MHSA 8630 Health Care Financial Management

MHSA 8630 – Health Care Financial Management

Capital Budgeting and Project Risk Assessment

I.Principles of Capital Budgeting

**Utilizing basic financial analysis principles such as discounted cash flow analysis and cost of capital estimation, we now turn our attention to the process by which organizational financial managers make decisions regarding capital investments. In this context, capital investments are regarded as fixed asset(s) having long useful lives that typically require the organization to expend significant internal financial resources and/or obtain external capital to finance such purchases.

**The process by which organizations systematically evaluate alternative capital investment projects and make decisions as to which should be funded given limited capital resources is known as capital budgeting.

**The capital budgeting process is of significant strategic importance to all types of organizations, both FP and NFP, as appropriate long-term investments in capital resources ensures, to the extent possible, that the organization will remain viable in the future. Capital budgeting also yields a shorter-term benefit in that it allows the organization to effectively plan for capital expenditures ex ante, so that any required sources of capital financing (debt, equity) can be obtained at the lowest possible cost of capital to the organization.

**Organizational failure to appropriately budget for its strategic capital needs typically results in either (1) too much capital being deployed, thus reducing organizational efficiency and cost competitiveness, or (2) too little capital being deployed, thus resulting is lost strategic opportunities to the organization and reduced long term growth.

**Capital Project Classification: for purposes of capital budgeting analysis, the following types of capital projects are typically included:

**Discretionary replacement: capital projects intended to replace

existing equipment that is dated, but operational. The intention is presumably to reduce equipment maintenance costs and/or improve patient service. (mid-level management decision)

**Existing product/service line expansion: capital projects intended to increase service capacity in existing lines of business. (senior-level management decision)

**New product/service line expansion: capital projects intended to expand/move into new business lines (senior-level management).

**Steps in the Capital Budgeting Process

(1)Estimate Cash Flows: includes estimation of initial cash outflow(s) or cost of financing the project as well as estimation of all subsequent projected cash inflow(s) associated with the project, including the terminal cash flow(s) associated with project termination.

**For purposes of capital budgeting analysis, only actual incremental cash flows associated with the project should be included and not various accounting measures such as net income, which can present a misleading picture of project profitability. Also, sunk costs (cash flows that have already occurred prior to project initiation) should generally be ignored regardless of association with project.

**Though it is likely that project-related cash flows will occur at sporadic intervals throughout the project’s life, it is generally assumed that all project-related flows occur once per year, usually at the end of the year, for purposes of analytical simplicity.

**In terms of length of project life, most organizations will specify a useful life of between five and ten years for most capital investments, though some projects associated with the addition of organizational capacity will likely be analyzed over longer periods. Of note, for a given corporate cost of capital, cash flows that occur far into the future (20 years or greater) contribute little to the overall capital budgeting analysis.

**Miscellaneous methodological issues in the estimation of cash flows include the following:

**Opportunity cost estimation as it relates to the project at hand is generally regarded as being roughly accounted for in the organization’s chosen cost of capital/discount rate if (and only if) the project’s risk is comparable to the risk of the organization’s portfolio of projects as a whole.

**Opportunity costs associated with other project-related resources (e.g. land, building space) should be included within such analyses as well if the project at hand makes collateral use of such resources and imputes a cost as a result.

**Miscellaneous methodological issues (continued):

**To the extent that a project may effect other projects, positively or negatively, such spillover effects (in terms of incremental cash flows) should be incorporated into the analysis.

**In general, most projects will entail administrative costs, such as shipping/delivery costs, setup and training costs, maintenance/upkeep costs, etc. Such costs are explicit and should obviously be incorporated into the analysis as well.

**If applicable, the cash flow-related effects of a project on the organization’s net working capital (current assets less current liabilities) balance should be included in the analysis as well, especially if it is expected that a project will dramatically reduce the NWC of the organization (i.e. increase inventories, accounts receivables, etc.)

**Inflation effects on organizational cash flow over time should also be incorporated into such analyses.

Inflation should be accounted for with respect to third party reimbursement, cost of goods, labor costs, supply costs, etc. Depreciation expense should NOT be adjusted for inflation.

**In addition to the use of various objective criteria (see below) to evaluate the worthiness of a specific capital investment, organizational managers also utilize a number of subjective criteria, including the implied strategic value of a given project to the organization, to assist in making such evaluations.

