HM 416 Chapter 8

1. © 2018 American Health Information Management Association© 2018 American Health Information Management Association
Principles of Finance for
Health Information and
Informatics Professionals
Second Edition
Chapter 8
Capital Investment Decisions

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Learning Objectives
• Define capital investment
• Discuss how the cash flows of an investment
project differ from its accounting profits
• Identify and discuss the four main cost analysis
methods used in practice to compare capital
investments
• Discuss various techniques for assessing risk in
capital projects

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Capital Purchases
• Capital purchases are items with a useful life of more
than one year and of high value
– Typically items that can be depreciated (except land)
• Capital budget
– Determine the projects that must be funded in next 3-5 years
– Examples: medical equipment, facility expansion, satellite
clinics, computer hardware
• Each potential purchase should be analyzed to
determine expected return on investment (ROI)
– Expected return
– Expected cost of acquiring capital funding
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Project Cash Flow Analysis
• Used to determine the impact of a project on
the financial position of the organization
• Recall: statement of cash flows takes income
statement and balance sheet and translates the
information into movement of cash
• Project cash flow analysis is the same
information, but for the particular project (not
the entire organization)
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Stand Alone Principle
• Each project should be analyzed in isolation to determine
its impact on the organization’s overall cash flow
• Should only consider the incremental cost and revenue
produced by the project
– Incremental cost: additional cost incurred by implementing a project
– Incremental revenue: revenue produced by implementing a project
• Example: Purchase an MRI machine to reside in space
already leased by an organization
– Cost of leasing the space to house the MRI machine is not
considered as incremental cost
– If new space was required to house new equipment or services,
then leasing of space should be included in incremental cost
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Project Cash Flow Analysis—Costs
• Cash flow analysis should not include
– Sunk costs: costs incurred whether or not the project is pursued
• Feasibility studies
• Market analysis
– Financing costs
• Cash flow produced should be compared to the net present value of the acquisition
cost
• Cost of capital goes into the full assessment of the project, but is not included in the
cash flow analysis
• Cash flow analysis should include
– Opportunity cost – benefits that are given up or extra cost incurred by choosing
one project over another
– Cost of side effects – incidental costs such as supplies for MRI machine
– Impact on net working capital – start up costs, down payment
– Tax impact, if for profit
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Pro Forma Financial Statements
• Pro forma – projection of financial results
based on a set of assumptions
• Pro forma income statement
– Revenues and expenses associated with the
project
• Pro forma balance sheet
– Impact on assets and liabilities
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Pro Forma Example
• Purchase of MRI machine—assumptions
– Annual volume of 1,000 tests
– Average revenue of $250 per test
– Variable cost per procedure = $50 per test
– Fixed cost (staff) = $50,000
– Cost of MRI machine = $300,000; useful life of 5 years
– $10,000 initial supplies (inventory)

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Calculating Project Cash Flow
• Project cash flow, also known as cash flow from assets
(CFFA)
• Two components of CFFA:
– Operating cash flow (OCF)
– Change in assets during life of project
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Calculating Project Cash Flow Example
OCF= EBIT + Depreciation – Taxes
OCF= 90,000 + 60,000 – 0 = $150,000

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Calculating Project Cash Flow Example
• OCF = $90k + $60k = $150k
• Change in assets: $300,000 purchase price + $10,000 is start up supplies
• In year 5 $10,000 in start up supplies is a remaining asset
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CCFA = OCF – Capital Spending – Networking Capital

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Cost–Benefit Analysis
• Cash flow analysis quantifies one aspect of capital
purchase
• Cost benefit analysis methods consider all aspects of
purchase:
– Payback period
– Average rate of return
– Net present value
– Internal rate of return
• Non-monetary (mission-related) benefits should
also be taken into consideration
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Payback Period
• Amount of time it takes for the accumulated cash
flow to exceed the initial investment amount
• How long before the investor makes her money
back?
• Once calculated, the payback period must be
compared to a organizational standard or between
alternative projects
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Payback Period Example
• MRI purchase
• Initial investment = $310,000
• Annual net cash flow = $150,000
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Payback Period Example
Alternative Calculation
• Previous calculation appropriate if cash flow is even throughout the years
• MRI purchase
• Initial investment = $310,000
• Annual net cash flow = $150,000 for year 1 with a 10% increase in subsequent
years
Payback
slightly less
than 2 years
Net cash flow
increases by
10% each year

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Payback Period—Strengths/Weaknesses
Strengths
• Intuitive
• Favors investments with
high level of liquidity
Weaknesses
• Ignores time value of money
• Requires a cutoff to be
defined by organizational
leadership
• Does not consider cash flow
after payback is complete
• Biased against investments
that take longer to mature
(those with ramp up
periods)
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Average Rate of Return (ARR)
• Also called accounting rate of return
• Average annual accounting profit divided by the
average annual accounting value of the investment
• Important note: numerator is annual net income
NOT cash flow—includes depreciation expense
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Average Rate of Return Example
• MRI Example
– Average net income per year = $90,000
– Average investment amount =
($310,000 +- $10,000)/2 = $150,000
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Average Rate of Return—Strengths and
Weaknesses
Strengths
• Ease of calculation
• May be compared to
organization-wide ARR
Weaknesses
• Ignores time value of
money
• Based on accounting net
income not cash flow
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Net Present Value (NPV)
• Difference between a capital investment’s market value and its
cost
• NPV calculation is based on the concept of discounted cash flow
(DCF)
• Recall the present value/future value formula from Chapter 7:
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Discounting or
Present Value
Factor
  n
n
r
FV
rFVPV
)1(
1




