
Unfortunately, there is evidence that some managers tend to overstate revenues and understate costs, which results in an upward bias in estimated profitability. If this occurs, more projects will be accepted than would be if no bias existed. There are several potential reasons for cash flow estimation bias. Perhaps managers have an incentive to maximize department size rather than profitability. Or managers may become emotionally attached to their project proposals and are unable to make objective estimates.
Do you think that cash flow estimation bias exists in healthcare providers? If so, why might that be the case? What are some steps that senior management could take to eliminate, or at least reduce, the bias?
The MRI system is estimated to have weekly utilization (i.e., volume) of 40 scans, and each scan on average would cost the hospital $15 in supplies. The system is expected to be operated 50 weeks a year, with the remaining two weeks devoted to maintenance. The estimated average charge per scan is $500, but 25 percent of this amount, on average, is expected to be lost to indigent patients, contractual allowances, and bad debt losses. Thus, the average reimbursement per scan is $500 × 0.75 = $375. Bayside’s managers developed the project’s forecasted revenues by conducting the revenue analysis contained in
Exhibit 14.1
.
The MRI system would require one technician, resulting in an incremental increase in annual labor costs of $50,000, including fringe benefits. Cash overhead costs would increase by $10,000 annually if the MRI is activated. The equipment would require maintenance, which would be furnished by the manufacturer for an annual fee of $150,000, payable at the end of each year of operation. For book purposes, the MRI will be depreciated by the straight-line method over a five-year life.
The MRI system is expected to be in operation for five years, at which time the hospital’s master plan calls for a new imaging facility. The hospital plans to sell the MRI at that time for an estimated $750,000 salvage value, net of removal costs. The inflation rate is estimated to average 5 percent over the period, and this rate is expected to affect all revenues and costs except depreciation. Bayside’s managers initially assume that projects under evaluation have average risk, and thus the hospital’s 10 percent corporate cost of capital is the appropriate project cost of capital (opportunity cost discount rate). In
Chapter 15
, a risk assessment of the project may indicate that a different cost of capital is appropriate.
Although the MRI project is expected to take away some patients from the hospital’s other imaging systems, the new MRI patients are expected to generate revenues for some of the hospital’s other departments. On net, the two effects are expected to balance out—that is, the cash flow loss from other imaging systems is expected to be offset by the cash flow gain from other services used by new MRI patients. Also, the project is estimated to have negligible current account implications, so such changes will be ignored in the analysis.
Cash Flow Analysis (Not-for-Profit Businesses)
The first step in the financial analysis is to estimate the MRI site’s net cash flows. This analysis is presented in
Exhibit 14.2
, which shows the key points of the analysis by line number.
· Line 1. Line 1 contains the estimated cost of the MRI system. In general, capital budgeting analyses assume that the first cash flow, normally an outflow, occurs at the end of Year 0. Expenses, or cash outflows, are shown in parentheses.
· Line 2. The related site construction expense, $1,000,000, is also assumed to occur at Year 0.
· Line 3. Annual net revenues = Weekly volume × Weeks of operation per year × Net revenue per scan = 40 × 50 × $375 = $750,000 in the first year. The 5 percent inflation rate is applied to all charges and costs that would likely be affected by inflation, so the amount shown on Line 3 increases by 5 percent over time. Although most of the operating revenues and costs would occur more or less evenly over the year, it is difficult to forecast exactly when the flows would occur. Furthermore, there is significant potential for large errors in cash flow estimation. For these reasons, operating cash flows are often assumed to occur at the end of each year. Also, the assumption is that the MRI system could be placed in operation quickly. If this were not the case, then the first year’s operating flows would be reduced. In some situations, it might take several years from the first investment cash flow to the point when the project is operational and begins to generate revenues.
· Line 4. Labor costs are forecasted to be $50,000 during the first year, and they are assumed to increase over time at the 5 percent inflation rate.
· Line 5. Maintenance fees must be paid to the manufacturer at the end of each year of operation. These fees are assumed to increase at the 5 percent inflation rate.
· Line 6. Each scan uses $15 of supplies, so supply costs in the first year total 40 × 50 × $15 = $30,000, and they are expected to increase each year by the inflation rate.
· Line 7. If the project is accepted, overhead cash costs will increase by $10,000 in the first year. Note that the $10,000 expenditure is a cash cost that is related directly to the acceptance of the MRI project. Existing overhead costs that are arbitrarily allocated to the MRI project are not incremental cash flows and thus should not be included in the analysis. Overhead costs are also assumed to increase over time at the inflation rate.
