The document discusses methods for evaluating capital investment decisions in healthcare organizations. It introduces the payback period method, which calculates the number of years to recover an initial investment without considering the time value of money. The net present value (NPV) method is presented, which discounts future cash flows to account for the cost of capital and calculates the difference between the initial investment and discounted cash flows. The internal rate of return (IRR) method is also covered, which is the discount rate that makes the NPV equal to zero. Decision rules for accepting or rejecting projects using NPV and IRR are provided.

1. The Investment
Decision
Chapter 7

2. 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)

3. Capital Investments
• Strategic Decisions: decisions designed to increase a health care
organization’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

4. Capital Investment Decisions

5. Capital Investment Decisions
• Financial Return: 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.
• Future Funding: without new capital funds, many health care
organizations would be unable to offer new services, support
medical research, or subsidize unprofitable services.
• Nonfinancial Benefits : how well an investment enhances the
survival of the organization and supports its mission, patients,
employees and the community is the primary concern.

6. Decisions
• 3 Financial techniques (use only cash flows)
• Payback Method-calculate the time needed to recoup each
investment.
• Net Present Value Method- difference between the initial
amount paid for an investment and future cash inflows the
investment brings in adjusted for the cost of capital.

7. Payback method
• A method to evaluate the feasibility of an investment by
determining how long it would take to recover the initial
investment disregarding the time value of money.
• If the cash flows are equal each year:
Payback period=
풊풏풊풕풊풂풍 풊풏풗풆풔풕풎풆풏풕
풂풏풏풖풂풍 풄풂풔풉 풇풍풐풘풔

8. Example 1:
Givens Years 0 1 2 3 4 5
1. Initial investment ($15,000,0
00)
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] ($15,000,0
00)
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) ($15,000,0
00)
$13,000,00
0
$9,000,000 $4,000,000 $4,000,000 $20,000,000
Solution:
Payback = year 3.5

9. 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

10. 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

11. Net Present Value (NPV)
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).

12. Taking example 1: discount rate = 15%
Givens 0 1 2 3 4 5
A. Initial
investment
[Given 1] ($15,000,0
00)
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) ($15,000,0
00)
$13,000,00
0
$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%
ퟏ
(ퟏ + 풊)풏
[Table
B3]
0.8696 0.7561 0.6575 0.5718 0.4972
E. Present value
of cash flows
[B X D] $1,739,13
0
$3,024,57
5
$3,287,581 $4,574,026 $7,954,828
F. Sum of annual
Cash Flows
[Sum E] $20,580,1
40
G1. Net Present
Value
[A + F] $5,580,14
0
G2. Net Present
value function
$5,580,14
0

13. 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%
ퟏ
(ퟏ + 풊)풏
[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

14. 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)

15. 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

16. 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
ퟏ
(ퟏ + 풊)풏
[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

17. Decision rules while using NPV

19. 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 same
rate.
• It is also the discount rate at which the discounted cash flows
over the life of the project exactly equal the initial
investment.

20. 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.
• 푷푽 = 푨풏풏풖풊풕풚 푿 푷푽푭푨풊,풏
• Unequal Cash flows: used excel sheet.

21. Example 4: Taking example 1 discount rate = 20%
Givens 0 1 2 3 4 5
A. Initial
investment
[Given 1] ($15,000,0
00)
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) ($15,000,0
00)
$13,000,00
0
$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%
ퟏ
(ퟏ + 풊)풏
[Table
B3]
0.8696 0.7561 0.6575 0.5718 0.4972
E. Present value
of cash flows
[B X D] $1,739,13
0
$3,024,57
5
$3,287,581 $4,574,026 $7,954,828
F. Sum of annual
Cash Flows
[Sum E] $20,580,1
40
G1. Net Present
Value
[A + F] $5,580,14
0
G2. Net Present
value function
$5,580,14
0

22. Givens 0 1 2 3 4 5
H. Present Value
interest factors
for 20%
ퟏ
(ퟏ + 풊)풏
[Table
B3]
0.6944 0.5787 0.4823 0.5718 0.4019
I. Present Values
of Cash Flows
[B X H] $1,666,66
7
$2,777,77
8
$2,893,519 $3,858,025 $6,430,041
J. Sum of Present
Value of cash
flows
[Sum I] $17,626,0
29
K1. Net Present
Value
[A + J] $2, 626,
029
K2. Net Present
Value Function
$2, 626,
029
L. Internal Rate
of Return
25.56%

23. Decision Rules when using the IRR

24. Internal Rate of Return

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