3. Learning Objectives
After completing this lecture, you will be able to:
1-Explain the financial objectives of health care providers.
2-Evaluate various capital investment alternatives.
3-Calculate and interpret Payback period.
4-Calculate and interpret net present value (NPV).
5-Calculate and interpret the internal rate of return (IRR).
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4. What is Capital Investment Decisions
*Capital investment decisions involve large monetary investments expected to achieve long-
term benefits for an organization. Such investments, common in health care, fall into three
categories:
*Strategic decisions:
Capital investment decisions designed to increase a health care organization’s strategic
(long-term) position (e.g., purchasing physician practices to increase horizontal integration)
*Expansion decisions:
Capital investment decisions designed to increase the operational capability of a health care
organization (e.g., increasing examination space in a group practice to accommodate
increased volume)
.
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5. Cont…
*Replacement decisions: Capital investment decisions designed to
replace older assets with newer,
cost-saving ones (e.g., replacing a hospital’s existing cost-accounting
system with a newer, cost-saving one)
*A capital investment decision has two components: determining if
the investment is worthwhile, and determining how to finance the
investment. Although these two decisions are interrelated, they should
be separated. (this lecture focuses on the first component: determining
whether a capital should be undertaken or not
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6. Objectives of Capital Investment Analysis
A capital investment is expected
to achieve long-term benefits for
the organization that generally fall
into three categories:
◦nonfinancial benefits
◦financial returns,
◦and the ability to attract more funds in
the future .
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7. Nonfinancial Benefits
*How well an investment enhances the survival of the organization and
supports its mission, patients, employees, and the community is a primary
concern in many capital investment decisions. A particularly interesting
movement in health care is the increasing number of governmental agencies
with taxing authority asking for proof of community benefit.
*Community benefits include increased access to different types of care,
higher quality of care, lower charges, the provision of charity care, and the
employment of community members,
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8. Financial Returns
Direct financial benefits are a primary concern not only to health care
organizations but also to many—if not all—investors who invest in health
care organizations and their projects.
Direct financial benefits to investors can take two forms. The first is periodic payments in the
form of dividends to stockholders or interest to bondholders, or both. Dividends represent the
portion of profit that an organization distributes to equity investors, whereas interest is a payment
to creditors, those who have loaned the organization funds or otherwise extended credit.
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9. Mahmoud shaqria 9
*The second type of benefit to an investor comes in the form of
retained earnings, the portion of the profits the organization
keeps in-house to use for growth and to support its mission. This
describes the plowing back or investing of funds (including
retained earnings) into capital projects that appreciate in value.
Capital appreciation takes place whenever an investment is worth
more when it is sold than when it was purchased. For investor-
owned organizations, this appreciation in value increases the
value of investors’ stock.
*Although almost all organizations can make periodic payments to
their investors in the form of interest, by law only investor-owned
health care organizations can distribute dividends outside the
10. Ability to Attract Funds in the Future
*Without new capital funds, many health care organizations would be
unable to offer new services, support medical research, or subsidize
unprofitable services. Therefore, another objective of capital
investment is to invest in profitable projects or services that will attract
debt (borrowing) and equity financing in the future by external
investors. (Capital financing includes funds from a variety of sources,
such as governmental entities, foundations, and community-based
organizations.)
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11. Analytical Methods
*An investment decision involves many factors. Three
commonly used financial techniques to analyze capital
investment decisions for health care organizations are
• Payback method
• Net present value method
• Internal rate of return method
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12. Example No. (5/1)
Suppose Al salaam Hospital has EGP1 million available to
invest in a new business. After examining the market place,
the hospital has narrowed its possibilities to two promising
options, each of which would expend the full amount of
money available: it could buy an existing physician practice,
or it could build its own small satellite clinic. If it buys the
physician practice, it would expect to generate new net cash
inflows of EGP333,333 each year for six years . By investing
in its own satellite clinic, Al salaam could expect to generate
net cash flows of EGP200,000, EGP250,000, EGP300,000,
EGP350,000, EGP450,000, and EGP650,000 over the next
six years. Mahmoud shaqria 12
13. Example No. (5/1)
Required
a. Determine the payback for both projects.
b. Determine which project should be accepted?
