The Investment Decision

Chapter 7

Learning Objectives

• Explain the financial objectives of health care providers

• Evaluate various capital investment alternatives

• Calculate and interpret net present value (NPV)

• Calculate and interpret the internal rate of return (IRR)

Capital Investments

• Strategic Decisions: decisions designed to increase a health careorganization’s strategic (long-term) position.

Example: purchasing physician practices to increase horizontal integration.

• Expansion Decisions: decisions designed to increase the operational capability of a heath care organization.

Example: increasing examination space in a group practice to accommodate increased volume.

• Replacement Decisions: decisions designed to replace older assets with newer, cost-saving ones.

Example: replacing a hospital’s existing cost-accounting system with a newer cost-saving one.

• Decision has 2 components: • Determine if investment is worthwhile• Determine how to finance the investment

Capital Investment Decisions

Capital Investment Decisions

• Financial Return: direct financial benefits are a primary concern notonly to health care organizations but also to many –if not all-investors who invest in health care organizations and their projects.

• Future Funding: without new capital funds, many health careorganizations would be unable to offer new services, supportmedical research, or subsidize unprofitable services.

• Nonfinancial Benefits : how well an investment enhances thesurvival of the organization and supports its mission, patients,employees and the community is the primary concern.

Decisions

• 3 Financial techniques (use only cash flows)

• Payback Method-calculate the time needed to recoup eachinvestment.

• Net Present Value Method- difference between the initialamount paid for an investment and future cash inflows theinvestment brings in adjusted for the cost of capital.

Payback method

• A method to evaluate the feasibility of an investment bydetermining how long it would take to recover the initialinvestment disregarding the time value of money.

• If the cash flows are equal each year:

Payback period= 𝒊𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔

Example 1:

Givens Years 0 1 2 3 4 5

1. Initial investment ($15,000,000)

2. Net opening cash flows

$2,000,000 $4,000,000 $5,000,000 $8,000,000 $16,000,000

Givens 0 1 2 3 4 5

A. Initial investment

[Given 1] ($15,000,000)

B. Net opening cash flows

[Given 2] $2,000,000 $4,000,000 $5,000,000 $8,000,000 $16,000,000

C. Cumulative Cash Flows

(a) ($15,000,000)

$13,000,000

$9,000,000 $4,000,000 $4,000,000 $20,000,000

Solution:

Payback = year 3.5

Example 2:

Givens Years 0 1 2 3 4 5

1. Initial investment ($28,000)

2. Net opening cash flows

$8,000 $8,000 $8,000 $8,000 $8,000

Givens 0 1 2 3 4 5

A. Initial investment

[Given 1] ($28,000)

B. Net opening cash flows

[Given 2] $8,000 $8,000 $8,000 $8,000 $8,000

C. Cumulative Cash Flows

(a) ($28,000) $20,000 $12,000 $4,000 $4,000 $12,000

Solution:

Payback = year 3.5

Strengths and weaknesses of Payback method

Strengths:

• Simple to calculate

• Easy to understand

Weaknesses:

• Answers in years not dollars

• Disregards cash flows after payback

• Does not account for the time value of money

Net Present Value (NPV) : difference between the initial amount paid for an investment and future cash inflows the investment brings in adjusted for the cost of capital.

Discounted cash flows: cash flows adjusted to account for the cost of capital.

Cost of capital: the rate of return acquired to undertake a project.; the cost of capital accounts for both the time value of money and the risk (hurdle rate or discount rate).

Net Present Value (NPV)

Taking example 1: discount rate = 15%

Givens 0 1 2 3 4 5

A. Initial investment

[Given 1] ($15,000,000)

B. Net opening cash flows

[Given 2] $2,000,000 $4,000,000 $5,000,000 $8,000,000 $16,000,000

C. Cumulative Cash Flows

(a) ($15,000,000)

$13,000,000

$9,000,000 $4,000,000 $4,000,000 $20,000,000

Givens 0 1 2 3 4 5

D. Present value interest factors for 15%

𝟏

(𝟏 + 𝒊)𝒏[Table B3]

0.8696 0.7561 0.6575 0.5718 0.4972

E. Present value of cash flows

[B X D] $1,739,130

$3,024,575

$3,287,581 $4,574,026 $7,954,828

F. Sum of annual Cash Flows

[Sum E] $20,580,140

G1. Net Present Value

[A + F] $5,580,140

G2. Net Present value function

$5,580,140

Taking example 2: discount rate = 20%

Givens 0 1 2 3 4 5

A. Initial investment

[Given 1] ($28,000)

B. Net opening cash flows

[Given 2] $8,000 $8,000 $8,000 $8,000 $8,000

C. Cumulative Cash Flows

(a) ($28,000) $20,000 $12,000 $4,000 $4,000 $12,000

Givens 0 1 2 3 4 5

D. Present value interest factors for 15%

𝟏

(𝟏 + 𝒊)𝒏[Table B3]