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Discounting or PV Factor
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DCF—How to Choose Discounting
Factor?
• Cost of capital
• Impact of alternative investments
– What is return if capital expense was invested
elsewhere?
• Inflation rate (medical CPI?)
• Typically a mix of factors or simply cost of
capital
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Discounted Cash Flow Example
Recall: MRI purchase price = $300,000 + $10,000 in
startup supplies. If we are able to borrow funds for an
annual interest rate of 5%, the 5-year DCF analysis is:
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• Net Present Value of the investment is:
NPV = -310,000+142,860+136,050+129,570+123,405+125,360=347,245

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Discounted Cash Flow Example
Recall: MRI purchase price = $300,000 + $10,000 in start
up supplies. We are able to borrow funds at an annual
interest rate of 10%. The 5-year DCF analysis is:
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• Net Present Value of the investment is:
NPV = -310,000+136,364+123,967+112,697+102,452+99,347=$264,827

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DCF—Impact of Interest Rate
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Using NPV to Compare Investments
Example: Comparing competing investments with NPV
Consider two competing investments in computer equipment. Each calls for an initial cash
outlay of $100, and each returns a total of $200 over the next 5 years, making net gain of
$100. But the timing of the returns is different, and therefore the present value of each year’s
return is different. The sum of each investment’s present values is called the DCF or NPV.
Using a 10% discount rate, we find:
http://www.solutionmatrix.com/discounted-cash-flow.html#example

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NPV—Decision Making
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Net Present Value
Strengths
• Takes time value of
money into account
• Uses realistic cost of
capital – is included as
part of the “discount rate”
• Considers cash flow
during entire investment
period
Weaknesses
• Complexity
• Difficult to explain to non-
finance audience
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Internal Rate of Return (IRR)
• IRR is closely related to NPV
• The IRR is the discounting rate that results
in a NPV of zero
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  n
n
r
FV
rFVPV
)1(
1



Discounting
Rate

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Internal Rate of Return
• IRR is the discount rate that sets the net present
value of an investment to zero
• Cost of capital that results in “break even”
IRR

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Internal Rate of Return
• If the inflation rate is less than IRR then investment
is favorable
• If cost of capital is less than IRR then investment is
favorable

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Lease vs. Purchase Decision
Lease
• May be a capital or
operating lease depending
on the agreement terms
• Operating
– Lessor transfers only right to
use
– Item must be returned at end
of lease
• Capital
– Lessee takes on more
ownership responsibility
– Recorded as an asset
Purchase / Buy
• Recorded as a fixed
asset – appears on
balance sheet
• Depreciation is reported
as an expense on income
statement
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MRI Example—Pro Forma Income
Statement: Lease vs. Buy
Lease terms: $60,000/year for five years

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Tax Implications of Lease vs. Buy
Decision
• Depreciation does not impact cash flow
directly
• In a for-profit entity, depreciation expense
reduces tax liability
• Lower tax payments will impact the cash
flow of a for-profit entity
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FP versus NFP Lease vs. Buy
Example
• Two physician practices considering
acquisition of new computer system to
support EMR
• Cost: $50,000
• Lease: $10,000/year over 5 years
• Both practices may borrow @ 7%
• Docs, Inc. – For profit
• Treat-em – Not-for-profit
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FP vs. NFP Lease vs. Buy Example
Pro forma for buy scenario for both practices
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FP vs. NFP Lease vs. Buy Example
• Convert pro forma income statement to cash
flow
• OCF for Docs, Inc.
OCF = EBIT + Depreciation – Taxes
= (-15,000) + 10,000 – (-5,100) = $100
– Note: The 5,100 in taxes offsets tax liability on other
revenue and therefore is considered a ‘positive’ here
• OCR for Treat-em
OCF = EBIT + Depreciation – Taxes
= (-15,000) + 10,000 = (-$5,000)
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FP vs. NFP Lease vs. Buy Example
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Add in DCF for the 7% cost of capital

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FP vs. NFP Lease vs. Buy Example
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Create the pro forma income statement for the lease scenario

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FP vs. NFP Lease vs. Buy Example
• Convert pro forma income statement to cash flow
• OCF for Docs, Inc.
OCF = EBIT + Depreciation – Taxes
= (-15,000) + 0 – (-5,100) = -$9,900
– Note: The $5,100 in taxes offsets tax liability on other
revenue and therefore is considered a “positive” here
• OCR for Treat-em
OCF = EBIT + Depreciation – Taxes
= (-15,000) + 0 = (-$15,000)
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FP vs. NFP Lease vs. Buy Example
Convert to a cash flow analysis
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FP vs. NFP Lease vs. Buy Example
Add in DCF for the 7% cost of capital
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FP vs. NFP Lease vs. Buy Example
• Conclusion: Lease is a better option for both
• Tax advantage leaves both options with a
more favorable NPV for the for-profit entity
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Summary
• Providers operate on very small margins and
must have objective quantitative criteria for
deciding which projects will help improve
financial position
• There are four methods of measuring the
return on investment—payback period,
average rate of return, net present value, and
internal rate of return