· Line 8. Book depreciation in each year is calculated by the straight-line method, assuming a five-year depreciable life. For book purposes, the depreciable basis is equal to the capitalized cost of the project, which includes the cost of the asset and related construction, less the estimated salvage value. Thus, the depreciable basis is ($1,500,000 + $1,000,000) − $750,000 = $1,750,000, and the straight-line depreciation in each year of the project’s five-year depreciable life is $1,750,000 ÷ 5 = $350,000. Note that depreciation is based solely on acquisition costs, so it is unaffected by inflation. Also, note that the
Exhibit 14.2
cash flows are presented in a generic format that can be used by both investor-owned and not-for-profit hospitals. Depreciation expense is not a cash flow but an accounting convention that amortizes the cost of a fixed asset over its revenue-producing life. Because Bayside Memorial Hospital is tax exempt, and hence depreciation will not affect taxes, and because depreciation is added back to the cash flows on Line 12, depreciation could be totally omitted from the cash flow analysis.
· Line 9. Operating income in each year is calculated as net revenues less all operating expenses.
· Line 10. Bayside is a not-for-profit hospital and does not pay taxes; thus, this line contains zeros.
· Line 11. Bayside pays no taxes, so the project’s net operating income equals its operating income.
· Line 12. Because depreciation, a noncash expense, was included on Line 8, it must be added back to the project’s net operating income in each year to obtain each year’s net cash flow.
· Line 13. The project is expected to be terminated after five years, at which time the MRI system would be sold for an estimated $750,000. This salvage value cash flow is shown as an inflow at the end of Year 5.
· Line 14. The project’s net cash flows consist of a $2,500,000 investment at Year 0 followed by five years of cash inflows.
The
Exhibit 14.2
cash flows do not include interest expense on any debt financing that might be required to fund the project. On average, Bayside Memorial Hospital will finance new projects in accordance with its target capital structure, which consists of 50 percent debt financing and 50 percent equity (fund) financing. The costs associated with this financing mix, including both interest costs and the opportunity cost of equity capital, are incorporated into the firm’s 10 percent corporate cost of capital. Because the cost of debt financing is included in the discount rate that will be applied to the cash flows, recognition of interest expense in the cash flows would be double counting.
Cash Flow Analysis (For-Profit Businesses)
The
Exhibit 14.2
cash flow analysis can be easily modified to reflect tax implications if the analyzing organization is a for-profit business. To illustrate, assume that the MRI project is being evaluated by Ann Arbor Health Systems, an investor-owned hospital chain. Assume also that all of the project data presented earlier apply to Ann Arbor, except that the MRI falls into the Modified Accelerated Cost Recovery System (MACRS) five-year class for tax depreciation and the firm has a 40 percent tax rate.
Exhibit 14.3
contains Ann Arbor’s cash flow analysis. Note the following differences from the not-for-profit analysis performed in
Exhibit 14.2
:
· Line 8. Depreciation expense must be modified to reflect tax depreciation rather than book depreciation. Tax depreciation is calculated using the MACRS as specified in current tax laws. Each year’s tax depreciation is found by multiplying the asset’s depreciable basis, without reduction by the estimated salvage value, by the appropriate depreciation factor. In this illustration, the depreciable basis is $2,500,000, and the MRI system falls into the MACRS five-year class, so the MACRS factors specified by the tax code are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06, in Years 1 to 6, respectively. Thus, the tax depreciation in Year 1 is 0.20 × $2,500,000 = $500,000, in Year 2 the depreciation is 0.32 × $2,500,000 = $800,000, and so on. (Tax laws are complex and change often. Therefore, this book does not include a complete discussion of MACRS. For more information, see either the IRS publication pertaining to depreciation or any of the many tax guidebooks available at bookstores or online.)
· Line 10. Taxable firms must reduce the operating income on Line 9 by the amount of taxes. Taxes, which appear on Line 10, are computed by multiplying the Line 9 pretax operating income by the firm’s marginal tax rate. For example, the project’s taxes for Year 1 are 0.40 × $10,000 = $4,000. The taxes shown for Year 2 are a negative $105,800. In this year, the project is expected to lose $264,500, and hence Ann Arbor’s taxable income, assuming that its existing projects are sufficiently profitable, will be reduced by this amount if the project is undertaken.
This reduction in Ann Arbor’s overall taxable income would lower the firm’s tax bill by T × Reduction in taxable income = 0.40 × $264,500 = $105,800.
· Line 12. The MACRS depreciation amount, because it is a noncash expense, is added back in Line 12.
· Line 13. Investor-owned firms will normally incur a tax liability on the sale of a capital asset at the end of the project’s life. According to the IRS, the value of the MRI system at the end of Year 5 is the tax book value, which is the depreciation that remains on the tax books. For the MRI, five years’ worth of depreciation would be taken, so only one year of depreciation remains. The MACRS factor for Year 6 is 0.06, so by the end of Year 5, Ann Arbor has expensed 0.94 of the MRI’s depreciable basis and the remaining tax book value is 0.06 × $2,500,000 = $150,000. Thus, according to the IRS, the value of the MRI system is $150,000. When Ann Arbor sells the system for its estimated salvage value of $750,000, it realizes a “profit” of $750,000 − $150,000 = $600,000, and it must repay the IRS an amount equal to 0.4 × $600,000 = $240,000. The $240,000 tax bill recognizes that Ann Arbor took too much depreciation on the MRI system, so it represents a recapture of the excess tax benefit taken over the five-year life of the system. The $240,000 in taxes reduces the cash flow received from the sale of the MRI equipment, so the salvage value net of taxes is $750,000 − $240,000 = $510,000.
