Capital Budgeting Decisions Clifton Louie, RPh, DPA, FACHE May 2003
So You Want To Purchase Something………. • The available alternatives • Cash available • Cost Information • Benefit Information • Risk Profile
Which Project to Fund? • Solvency • Incremental management time required • Public image • Medical staff approval
Which to Fund - UCSF Style • Required by code or regulations • Patient or employee safety • Revenue generation or cost avoidance • Replacement
Justification • Need - relative to attainment of mission and goals • Economic feasibility • Acceptability (vis-à-vis established priorities or other criteria)
Sources of Cash • From Operations • Collections from A/R • Cash sales • From Investments • From Debt • From Charitable donations • From selling assets
Uses of Cash • Payroll • Accounts Payables • Payment on debt • Capital purchases • Investment
Liquidity Concerns • Increase the level of cash and investment reserves • Restructure debt • Arrange a line of credit against a collateral • Shorten A/R Cycle • Lengthen Payment Cycle
Working Capital • Relationship between • Current Assets • Current Liabilities
Current Assets • Cash and investments • A/R • Inventories • Other current assets • A Balance Sheet Parameter
Current Liabilities • A/P • Accrued salaries and wages • Accrued expenses • Notes payable • Current position on long term debt • A Balance Sheet Parameter
Management of the A/R • Minimize lost charges • Minimize late charges • Minimize write-offs • Minimize the A/R days to an acceptable level
Management of A/P • Minimize the amount of vendors • Track the invoice to purchase order to the receiver • Maximize payment cycle or gain financial incentive for shorter payment cycle
Cash Budget - 4 Activities • Purchasing of resources (Capital equipment) • Production/sale of service • Billing • Collection
Rule of Thumb • Minimize the A/R cycle and lengthen the A/P cycle within limits. By doing so, there is usually a positive cash flow within the organization
Financial Ratio Analysis • Are the fundamental analytical tools for interpreting financial statements • Four classes of ratios: • Liquidity • Solvency • Funds management • Profitability
Liquidity Ratios • Liquidity is measured by its ability to raise cash from all sources (credit, sale of assets, and operations) • Used to appraise a company’s ability to meet its current obligations using existing cash and current assets • Typically, it is assumed that the higher the ratio, the more protection the company has against liquidity problems
Liquidity Ratios • Current Ratio is current assets / current liabilities • What is the current ratio for XYZ Corporation? • Acid-Test or Quick Ratio is quick assets / current liabilities • Measures the ability of a company to use its “near-cash” or quick assets to meet its current liabilities • What is the acid-test ratio for XYZ Corporation?
XYZ Corporation Comparative Balance Sheet ($000’s)
XYZ Corporation Income Statement ($000’s)
Accounts Payable Management • The day’s payables ratio becomes meaningful when compared to the credit terms given by the suppliers. • To calculate the day’s payables: • Purchases / Day • Then, Accounts payable / Purchases per day = Day’s Payables • Inventory Turnover is important to management • Inventory turnover = cost of sales / average inventory
Solvency Ratios • These ratios generate insight into a company’s ability to meet long-term debt payment schedules • “Times Interest Earned” is Operating profit (before interest expense) / Long-term debt interest What is XYZ Corporation’s Times Interest Earned Ratio? • The ratio indicates the extent to which operating profits can decline without impairing the company’s ability to pay the interest on its long-term debt.
Solvency Ratios • Debt-to-equity ratios – relationship of borrowed funds to ownership funds is an important solvency ratio. Capital from debt and other creditor sources is more risky for a company than equity capital. • One common ratio is • Total Liabilities / Total Assets • What is XYZ Corporation’s Debt-to-equity ratio?
Funds Management Ratios • The financial situation of a company is affected in large measure on how its investments in accounts receivable, inventories, and fixed assets are managed • Receivables to Sales: • Accounts receivable (net) / Net sales • Average Collection Period: • Accounts receivable / Net sales x Days in the annual period = Collection period • Average Accounts Payable Period: • Accounts payable / Purchases
Profitability Ratios • Profit margin (Gross or Net) • ROI
Making The Right Decision • Life of capital assets • Meeting the “expected demand” • Investment of cash
Types of Investments • Replacement of damaged equipment • Replacement of obsolete equipment • Expansion • New technology, services and markets • Safety improvement • Others
5 Steps in Capital Budgeting • Identify the initial cost • Forecast operating cash flows • Assess the risk • Measure the investment’s worth • Assess the profitability
4 Questions - Initial Cost Analysis • What is the invoice price? • Additional expenses? • Revenues from sales of old equipment? • How tax is owed?
