9 - 1 CHAPTER 9 Capital Investment Decision Basics Project classifications Role of financial...

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CHAPTER 9Capital Investment Decision Basics

Project classificationsRole of financial analysisTime value of moneyProject evaluation measures

PaybackNPVIRR

Project scoringPost audit

Copyright © 2013 by the Foundation of the American College of Healthcare Executives

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Capital Investment Basics

Capital investment decisions (capital budgeting) involve the process of analyzing proposed new investments in land, buildings, and equipment.

Such decisions:Typically are long-term in natureOften involve large expendituresUsually define strategic direction

Thus, these decisions are very important to businesses.


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Project ClassificationsProposed investments (projects) are classified according to

purpose and size. For example,Mandatory replacementExpansion of existing services

• Less than $1 million• $1 million or more

Expansion into new services• Less than $1 million• $1 million or more

How are such classifications used?


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Role of Financial Analysis

For investor-owned businesses, financial analysis identifies those projects that are expected to contribute to owners’ wealth.

For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’s financial condition. Why is this important?


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Overview of Capital Investment Financial Analysis

1. Estimate the project’s cash flows.

2. Assess the project’s riskiness.

3. Estimate the project cost of capital (opportunity cost of capital or discount rate).

4. Measure the financial impact.

In this chapter, we focus on Step 4 (measuring the financial impact). The first three steps will be covered in Chapter 10.


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Capital Budgeting Example

Assume that Midtown Clinic is evaluating the purchase of a x-ray machine.

Cost = $240,000.

Expected life = 4 years.

Corporate cost of capital = 10%.

The expected cash flows from buying and operating the equipment are listed on the next slide.


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0

$100

1

$105

2

$110

3

$141

4

($240)

Note that the cash flows have been laid out on a time line. Also, the cash flows are merely estimates based on volume, reimbursement rate, and operating cost assumptions.

Project Cash Flows (in thousands)


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Breakeven Analysis

It is very difficult to make judgments about the financial attractiveness of a project by looking at its cash flows.

Breakeven analysis is one way to help interpret the information embedded in the cash flows.

We will focus on time breakeven, which is measured by payback (payback period).


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Payback Illustration

0

$100

1

$105

2

$110

3

$141

4

($240)

Cumulative CFs:$ 75($240) ($ 35)($140) $216

Payback = 2 + $35 / $110 = 2.3 years.


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Advantages of Payback:

1. Easy to calculate and understand.

2. Provides an indication of a project’s risk and liquidity.

Disadvantages of Payback:

1. Ignores time value (discussed next).

2. Ignores all cash flows that occur after the payback period.


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Time Value of Money

Time value analysis is necessary because money has time value.A dollar in hand today is worth more than a dollar to be

received in the future. Why?Because of time value, the values of future dollars must be

adjusted before they can be compared to current dollars.

Discounted cash flow (DCF) analysis is the name given to techniques that account for the time value of money.


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What is the FV after 3 years ofa $100 lump sum invested at 10%?

FV = ?

0 1 2 310%

-$100

Finding future values (moving to the right along the time line) is called compounding.

For ease, assume interest is paid annually.


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After 1 year:

FV1 = PV + INT1 = PV + (PV × I)= PV × (1 + I)= $100 × 1.10 = $110.00.

After 2 years:

FV2 = FV1 + INT2

= FV1 + (FV1 × I) = FV1 × (1 + I)

= PV × (1 + I) × (1 + I) = PV × (1 + I)2

= $100 × (1.10)2 = $121.00.Copyright © 2013 by the Foundation of the American College of Healthcare Executives

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After 3 years:

FV3 = FV2 + I3

= PV x (1 + I)3

= 100 x (1.10)3

= $133.10.

In general,

FVN = PV x (1 + I)N .


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Three Primary Methods to Find FVs

Solve the FV equation using a regular (non-financial) calculator.

Use a financial calculator; that is, one with financial functions.

Use a computer with a spreadsheet program such as Excel.


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Non-Financial Calculator Solution

$133.10

0 1 2 310%

-$100 $110.00 $121.00

$100 x 1.10 x 1.10 x 1.10 = $133.10.


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3 10 -100 0N I/YR PV PMT FV

133.10

(1) Set your calculator on P/YR = 1, END.

INPUTS

OUTPUT

Notes:

(2) For lump sums, the PMT key is not used. Either clear the calculator before you start or enter PMT = 0.

Financial Calculator Solution


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Financial Calculator SolutionSpreadsheet Solution (Optional Slide)

A B C D12 3 Nper Number of periods3 100.00$ Pv Present value4 10.0% Rate Interest rate56 133.10$ =100*(1.10)^3 (entered into Cell A6)78 133.10$ =A3*(1+A4)^A2 (entered into Cell A8)910 133.10$ =FV(A4,A2,,-A3) (entered into Cell A10)


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10%

What is the PV of $100 duein 3 years if I = 10%?

$100

0 1 2 3

PV = ?

Finding present values (moving to the left along the time line) is called discounting. The interest rate applied is called the discount rate.