As can be seen by comparing Line 14 in Exhibits
14.2
and
14.3
, all else the same, the taxes paid by investor-owned firms tend to reduce a project’s net operating cash flows and net salvage value, reducing the project’s financial attractiveness.
Replacement Analysis
Bayside’s MRI project was used to illustrate how the cash flows from an expansion project are analyzed. That is, the assumption was made that the hospital did not have an MRI system in operation at the time of the analysis. All businesses, including Bayside Memorial Hospital, also make replacement decisions, in which a new asset is being considered to replace an existing asset that could, if not replaced, continue in operation. The cash flow analysis for a replacement decision is somewhat more complex than for an expansion decision because the cash flows from the existing asset must be considered.
Again, the key to cash flow estimation is to focus on the incremental cash flows. If the new asset is acquired, the existing asset can be sold, so the current market value of the existing asset is a cash inflow in the analysis. When considering the operating flows, the incremental flows are the cash flows expected from the replacement asset less the flows that the existing asset would produce if not replaced. By applying the incremental cash flow concept, the correct cash flows can be estimated for replacement decisions.
Breakeven Analysis
Breakeven analysis was introduced in
Chapter 5
in conjunction with breakeven volume in an accounting profit analysis. Now, the breakeven concept is applied in a project analysis setting. In project analyses, many different types of breakeven can be determined. Rather than discuss all the possible types of breakeven, the focus here is on one type—time breakeven.
Payback is defined as the expected number of years required to recover the investment in a project, so payback, or payback period, measures time breakeven. To illustrate, consider the net cash flows for the MRI project contained on Line 14 in
Exhibit 14.2
. The best way to determine the MRI’s payback is to construct the project’s cumulative cash flows as shown in
Exhibit 14.4
. The cumulative cash flow at any point in time is merely the sum of all the cash flows (with proper sign indicating an inflow or outflow) that have occurred up to that point. Thus, in
Exhibit 14.4
, the cumulative cash flow at Year 0 is −$2,500,000; at Year 1 it is −$2,500,000 + $510,000 = −$1,990,000; at Year 2 it is −$2,500,000 + $510,000 + $535,500 = −$1,990,000 + $535,500 = −$1,454,500; and so on.
Industry Practice
Discounted Payback
The discounted payback is a breakeven measure similar to the conventional payback, except that the cash flows in each year are discounted to Year 0 by the project’s cost of capital (but kept at their original positions on the time line) prior to calculating the cumulative cash flows and payback. Thus, the discounted payback solves the conventional payback’s problem of not considering the project’s cost of capital in the payback calculation. The table below contains the calculation for Bayside’s MRI project. Note that each entry in the middle column is the matching annual cash flow discounted at the 10 percent cost of capital for the number of years it occurs in the future. For example, the discounted Year 2 cash flow is $535,500÷(1.10)2 = $442,562.
Now, with discounted instead of raw cash flows, the payback is 4 + (768,112÷850,605) = 4.90 years. Because time value is recognized in the discounted payback, it takes longer than the conventional payback (4.22 years) to recover the initial investment.
What do you think? Is the discounted payback a better measure of time breakeven than the conventional payback? Does it solve all the conventional payback’s problems?
As shown in the rightmost column of
Exhibit 14.4
, the $2,500,000 investment in the MRI project will be recovered at the end of Year 5 if the cash flow forecasts are correct. Furthermore, if the cash flows are assumed to come in evenly during the year, breakeven will occur $301,836 ÷ $1,369,908 = 0.22 years into Year 5, so the MRI project’s payback is 4.22 years.
Initially, payback was used by managers as the primary financial evaluation tool in project analyses. For example, a business might accept all projects with paybacks of five years or less. However, payback has two serious deficiencies when it is used as a project selection criterion. First, payback ignores all cash flows that occur after the payback period. To illustrate, Bayside might be evaluating a competing project that has the same cash flows as the MRI project in years 0 through 5. However, the alternative project might have a cash inflow of $2 million in Year 6. Both projects would have the same payback, 4.22 years, and hence be ranked the same, even though the alternative project clearly is better from a financial perspective. Second, payback ignores the opportunity costs associated with the capital employed. For these reasons, payback generally is no longer used as the primary evaluation tool.
In spite of its shortcomings, payback is useful in capital investment analysis. The shorter the payback, the more quickly the funds invested in a project will become available for other purposes and the more liquid the project. Also, cash flows expected in the distant future are generally regarded as being riskier than near-term cash flows, so shorter payback projects generally are less risky than those with longer paybacks. Therefore, payback is often used as a rough measure of a project’s liquidity and risk.