0.8333 0.6944 0.5787 0.4823 0.4019

E. Present value of cash flows

[B X D] $6,667 $5,556 $4,630 $3,868 $3,215

F. Sum of annual Cash Flows

[Sum E] $23,925

G1. Net Present Value

[A + F] $4,075

G2. Net Present value function

$4,075

Example 3: Givens (in thousands) Years 0 1 2 3 4 5

1. Initial investment ($5,500)

2. Net Revenues $3,000 $3,000 $3,000 $3,000 $3,000 $3,000

3. Cash operating expenses

$1,200 $1,200 $1,200 $1,200 $1,200 $1,200

4. Depreciation Expenses

[a] $940 $940 $940 $940 $940 $940

5. Sale of Asset at salvage value

$800

6. Cost of capital 12%

7. Change in net working capital

$0 $0 $0 $0 $0 $0

[a] ($5,500,000 Purchase price -$800,000 salvage value) / 5 years = $940 (in ‘000)

Solution:

Non-Profit Analysis Years 0 1 2 3 4 5

A. Initial investment [Given 1] ($5,500)

B. Net Revenues [Given 2] $3,000 $3,000 $3,000 $3,000 $3,000 $3,000

C. Less: cash operating expenses before depreciation

[Given 3] $1,200 $1,200 $1,200 $1,200 $1,200 $1,200

D. Less: Depreciation Expense

[Given 4] $940 $940 $940 $940 $940 $940

E. Operating Income [B – C - D] 860 860 860 860 860 860

F. Add: Depreciation Expense

[Given 4] $940 $940 $940 $940 $940 $940

G. Net Operating Cash Flows

[E+F] 1,800 1,800 1,800 1,800 1,800 1,800

H. Add: sale of assets at salvage value

[Given 5] 800

I. Adjustments for changing in working capital

-[Given 7) $0 $0 $0 $0 $0 $0

J. Recapture of Net working capital

-[Sum I] $ 0

K. Project cash flows [G+H+I+J] (5,500) $1,800 $1,800 $1,800 $1,800 $2,600

Non-Profit Analysis Years 0 1 2 3 4 5

L. Cost of Capital [Given 6] 12% 12% 12% 12% 12%

M. Present value interest factors

𝟏

(𝟏 + 𝒊)𝒏[Table B3] 0.8929 0.7972 0.7118 0.6355 0.5674

N. Annual PV of Cash flows

[K X M] 1,607 1,435 1,281 1,144 1,475

O. PV of cash Flows [Sum N] $6,943

P. Net Present Value [A + O] $ 1,443

Q. Net Present Value function check

$ 1,443

Accept Project because NPV is Positive

Decision rules while using NPV

Internal Rate of Return Method

• Rate of return on an investment that makes the NPV equal to$0 after all cash flows have been discounted at the samerate.

• It is also the discount rate at which the discounted cash flowsover the life of the project exactly equal the initialinvestment.

Calculations

• Equal cash flows:

• When the cash flows are equal in each period, the IRR can be determined by first finding the present value factor for an annuity and then converting the answer to a discount rate depending on the number of years.

• 𝑷𝑽 = 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 𝑿 𝑷𝑽𝑭𝑨𝒊,𝒏

• Unequal Cash flows: used excel sheet.

Example 4: Taking example 1 discount rate = 20%

Givens 0 1 2 3 4 5

A. Initial investment

[Given 1] ($15,000,000)

B. Net opening cash flows

[Given 2] $2,000,000 $4,000,000 $5,000,000 $8,000,000 $16,000,000

C. Cumulative Cash Flows

(a) ($15,000,000)

$13,000,000

$9,000,000 $4,000,000 $4,000,000 $20,000,000

Givens 0 1 2 3 4 5

D. Present value interest factors for 15%

𝟏

(𝟏 + 𝒊)𝒏[Table B3]

0.8696 0.7561 0.6575 0.5718 0.4972

E. Present value of cash flows

[B X D] $1,739,130

$3,024,575

$3,287,581 $4,574,026 $7,954,828

F. Sum of annual Cash Flows

[Sum E] $20,580,140

G1. Net Present Value

[A + F] $5,580,140

G2. Net Present value function

$5,580,140

Givens 0 1 2 3 4 5

H. Present Value interest factorsfor 20%

𝟏

(𝟏 + 𝒊)𝒏[Table B3]

0.6944 0.5787 0.4823 0.5718 0.4019

I. Present Values of Cash Flows

[B X H] $1,666,667

$2,777,778

$2,893,519 $3,858,025 $6,430,041

J. Sum of Present Value of cash flows

[Sum I] $17,626,029

K1. Net Present Value

[A + J] $2, 626, 029

K2. Net Present Value Function

$2, 626, 029

L. Internal Rate of Return

25.56%

Decision Rules when using the IRR

Internal Rate of Return

Summary

• Methods to evaluate capital investment were introduced. The 3 methods specifically discussed were payback, net present value and internal rate of return.