In general, the better the strategic “fit” between a proposed capital investment and the organization’s strategic plan/mission/vision, the more likely that such a capital investment should be made.

**For investor-owned, for-profit organizations, the effect of corporate taxation on project cash flows must also be accounted for as part of the analysis, as such taxes will affect organizational cash flows during the life of the project as well as at project termination, when the asset will presumably be sold for salvage.

(2)Discount Project Cash Flows: based on the derived estimate for the corporate cost of capital/discount rate (adjusted if required to reflect greater/lower project risk), all projected cash flows over the project’s useful life are discounted back to present value.

(3) Evaluate Project Financial Impact: based on the result obtained from discounting future cash flows, a formal evaluation of the projected financial impact of the capital investment on the organization can be conducted using one of several methods:

**Net Present Value (NPV) Method -- NPV calculated as:

NPV = Σ [CFi / (1 + r)n] - Initial Investment

The decision rule with respect to using NPV to make capital budgeting decisions is to only select those capital investments that have a positive NPV, and reject those whose NPV is negative.

A positive NPV indicates that the capital project is expected to provide a return on investment that is greater than the corporate cost of capital, and thus will presumably add to the value of the organizational enterprise as a result.

A negative NPV implies the opposite.

The greater the NPV estimate, the greater the financial return associated with the capital project. Among capital projects with positive NPV estimates, those with the highest NPV estimates are preferred, other things being equal.

**Project Implied Rate of Return (IRR) – also known as the internal rate of return, it is the rate of return that forces the project’s discounted cash flows to exactly equal the initial investment (or NPV = 0).

The decision rule with respect to using IRR to make capital budgeting decisions is to only select those capital investments where the IRR is greater than the corporate cost of capital as specified. For all projects where IRR is greater than the corporate cost of capital, the projected cash flows are sufficient to provide a return that covers the organization’s cost of capital in addition to providing returns to the organization and thus increasing its value.

Either the NPV or IRR approaches to capital budgeting analysis may be used in this case, and the results will be the same regardless of which method used – i.e. projects with positive NPV’s will be consistent with projects whose IRR estimates exceed corporate cost of capital, and vice versa.

**Breakeven Analysis Methods – estimation of either the period of time required (payback period/discounted payback period) or the utilization volume required (breakeven point) for the organization to recoup its initial capital investment.

Breakeven evaluation of capital investment alternatives provide the organization with an estimate of the potential profitability and risk associated with a given project. In terms of roughly assessing the riskiness of a project, breakeven methods are preferred to NPV and IRR, and are often estimated concurrent with either/both measures of project profitability.

In general, the greater the breakeven utilization volume required and/or the longer the payback/discounted payback periods associated with a project, the riskier those projects tend to be.

**Capital Budget Decision Making

**As mentioned previously, most of the decision-making as it relates to capital budgeting resides with senior-level management within the organization, especially as it relates to capital projects that have significant strategic importance to the organization and/or involve the commitment of significant organizational resources.

**For capital projects that have similar useful lives in terms of their investment time horizons, those projects that are preferred tend to be those that (a) have significant strategic importance to the organization, (b) are projected to be reasonably profitable as measured by a positive NPV or an IRR that exceeds CCC, and

**Organizations will, from time to time, be faced with the evaluation of mutually exclusive capital investment alternatives that have significantly unequal useful lives in terms of investment time horizon. Different methods must be applied to make such comparisons fair.

**Methods for Evaluating Projects with Unequal Useful Lives

**Replacement Chain Analysis–assumes that any given project can be replicated after its termination. For example, if a project has an estimated useful life of three years, this method would assume that the same investment could be made at the termination of the project at the end of year three, with commensurate cash flows during years four, five, and six similar to years one, two, and three. The obvious, and most tenuous, assumption with this method is that the project can be perfectly replicated. If such an assumption isn’t reasonable, this method shouldn’t be used.

Also difficult to use when investment time horizons are roughly similar (differ by a few years only).

**Equivalent Annual Annuity (EAA) – based on the estimated NPV for each project, involves the estimation of the implied annuity amount (PMT) for each project that would yield the same estimated NPV. That project which is associated with the higher EAA is the one that would be preferred using this method because a higher EAA implies a higher cash flow/higher NPV associated with a project of whatever investment time horizon, assuming that such investments could be easily replicated over time.