Payback period
The number of years it takes for a business to recover its investment in a project without considering the time value of money.
Return on Investment (Profitability) Analysis
Up to this point, the chapter has focused on cash flow estimation and breakeven analysis. Perhaps the most important element in a project’s financial analysis is its expected profitability, which generally is expressed by return on investment (ROI) measured either in dollars or in percentage (rate of) return. In the next sections, we discuss one dollar measure and two rate-of-return ROI measures.
Return on investment (ROI)
The estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollars or percentage (rate of) return.
Net Present Value
Net present value (NPV), which was first discussed in
Chapter 9
, is a dollar ROI measure that uses discounted cash flow (DCF) techniques, so it is often referred to as a DCF profitability measure. To apply the NPV method:
· Find the present (Time 0) value of each net cash flow, including both inflows and outflows, when discounted at the project’s cost of capital.
· Sum the present values. This sum is defined as the project’s net present value.
· If the NPV is positive, the project is expected to be profitable, and the higher the NPV, the more profitable the project. If the NPV is zero, the project just breaks even in an economic sense. If the NPV is negative, the project is expected to be unprofitable.
With a project cost of capital of 10 percent, the NPV of Bayside’s MRI project is calculated as follows:
Financial calculators and spreadsheets have NPV functions that easily perform the mathematics if given the cash flows and cost of capital.
Here is the spreadsheet solution:
Note that we have merely entered the net cash flows into the spreadsheet. In a typical project analysis, the spreadsheet also would be used for the cash flow analysis, with the last row of the analysis containing the net cash flows. The project’s NPV is calculated in Cell A10 using the NPV function. The first entry in the function (A2) is the discount rate (project cost of capital), while the second entry (A4:A8) designates the range of cash inflows from years 1 through 5. Because the NPV function calculates NPV one period before the first cash flow entered in the range, it is necessary to start the range with Year 1 rather than Year 5. Finally, to complete the calculation in Cell A10, A3 (the initial outlay) is added to the NPV function. The end result, $82,493, is displayed in Cell A10.
The rationale behind the NPV method is straightforward. An NPV of zero signifies that the project’s cash inflows are just sufficient to (1) return the capital invested in the project and (2) provide the required rate of return on that capital (the opportunity cost of capital). If a project has a positive NPV, it is generating excess cash flows, and these excess cash flows are available to management to reinvest in the business and, for investor-owned firms, to pay bonuses (if a proprietorship or partnership) or dividends. If a project has a negative NPV, its cash inflows are insufficient to compensate the firm for the capital invested or perhaps even insufficient to recover the initial investment, so the project is unprofitable and acceptance would cause the financial condition of the firm to deteriorate. For investor-owned firms, NPV is a direct measure of the contribution of the project to owners’ wealth, so NPV is considered by many academics and practitioners to be the best measure of project profitability.
The NPV of the MRI project is $82,493, so on a present value basis, the project is expected to generate a cash flow excess of more than $80,000 after all costs, including the opportunity cost of capital, have been considered. Thus, the project is economically profitable, and its acceptance would have a positive impact on Bayside’s financial condition.
Internal Rate of Return
Like NPV, internal rate of return (IRR) is a discounted cash flow ROI measure. However, whereas NPV measures a project’s dollar profitability, IRR measures a project’s percentage profitability (i.e., its expected rate of return).
Mathematically, IRR is defined as the discount rate that equates the present value of the project’s expected cash inflows to the present value of the project’s expected cash outflows, so the IRR is simply the discount rate that forces the NPV of the project to equal zero. Financial calculators and spreadsheets have IRR functions that rapidly calculate IRRs. Simply input the project’s cash flows, and the computer or calculator computes the IRR.
For Bayside’s MRI project, the IRR is that rate that causes the sum of the present values of the cash inflows to equal the $2,500,000 cost of the project:
When all of the MRI project’s cash flows are discounted at 11.1 percent, the NPV of the project is approximately zero. Thus, the MRI project’s IRR is 11.1 percent. Put another way, the project is expected to generate an 11.1 percent rate of return on its $2,500,000 investment. Note that the IRR is like a bond’s yield to maturity: It is the rate of return expected on the investment assuming that all the cash flows anticipated actually occur.
Here is the spreadsheet solution:
Note that we have placed the IRR function in Cell A10; the entry in the IRR function (A3:A8) specifies the range of cash flows to be used in the calculation. The answer, 11.1%, is displayed in Cell A10.
If the IRR exceeds the project cost of capital, a surplus is projected to remain after recovering the invested capital and paying for its use, and this surplus accrues to the firm’s stockholders (in Bayside’s case, to its stakeholders). If the IRR is less than the project cost of capital, however, taking on the project imposes an expected financial cost on the firm’s stockholders or stakeholders. The MRI project’s 11.1 percent IRR exceeds its 10 percent project cost of capital. Thus, as measured by IRR, the MRI project is profitable and its acceptance would enhance Bayside’s financial condition.