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Solve FVN = PV x (1 + I )N for PV

PV = $100 ÷ (1.10)3

= $100 × 0.7513 = $75.13.

PV = FVN ÷ (1 + I )N.


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Time Line Solution

$100

0 1 2 310%

$75.13 $82.64 $90.91

$100 1.10 1.10 1.10 = $75.13.

Note that the calculated present value ($75.13), when invested at 10 percent for 3 years, will produce the starting future value ($100).


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Financial Calculator Solution

3 10 0 100

-75.13

Either PV or FV must be negative on most calculators. Here, PV = -75.13. Put in $75.13 today, take out $100 after 3 years.

INPUTS

OUTPUTN I/YR PV PMT FV


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Financial Calculator SolutionSpreadsheet Solution (Optional Slide)

A B C D12 3 Nper Number of periods3 100.00$ Fv Future value4 10.0% Rate Interest rate56 75.13$ =A3/(1+A4)^A2 (entered into Cell A6)78 75.13$ =PV(A4,A2,,-A3) (entered into Cell A8)910


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Opportunity Cost Rate

On the present value illustration we needed to apply a discount rate.The appropriate discount rate is the opportunity cost rate or

opportunity cost of capital.It is the rate that could be earned on alternative investments of

similar risk.

In capital investment analyses, the corporate cost of capital typically is used as the benchmark discount rate.


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Profitability (ROI) Analysis

Return on investment (ROI) analysis focuses on a project’s financial return.

Financial returns can be measured either in dollar terms or in rate of return (percentage) terms.Net present value (NPV) measures a

project’s time value adjusted dollar return.Internal rate of return (IRR) measures a

project’s rate of (percentage) return.


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Net Present Value (NPV)

NPV measures return on investment (ROI) in dollar terms.

NPV is merely the sum of the present values of the project’s cash flows.

The discount rate used in project analysis is called the project cost of capital. If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%.


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Net Present Value (NPV) Calculation

0

$100

1

$105

2

$110

3

$141

4

($240.00)

10%

90.9186.7882.64

96.30$116.63

Thus, the project’s NPV is about $117,000.

Note that financial calculators have functions that perform capital investment analyses.Copyright © 2013 by the Foundation of the American College of Healthcare Executives

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Spreadsheet Solution (Optional Slide)

A B C D12 10.0% Project cost of capital3 (240)$ Cash flow 0 (000s)4 100 Cash flow 1 (000s)5 105 Cash flow 2 (000s)6 110 Cash flow 3 (000s)7 141 Cash flow 4 (000s)8910 117$ =NPV(A2,A4:A7)+A3 (entered into Cell A10)


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Interpretation of the NPV

NPV is the excess dollar contribution of the project to the value of the business.

A positive NPV signifies that the project will enhance the financial condition of the business.

The greater the NPV, the more attractive the project financially.


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Discussion Item

What is the meaning of an NPV of $0?


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Internal Rate of Return (IRR)

IRR measures ROI in percentage (rate of return) terms.

It is the discount rate that forces the PV of the inflows to equal the cost of the project. (In other words, it is the discount rate that forces the project’s NPV to equal $0.)

IRR is the project’s expected rate of return.


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IRR Calculation (Cont.)

0

$100

1

$105

2

$110

3

$141

4

($240.00)77.1162.4650.4849.95

$240.00

29.7%

Thus, the project’s IRR is 29.7%.$ 0 = NPV.


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Spreadsheet Solution (Optional Slide)

A B C D12 10.0% Project cost of capital3 (240)$ Cash flow 0 (000s)4 100 Cash flow 1 (000s)5 105 Cash flow 2 (000s)6 110 Cash flow 3 (000s)7 141 Cash flow 4 (000s)8910 29.7% =IRR(A2,A3:A7) (entered into Cell A10)


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Interpretation of the IRR

If a project’s IRR is greater than its cost of capital, then there is an “excess” return that contributes to the equity value of the business.

In our example, IRR = 29.7% and the project cost of capital is 10%, so the project is expected to enhance Midtown Clinic’s financial condition.


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Discussion Items

What is the meaning of an IRR of 0%?

Of an IRR of 10%?


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Some Thoughts on Project Analysis

Although NPV and IRR generally are perfect substitutes, there are yet other ROI measures that can be used; i.e., the Profitability Index.

A thorough analysis will consider all profitability measures, plus examine input variable breakevens.

However, the key to effective project analysis is the ability to forecast the cash flows with some confidence.


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Project Scoring

Project measures thus far have focused on financial value.

Other factors can be incorporated into the analysis by using project scoring, which is a matrix that considers factors such as patient, staff, and physician value in addition to financial value.


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Post Audit

The post audit is a formal process for monitoring a project’s performance over time.

It has several purposes:Improve forecastsDevelop historical risk dataImprove operationsReduce losses


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This concludes our discussion of Chapter 9 (Capital Investment Decision Basics).

Although not all concepts were discussed in class, you are responsible for all of the material in the text.

Do you have any questions?

Conclusion


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