And why?
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14. Solution of example No (5/1)
First we have to draw a table showing the cash flows
of two alternative investment decisions:
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physician practice
year 0 1 2 3 4 5 6
Initial
investment
(EGP1,000,000)
Project’s
Cash
flows
EGP333,33
3
EGP333,333 EGP333,333 EGP333,333 EGP333,333 EGP333,333
satellite clinic year 0 1 2 3 4 5 6
Initial
investment
(EGP1,000,000)
Project’s
Cash
flows
EGP200,00
0
EGP250,000 EGP300,000 GP350,000 EGP450,000 EGP650,000
15. a. Payback Method
One way to analyze these investments is to calculate
the time needed to recoup each investment. This is
called the payback method. The formula for computing
the cash payback
period assuming equal annual cash flows.
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16. Payback period for first alternative
(physician practice)
The cash payback period in Al salaam Hospital example
for the first alternative (physician practice) is 3 years,
computed as follows.
EGP1,000,000 ÷ EGP333,333 = 3 years
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17. Payback period for second alternative
(satellite clinic)
The cash payback period in Al salaam Hospital example for
the second alternative (satellite clinic) can not computed
easily as the first one , because net cashflows are different. In
the case of uneven net annual cash flows, the hospital
determines the cash payback period when the cumulative
net cash flows from the investment equal the cost of the
investment
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18. Payback period for second alternative
(satellite clinic)
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year investment Net annual cash flow Cumulative Net annual cash flow
0 EGP1,000,000
1 EGP200,000 EGP200,000
2 EGP250,000 EGP450,000
3 EGP300,000 EGP750,000
4 EGP350,000 EGP1,100,000
5 EGP450,000 EGP1,550,000
6 EGP650,000 EGP2,200,000
Payback
period
In
between
3rd and 4th
year
19. Investment Decision
It follows that when the payback technique is used to decide among acceptable alternative projects,
the shorter the payback period, the more attractive the investment. This is true for two reasons:
First, the earlier the investment is recovered, the sooner the company can use the cash funds for other
purposes.
Second, the risk of loss from obsolescence and changed economic conditions is less in a shorter
payback period.
As previous table shows, at the end of year 3, cumulative net cash flow of EGP750,000 is less than the
investment cost of EGP1,000,000, but at the end of year 4 the cumulative cash inflow of EGP1,100,000
exceeds the investment cost. The cash flow needed in year 4 to equal the investment cost is
EGP250,000 (EGP1,000,000- EGP750,000).
Assuming the cash inflow occurred evenly during year 4, we then divide this amount by the net annual
cash flow in year 4 EGP350,000) to determine the point during the year when the cash payback
occurs. Thus, we get 0.7 (EGP250,000/ EGP350,000), or 2/3 of the year, and the cash payback period
is 3.7 years. ) Mahmoud shaqria 19
20. Strengths and Weaknesses of the Payback
Method The strengths of the payback method are that it is simple to calculate and easy to understand. There are
three major weaknesses of the payback method, however: it gives an answer in years, not dollars; it
disregards cash flows after the payback time; and it does not account for the time value of money. Each
of these is discussed briefly in this section.
• The payback is in years, not dollars. Knowing that a project has a payback of three years does
not provide certain key financial information, such as the size of the dollar impact on the organization in
future years.
• The payback method disregards cash flows after the payback time. For example, the physician
practice has equal annual cash inflows and a payback of three years, whereas the satellite clinic has
unequal annual cash inflows and does not reach payback until year 4. Tus the physician practice, with its
shorter payback, would appear to be the better investment. However, the satellite clinic has better cash
flows in later years, and by the end of year 6, it brings in EGP200,000 more than does the physician
practice. Hence, in addition to time until payback, it is important to consider the cash flows after the
payback date when making an investment.