Comparison of the NPV and IRR Methods
Consider a project with a zero NPV. In this situation, the project’s IRR must equal its cost of capital. The project has zero expected profitability, and acceptance would neither enhance nor diminish the firm’s financial condition. To have a positive NPV, the project’s IRR must be greater than its cost of capital, and a negative NPV signifies a project with an IRR less than its cost of capital. Thus, projects that are deemed profitable by the NPV method will also be deemed profitable by the IRR method. In the MRI example, the project would have a positive NPV for all costs of capital less than 11.1 percent. If the cost of capital were greater than 11.1 percent, the project would have a negative NPV. In effect, the NPV and IRR are perfect substitutes for each other in measuring whether or not a project is profitable. Note, however, that when mutually exclusive projects are being analyzed (i.e., two or more projects are being analyzed but only one can be chosen), NPV and IRR rankings can conflict—that is, Project A could have the higher NPV, but Project B could have the higher IRR. In such situations, the NPV method is generally considered to be the best measure of profitability.
Modified Internal Rate of Return
In general, academics prefer the NPV profitability measure. This preference stems from two factors: (1) NPV measures profitability in dollars, which is a direct measure of the contribution of the project to the value of the business, and (2) both the NPV and the IRR, because they are discounted cash flow techniques, require an assumption about the rate at which project cash flows can be reinvested, and the NPV method has the better assumption.
To further explain the second point, consider the MRI project’s Year 2 net cash flow of $535,500. In effect, the discounting process inherent in the NPV and IRR methods automatically assigns a reinvestment rate to this cash flow; that is, both the NPV and IRR methods assume that Bayside has the opportunity to reinvest the $535,500 Year 2 cash flow in other projects, and each method automatically assigns a reinvestment (earnings) rate to this flow for years 3, 4, and 5. The NPV method assumes reinvestment at the project cost of capital, 10 percent, while the IRR method assumes reinvestment at the IRR rate, 11.1 percent.
Which is the better assumption—reinvestment at the cost of capital or reinvestment at the IRR rate? In Bayside’s MRI project, it does not make much difference. However, in some projects, the difference in NPV and IRR measures is significantly affected by the reinvestment rate assumption. Here’s the logic behind favoring the cost of capital as the better assumption: Theoretically, a business will take on all projects that exceed the cost of capital. Thus, at the margin, the returns from capital reinvested within the firm are more likely to be at or close to the cost of capital than at the project’s IRR, especially for projects with exceptionally high or low IRRs. Furthermore, a business can obtain outside capital at a cost roughly equal to the cost of capital, so cash flows generated by a project could be replaced by capital having this cost. So, in general, reinvestment at the cost of capital is a better assumption than reinvestment at the IRR rate, and hence NPV is a theoretically better measure of profitability than IRR.
Even though academics strongly favor the NPV method, practicing managers prefer the IRR method because it is more intuitive for most people to analyze investments in terms of percentage (rates of) return than dollars of NPV. Thus, an alternative rate-of-return measure has been developed that eliminates the primary problem with IRR. This method is the modified IRR (MIRR), and it is calculated as follows:
· Discount all the project’s net cash outflows back to Year 0 at the project cost of capital.
· Compound all the project’s net cash inflows forward to the last (terminal) year of the project, at the project cost of capital. This value is called the inflow terminal value.
· The discount rate that forces the present value of the inflow terminal value to equal the present value of costs is the MIRR.
Applying these steps to Bayside’s MRI project produces a MIRR of about 10.7 percent:
Here is the spreadsheet solution for the MIRR:
The MIRR function was placed in Cell A10. The first entry in the function (A3:A8) is the range of cash flows, while the next two entries (A2,A2) are the project cost of capital. (The MIRR function allows the reinvestment rate to differ from the project cost of capital: The first of the two entries is the project cost of capital, and the second is the reinvestment rate. For our purposes, the two rates are the same.) The resulting MIRR, 10.7%, is displayed in Cell A10.
The MIRR method, by compounding the cash inflows forward at 10 percent, forces the reinvestment rate to equal 10 percent, which is the project cost of capital. Note that the MIRR for the MRI project is less than the project’s IRR because the cash inflows are reinvested at only 10 percent rather than at the project’s 11.1 percent IRR. In general, the MIRR is less than the IRR when the IRR is greater than the cost of capital, but it is greater than the IRR when the IRR is less than the cost of capital. In effect, the IRR overstates the profitability of profitable projects and understates the profitability of unprofitable projects. By forcing the correct reinvestment rate, the MIRR method provides decision makers with a theoretically better measure of a project’s expected rate of return than does the IRR.