Case Study – Identifying the Project’s Initial Costs East Oz Community Hospital is planning to buy an ultrasound unit for $200,000. The unit has a straight-line depreciation life of 5 years. The old ultrasound unit is being sold for $50,000. It was bought by the Hospital brand new 3 years ago for $100,000. The hospital must pay $2,000 for delivery and $11,000 for training and calibration. The tax rate for capital gains is 34 percent. Net working capital for the hospital does not change with this purchase. What is the initial cost for the project?
Forecasting the Cash Flows • Calculate additional net earnings • Calculate tax benefits of depreciation • Incremental cash flow = additional net earnings + additional tax benefits
Case Study – Forecasting Cash Flows East Oz Community Hospital is considering replacing their CT scanner with a newer, multi-slice, highly efficient, higher resolution state-of-the-art CT scanner. The existing scanner was purchased 3 years ago for $500,000. The new machine is $750,000. For each machine assume a 5-year straight-line depreciation. The capital gains tax rate is 34 percent. What are the incremental cash flows associated with the purchase of the new CT scanner?
Payback Analysis • The payback is the number of years needed to recover the initial investment
Easy to use Easy to understand The shorter the payback time, the less risky is the investment Ignores the time value of money Ignores the cash inflows produced after the initial investment is recovered Payback Analysis
Net Present Value (NPV) • NPV = Present value - Initial Investment • Positive or zero NPV, accept the project • Negative NPV, reject project • Importance on determining the right discount rate
Uses cash flows instead of earnings Recognizes the time value of money Positive NPV’s increases the value of the organization Future cash predictions are difficult to make NPV assumes the same discount rate throughout the life of the project NPV In a capital budget, go for the NPV with the greatest (+) In a operating budget, go for the NPV with the greatest (-)
NPV PV = Future Value / (1 + Discount Rate) ** (# of years) PV = $1.00 / (1+0.10)**1 = 0.909 PV = $1.00 / (1+0.10)**2 = 0.826 PV = $1.00 / (1+0.10)**3 = 0.751
Case Study - NPV A project will have an annual cash flow over the first 3 years of $6,000, $4,000 and $2,000. If the discount rate is 10% and the initial investment is $15,000, do you recommend funding this project?
Discount Rate Prediction • Riskier projects have a higher discount rate • When interest rate and inflation rates are up, the discount rate will be higher • Longer life of the project, higher the discount rate
Risk Assessment - Sensitivity Analysis • The purpose is to find out how sensitive various indicators are to change • A riskier project is more sensitive to change
Case Study – Sensitivity Analysis East Oz Community Hospital is considering two short- term projects. The first project has a cash flow of $1,000 in Year One of the project and $1,500 for Years Two and Three. Correspondingly, the second project has a cash flow of $1,800 in Year One and $700 in Years Two and Three. The initial investment for each project is $1,600. If the discount rate changes from 10 percent to 12 percent, which project is riskier?
Average Rate of Return (ARR) • Measures the relationship between the new earnings of a project to the average investment. • ARR = Average annual future net earnings / One-half of initial investment
Easy to Use Easy to understand The higher the ARR, the less risky the investment Ignores the time value of money Uses earnings instead of cash flow Ignores depreciation Ignores value of salvage Ignores time sequence of net earnings ARR
Case Study – Average Rate of Return The net earnings for a project over the next 5 years are $10,000 per year. If the initial investment is $60,000, what is the average rate of return?
Internal Rate of Return • IRR is a discount rate that makes the present value of cash flows equal to the initial investment • The rate below where projects are rejected is called the cutoff rate. • Predicts a firm’s opportunity to reinvest future cash flows from the project
Simple to use Takes into account the time value of money May give unrealistic rates of return IRR
Case Study – Internal Rate of Return The nursing department projected an annual cash flow for a new outreach program to be $2,500 for 6 years. The initial investment for the program is $17,500. What is the IRR and should the program be accepted if the cutoff rate is 10 percent?
Profitability Index • PI = Present value of cash flows / Initial investment • Project with a PI greater than one is accepted
Case Study – Profitability Index East Oz Community Hospital is considering a project with an annual cash flow of $5,000 for the next 5 years. The initial investment is $20,000. Using the PI method and a discount rate of 10 percent, should the project be accepted?
Equivalent Annual Cost Equivalent Annual Cost = Present value of operating cost + Present value of investment cost Present value of annuity