The payback method does not account for the time value of money. Chapter Six demonstrated that a
dollar received sometime in the future is not worth the same as a dollar received today. The two
evaluation methods discussed in the remainder of this lecture, net present value and internal rate of
return, take the time value of money into account, whereas the payback method does not.Mahmoud shaqria 20
21. Net Present Value
Because of the deficiencies of the payback method, a preferred alternative for analyzing
capital investments is a net present value analysis. Net present value (NPV) is the
difference between the initial amount paid for an investment and its associated future
cash flows that have been adjusted (discounted) by the cost of capital. The cost of capital
includes two costs:
First, investors (bondholders and stockholders) are being asked to delay the
consumption of their funds by investing in the project (time value of money);
and second, these investors face a risk that the investment may not generate the
revenues and net cash flows anticipated, leaving them with an inadequate rate of return,
or the project may fail altogether, leaving the investors with perhaps nothing other than a
tax loss.
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22. Net Present Value
On the one hand, if the sum of the discounted cash flows
resulting from the investment is greater than the initial investment
itself, then the NPV is positive. Thus, from a purely financial
standpoint, the project is acceptable, all else being equal. On the
other hand, if the sum of the discounted cash flows resulting from
the investment is less than the initial investment, then over time
the investment brings in less than what was initially paid out, the
NPV is negative, and the investment should be rejected.
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23. Strengths and Weakness of the NPV Method
The NPV method has a number of strengths and weaknesses.
Its strengths are that it provides an answer in dollars, not years;
it accounts for all cash flows in the project, including those
beyond the payback period; and it discounts the cash flows by
the cost of capital. Its main difficulties are developing estimates
of cash flows and the discount rate.
Conceptually, NPV is strong because it accounts for all cash
flows in a project and discounts at the cost of capital. However,
the cost of capital can be difficult to determine.
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24. Internal Rate of Return
The internal rate of return (IRR) on an investment can be
defined and
interpreted several ways. It can mean the discount rate at which
the discounted cash flows over the life of the project exactly equal
the initial investment, the discount rate that results in a net present
value equal to zero, or the percentage return on the investment.
(In contrast, NPV is the dollar return on the investment.) The
method used to solve for the IRR
depends on whether the cash flows are equal or unequal.
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25. Decision Rules When Using the IRR
When an organization chooses a project according to the IRR method,
its financial decision depends on the value of the IRR relative to the
required rate of return on the investment (which is also called the
cost of capital or hurdle rate).
• If the IRR is greater than the required rate of return, the project should
be accepted.
• If the IRR is less than the required rate of return, the project should be
rejected.
• If the IRR is equal to the required rate of return, the facility should be
indifferent about accepting or rejecting the project.
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26. Strengths and Weaknesses of IRR Analysis
IRR has three major strengths as a decision criterion it considers all the
relevant cash flows related to the investment project, it is a time value of
money–based approach, and managers are accustomed to evaluating
projects by their respective rates of return. IRR also has three
weaknesses as a decision criterion: it assumes that proceeds are
reinvested at the internal rate of return, which may or may not be equal
to the cost of capital; developing estimates of cash flows is difficult; and
the IRR sometimes generates multiple rates of return, if future cash
flows are estimates.
Still, this method is widely used in industry as the preferred way to make
responsible investment decisions.
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27. Assignments/ problem No.1
Al- Aml Care Medical Center expects Projects X and Y to generate
the following cash flows:
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Project X
year 0 1 2 3 4 5
Initial
investment
(EGP2,000,000)
Project’s
Cash flows
EGP700,000 EGP500,000 EGP300,000 EGP200,000 EGP150,000
Project Y year 0 1 2 3 4 5
Initial
investment
(EGP2,000,000)
Project’s
Cash flows
EGP150,000 EGP200,000 EGP300,000 GP500,000 EGP700,000
28. Assignments/ problem No.1
Required
a. Determine the payback for both projects.
b. Determine which project should be accepted? And
why?
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