In closing our discussion, note that the MIRR has other advantages over the IRR besides the proper reinvestment rate. Primarily, it avoids potential problems when a project has nonnormal cash flows. A project with normal cash flows has one or more outflows followed by one or more inflows, while one with nonnormal cash flows has outflows occurring after one or more inflows have occurred. In the nonnormal situation, it is possible for a project to have two IRRs or even to have no IRR. These unusual results occur because of the mathematics of the IRR calculation. The MIRR overcomes these problems, so it is the only rate-of-return measure that can be applied to some projects.
A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital.
Some Final Thoughts on Breakeven and Profitability Analyses
Although we have discussed one breakeven and three profitability measures, there are many other measures commonly used in project financial analyses. Today, virtually all capital budgeting decisions of financial consequence are analyzed by computer, and hence the mechanics of calculating and listing numerous breakeven and profitability measures are easy. Because each measure contributes slightly different information about the financial consequences of a project, managers should not focus on only one or two financial measures. A thorough financial analysis of a new project includes numerous financial measures, and capital budgeting decisions are enhanced if all information inherent in all measures is considered in the process.
However, just as it would be foolish to ignore any of the quantitative measures, it would be foolish to base capital budgeting decisions solely on these measures. The uncertainties in the cash flow estimates for many projects are such that the resulting quantitative measures can be viewed only as rough estimates. Furthermore, organizational missions and strategic factors are important elements in capital budgeting decision making. Thus, qualitative factors should play an important role in the decision process. (We discuss one approach, project scoring, in a later section.)
Finally, managers should be cautious of potential projects that have high expected profitability. In a highly competitive environment, there would be no highly profitable projects available because the marketplace would have already identified these opportunities and taken advantage of them. Thus, high-profitability projects must have some underlying rationale, such as market dominance or innovation, that justifies the profitability. Even then, under most circumstances, the project’s high profitability will be eroded over time by competition.
Capital Budgeting in Not-for-Profit Businesses
Although the capital budgeting techniques discussed to this point are appropriate for use by all businesses when assessing the financial impact of a proposed project, a not-for-profit business has the additional consideration of meeting its charitable mission. In this section, two models that extend the capital budgeting decision to include the charitable mission are discussed.
Net Present Social Value Model
The financial analysis techniques discussed so far have focused exclusively on the cash flow implications of a proposed project. Some healthcare businesses, particularly not-for-profit providers, have the goal of producing social services along with commercial services. For such firms, the proper analysis of proposed projects must, at least in theory, systematically consider the social value of a project along with its pure financial, or cash flow, value.
When social value is considered, the total net present value (TNPV) of a project can be expressed as follows:
TNPV = NPV + NPSV.
Industry Practice
Accounting Rate of Return
The accounting rate of return (ARR) uses accounting information to measure the profitability of an investment. Although there are alternative ways of performing the calculation, the generic formula is as follows:
Accounting rate of return = Average net profit ÷ Average investment.
Here, both profit and investment are measured in accounting terms and averaged over the life of the project. For example, a five-year project that cost $100,000 and has a zero salvage value would have an average investment of $100,000 ÷ 5 = $20,000. If the aggregate profit over the five years were forecast to be $25,000, the average annual net profit would be $5,000. Thus, the project’s ARR would be $5,000 ÷ $20,000 = 25%.
Proponents of the ARR cite the following advantages: (1) It is simple to use and understand. (2) It can be readily calculated from accounting data, unlike NPV and IRR. (3) It incorporates the entire stream of income as opposed to looking at only a single year.
What is your opinion of the ARR? Does it have any weaknesses compared to NPV and IRR? Should healthcare organizations use ARR to make capital budgeting decisions?
Here, NPV represents the conventional NPV of the project’s cash flow stream and NPSV is the net present social value of the project. The NPSV term, which represents managers’ assessment of the social value of a project, clearly differentiates capital budgeting in not-for-profit firms from that in investor-owned firms. In evaluating each project, a project is acceptable if its TNPV is greater than or equal to zero. This means that the sum of the project’s financial and social values is at least zero, so when both facets of value are considered, the project has positive, or at least nonnegative, worth. Probably not all projects will have social value, but if a project does, it is considered formally in this decision model. However, no project should be accepted if its NPSV is negative, even if its TNPV is positive. Furthermore, to ensure the financial viability of the firm, the sum of the conventional NPVs of all projects initiated in a planning period must equal or exceed zero. If this restriction were not imposed, social value could displace financial value over time, and a business cannot continue to provide social value without financial integrity. Note, however, that not-for-profit providers may be able to use contributions and grants to offset some, or even all, of any aggregate negative NPV created by the acceptance of projects with positive social value but negative financial value.
Key Equation: Net Present Social Value Model
The net present social value (NPSV) model incorporates both financial and social value into a single model:
TNPV = NPV + NPSV.
Here, TNPV is total net present value, NPV is the net present value of the project’s financial worth, and NPSV is the present value of the project’s social worth. Although NPSV is difficult to estimate, this model formalizes the concept that not-for-profit providers should consider both social and financial value when making capital budgeting decisions.