**Capital Budget Decision Making Within NFP Organizations

**Most of what has been discussed up to this point will apply to both investor-owned and charitable organizations as it relates to capital budget decision making.

**NFP organizations differ substantively from FP entities due largely to their charitable missions and the operational and strategic constraints these missions impose.

**One such constraint is particularly applicable in the capital budgeting process, involving some degree of consideration for the social value of a capital project in addition to considering its financial/strategic value to the organization.

**The Net Present Social Value Model was developed for the purpose of evaluating capital investment alternatives in a not-for-profit organizational setting, whereby both the net present social value (NPSV) of a project is formally considered along with the financial net present value (NPV). (TNPV = NPV + NPSV)

**In this model, it is assumed that the NFP entity will choose to invest its limited resources in those capital projects that provide the highest total net present value (TNPV). It is further assumed that such entities will also not invest in any capital projects where net present social value (NPSV) is negative, regardless of the financial net present value associated with such projects. Lastly, it is assumed that the financial NPV associated with all of the NFP’s capital projects will be greater than or equal to zero, to ensure long-run organizational viability.

**The estimation of NPSV is somewhat conceptual, and involves an attempt to assign a dollar value (cash flow equivalent) to the social (un-priced) benefits associated with a given capital project. Most often, such monetary benefits are estimated based on an estimate of average consumer willingness to pay for such benefits.

**The discounting of future social benefits associated with a capital project using the NPSV method requires the specification of a “social” discount rate, or cost of capital, much as in the investor-owned case. The social rate of return or discount rate is even more conceptually challenging to estimate than its investor-owned counterpart. The most typical approach to estimating this rate of return is to equate it to the returns that could be obtained by investing those resources in an equivalent for-profit entity.

**Evaluation of Capital Budgeting Financial Performance

**Organizations that are committed to effective and efficient capital budgeting processes will also have an interest in evaluating the performance of their chosen capital investment projects post hoc. Such retrospective forms of evaluation are referred to as post audits.

**Such audits involve the comparison of actual project results (in terms of cash flows) with initial project projections, explaining why differences exist between the two if present, and analyzing potential changes to the project’s operations, including replacement and/or termination.

**The primary purposes of the post capital budgeting audit are to improve future forecasts, develop historical risk and return data, improve organizational operations, and reduce organizational losses associated with capital projects.

II.Project Risk Measurement and Incorporation

**Up to this point, it has been acknowledged that the most critical, and least certain, part of the capital budgeting process involves the estimation of future project cash flows for the purpose of estimating the profitability associated with a capital project.

**The presence of uncertainty, sometimes substantial, in the estimation of future project cash flows introduces a degree of financial risk into the capital budgeting process. The estimation and incorporation of project risk into the capital budgeting process is necessary to account for those proposed projects that have higher risk compared to other projects, as the typical cost of capital estimate used to discount project cash flows only applies to projects of average risk.

**Measures of Project Risk

**Stand-alone risk – project-associated risk assuming the project is held in isolation of any other projects, measured as the standard deviation of the returns associated with the project.

**Corporate risk – project-associated risk assuming the project is part of the business’ portfolio of projects, measured by the firm’s corporate beta.

**Market risk – project-associated risk assuming the project is part of a stockholder’s portfolio of projects/stocks, measured by the market beta associated with the firm’s stock.

**Among these three measures of project risk, it was argued previously that corporate risk and market risk were more appropriate measures because all businesses invest in multiple projects and/or stocks, such that the risk associated with a single project is best evaluated in light of a much larger, more well diversified portfolio of projects/stocks.

**Be that as it may, attempts to estimate project risk vis-à-vis a firm’s corporate and/or market risk measures is fraught with methodological as well as theoretical difficulties. As the vast majority of projects that a firm may invest in are typically significantly positively correlated with the returns of the business as a whole/the returns of the company’s stock (r = 0.3-0.6), it is usually the case that estimates of a project’s stand-alone risk, which is much simpler to estimate, can be used to approximate either/both the corporate risk and/or market risk associated with a given project.

**Estimation of Project Stand-Alone Risk

**The three most common methods utilized to estimate a project’s stand-alone risk are sensitivity analysis, scenario analysis, and Monte Carlo simulation techniques. In this course, we will only discuss/examine the first two methods in any detail.