NPSV is the sum of the present (Year 0) values of each year’s social value. In essence, the suppliers of fund capital to a not-for-profit firm never receive a cash return on their investment. Instead, they receive a return on their investment in the form of social dividends. These dividends take the form of services with social value to the community, such as charity care; medical research and education; and myriad other services that, for one reason or another, do not pay their own way. Services provided to patients at a price equal to or greater than the full cost of production do not create social value. Similarly, if government entities purchase care directly for beneficiaries of a program or support research, the resulting social value is created by the funding organization as opposed to the service provider.
In estimating a project’s NPSV, first it is necessary to estimate in dollar terms the social value of the services provided in each year. When a project produces services to individuals who are willing and able to pay for those services, the value of those services is captured by the amount that the individuals actually pay. Thus, the value of the services provided to those who cannot pay, or to those who cannot pay the full amount, can be estimated by the average net price paid by those individuals who are able to pay. Next, a discount rate must be applied to the social value cash flows. In general, providers should require a return on their social value stream that approximates the return available on the equity investment in for-profit firms that offer the same services.
This approach to valuing social services has intuitive appeal, but certain implementation problems merit further discussion:
· Price is a fair measure of value only if the payer has the capacity to judge the true value of the service provided. Many observers of the health services industry would argue that information asymmetries between the provider and the purchaser inhibit the ability of the purchaser to judge true value.
· The fact that most payments for healthcare services are made by third-party payers may result in price distortions. For example, insurers may be willing to pay more for services than an individual would pay in the absence of insurance, or the market power of some insurers, such as Medicare, may result in a price that is less than individuals would be willing to pay.
· A great deal of controversy exists over the true value of treatment in many situations. Suppose that some people are entitled to whatever healthcare is available, regardless of cost, and are not required to personally pay for the care. Even though society as a whole must cover the cost, people may demand a level of care that is of questionable value. For example, should large sums be spent to keep a comatose 92-year-old alive for a few more days? If the true value to society of such an expenditure is zero, assigning a high social value just because that is its cost makes little sense.
Although the NPSV model formalizes the capital budgeting decision process applicable to not-for-profit healthcare firms, few organizations actually attempt to quantify NPSV. However, not-for-profit providers should, at a minimum, subjectively consider the social value inherent in projects under consideration.
Net present social value (NPSV)
The present value of a project’s social value. Added to the financial net present value (NPV) to obtain a project’s total value.
Project Scoring
Managers of not-for-profit businesses, as well as managers of most investor-owned firms, recognize that nonfinancial factors should be considered in any capital budgeting analysis. The NPSV model examines only one other factor, and it is difficult to implement in practice. Thus, many businesses use a quasi-subjective project scoring approach to capital budgeting decisions that attempts to capture both financial and nonfinancial factors.
Exhibit 14.5
, which is used by Bayside Memorial Hospital, illustrates one such approach.
Bayside ranks projects on three dimensions: stakeholder, operational, and financial. Within each dimension, multiple factors are examined and assigned scores that range from 2 points for very favorable impact to −1 point for negative impact. The scores within each dimension are added to obtain scores for each of the three dimensions, and then the dimension scores are summed to obtain a total score for the project. The total score gives Bayside’s managers a feel for the relative values of projects under consideration when all factors, including financial, are taken into account.
Bayside’s managers recognize that the scoring system is completely arbitrary, so a project with a score of 10, for example, is not necessarily twice as good as a project that scores 5. Nevertheless, Bayside’s project scoring approach forces its managers to address multiple issues when making capital budgeting decisions, and it does provide a relative ranking of projects under consideration. Although Bayside’s approach should not be used at other organizations without modification for organizational- and industry-unique circumstances, it does provide insights into how a unique matrix might be developed at any health services business.
Project scoring
An approach to project assessment that considers both financial and nonfinancial factors.
The Post-audit
Capital budgeting is not a static process. If there is a long lag between a project’s acceptance and its implementation, any new information concerning either capital costs or the project’s cash flows should be analyzed before the start-up occurs. Furthermore, the performance of each project should be monitored throughout the project’s life. The process of formally monitoring project performance over time is called the post-audit. It involves comparing actual results with those projected, explaining why differences occur, and analyzing potential changes to the project’s operations, including replacement or termination.
The post-audit has several purposes:
· Improve forecasts. When managers systematically compare projections to actual outcomes, there is a tendency for estimates to improve. Conscious or unconscious biases that occur can be identified and, one hopes, eliminated; new forecasting methods are sought as the need for them becomes apparent; and managers tend to do everything better, including forecasting, if they know that their actions are being monitored.
· Develop historical risk data. Post-audits permit managers to develop historical data on new project analyses regarding risk and expected rates of return. These data can then be used to make judgments about the relative risk of future projects as they are evaluated.
· Improve operations. Managers run businesses, and they can perform at higher or lower levels of efficiency. When a forecast is made, for example, by the surgery department, the department director and medical staff are, in a sense, putting their reputations on the line. If costs are above predicted levels and volume is below expectations, the managers involved will strive, within ethical bounds, to improve the situation and to bring results into line with forecasts. As one hospital CEO put it: “You academics worry only about making good decisions. In the health services industry, we also have to worry about making decisions good.”
· Reduce losses. Post-audits monitor the performance of projects over time, so the first indication that termination or replacement should be considered often arises when the post-audit indicates that a project is performing poorly.
Post-audit
The feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations.
Using Capital Budgeting Techniques in Other Contexts
The techniques developed in this chapter can help health services managers make a number of different types of decisions in addition to project selection. One example is the use of NPV and IRR to evaluate corporate merger opportunities. Healthcare companies often acquire other companies to increase capacity or expand into other service areas, among other reasons. A key element of any merger analysis is the valuation of the target company. Although the cash flows in such an analysis may be structured differently than in project analysis, the same evaluation tools are applied. We discuss business valuation in more detail in online Chapter 18, Lease Financing and Business Valuation.
Managers also use capital budgeting techniques when deciding whether or not to divest assets or reduce staffing. Like capital budgeting, these actions require an analysis of the impact of the decision on the firm’s cash flows. When eliminating personnel, businesses typically spend money up-front in severance payments but then receive benefits in the form of lower labor costs in the future. When assets are sold, the pattern of cash flows is reversed—that is, cash inflows occur when the asset is sold, but any future cash inflows associated with the asset are sacrificed. (If future cash flows are negative, the decision, at least from a financial perspective, should be easy.) In both situations, the techniques discussed in this chapter, perhaps with modifications, can be applied to assess the financial consequences of the action.
Key Concepts
This chapter discusses the basics of capital budgeting. The key concepts of this chapter are as follows:
· Capital budgeting is the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments.
· A capital budgeting financial analysis consists of four steps: (1) estimate the expected cash flows, (2) assess the riskiness of those flows, (3) estimate the appropriate cost-of-capital discount rate, and (4) determine the project’s profitability and breakeven characteristics.
· The most critical and most difficult step in analyzing a project is estimating the incremental cash flows that the project will generate.
· In determining incremental cash flows, opportunity costs (i.e., the cash flows forgone by using an asset) must be considered, but sunk costs (i.e., cash outlays that cannot be recouped) are not included. Furthermore, any impact of the project on the firm’s other projects must be included in the analysis.
· Tax laws generally affect investor-owned firms in three ways: (1) Taxes reduce a project’s operating cash flows, (2) tax laws prescribe the depreciation expense that can be taken in any year, and (3) taxes affect a project’s salvage value cash flow.
· Capital projects often require changes in current accounts in addition to the investment in fixed assets. Such changes represent a cash flow that, if material, must be included in the analysis. The net change in current accounts is recovered when the project is terminated.
· A project may have some strategic value that is not accounted for in the estimated cash flows. At a minimum, strategic value should be noted and considered qualitatively in the analysis.
· The effects of inflation must be considered in project analyses. The best procedure is to build inflation effects directly into the component cash flow estimates.
· Time breakeven, which is measured by the payback period, provides managers with insights concerning a project’s liquidity and risk.
· Project profitability is assessed by return on investment (ROI) measures. The two most commonly used ROI measures are net present value and internal rate of return.
· Net present value (NPV), which is simply the sum of the present values of all the project’s net cash flows when discounted at the project’s cost of capital, measures a project’s expected dollar profitability. An NPV greater than zero indicates that the project is expected to be profitable after all costs, including the opportunity cost of capital, have been considered. Furthermore, the higher the NPV, the more profitable the project.
· Internal rate of return (IRR), which is the discount rate that forces a project’s NPV to equal zero, measures a project’s expected rate of return. If a project’s IRR is greater than its cost of capital, the project is expected to be profitable, and the higher the IRR, the more profitable the project.
· The NPV and IRR profitability measures provide identical indications of profitability; that is, a project that is judged to be profitable by its NPV will also be judged profitable by its IRR. However, when mutually exclusive projects are being evaluated, NPV might rank a different project higher than IRR. This difference can occur because the two measures have different reinvestment rate assumptions—IRR assumes that cash flows can be reinvested at the project’s IRR, while NPV assumes that cash flows can be reinvested at the project’s cost of capital.
· The modified internal rate of return (MIRR), which forces a project’s cash flows to be reinvested at the project’s cost of capital, is a better measure of a project’s percentage rate of return than the IRR.
· The net present social value (NPSV) model formalizes the capital budgeting decision process for not-for-profit firms.
· Firms often use project scoring to subjectively incorporate a large number of factors, including financial and nonfinancial, into the capital budgeting decision process.
· The post-audit is a key element in capital budgeting. By comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process.
· Capital budgeting techniques are used in a wide variety of settings in addition to project evaluation.