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Capital Budgeting Decisions Clifton Louie, RPh, DPA, FACHE May 2003

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So You Want To Purchase Something………. The available alternatives Cash available Cost Information Benefit Information Risk Profile

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Which Project to Fund? Solvency Incremental management time required Public image Medical staff approval

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Which to Fund - UCSF Style Required by code or regulations Patient or employee safety Revenue generation or cost avoidance Replacement

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Justification Need - relative to attainment of mission and goals Economic feasibility Acceptability (vis-à-vis established priorities or other criteria)

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Sources of Cash From Operations Collections from A/R Cash sales From Investments From Debt From Charitable donations From selling assets

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Uses of Cash Payroll Accounts Payables Payment on debt Capital purchases Investment

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Liquidity Concerns Increase the level of cash and investment reserves Restructure debt Arrange a line of credit against a collateral Shorten A/R Cycle Lengthen Payment Cycle

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Working Capital Relationship between Current Assets Current Liabilities

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Current Assets Cash and investments A/R Inventories Other current assets A Balance Sheet Parameter

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Current Liabilities A/P Accrued salaries and wages Accrued expenses Notes payable Current position on long term debt A Balance Sheet Parameter

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Management of the A/R Minimize lost charges Minimize late charges Minimize write-offs Minimize the A/R days to an acceptable level

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Management of A/P Minimize the amount of vendors Track the invoice to purchase order to the receiver Maximize payment cycle or gain financial incentive for shorter payment cycle

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Cash Budget - 4 Activities Purchasing of resources (Capital equipment) Production/sale of service Billing Collection

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Rule of Thumb Minimize the A/R cycle and lengthen the A/P cycle within limits. By doing so, there is usually a positive cash flow within the organization

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Financial Ratio Analysis Are the fundamental analytical tools for interpreting financial statements Four classes of ratios: Liquidity Solvency Funds management Profitability

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Liquidity Ratios Liquidity is measured by its ability to raise cash from all sources (credit, sale of assets, and operations) Used to appraise a companys ability to meet its current obligations using existing cash and current assets Typically, it is assumed that the higher the ratio, the more protection the company has against liquidity problems

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Liquidity Ratios Current Ratio is current assets / current liabilities What is the current ratio for XYZ Corporation? Acid-Test or Quick Ratio is quick assets / current liabilities Measures the ability of a company to use its near-cash or quick assets to meet its current liabilities What is the acid-test ratio for XYZ Corporation?

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ASSETSYEAR ONEYEAR TWO Current assets: Cash 2030 Accounts receivable (net) 95 Inventory 130110 Total current assets 245235 Fixed assets: Land 10 Building and equipment (net) 120100 Total fixed assets (net) 130110 Other assets: Goodwill and organizational costs 10 Total Assets 385355 LIABILITIES Current liabilities: Accounts payable 5040 Estimated income taxes payable 10 Total current liabilities 6050 Long-term liabilities Mortgage bonds, 10 percent 50 Long-term debt 275255 Total Liabilities 385355 XYZ Corporation Comparative Balance Sheet ($000s)

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Gross Sales$11,516 Less: Returns and allowances 10 Net Sales1,506 Less: Cost of goods sold1,004 Gross profit502 Operating expenses400 Operating profit102 Interest5 Profit before taxes97 Income tax expense47 Net income50 XYZ Corporation Income Statement ($000s)

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Accounts Payable Management The days payables ratio becomes meaningful when compared to the credit terms given by the suppliers. To calculate the days payables: Purchases / Day Then, Accounts payable / Purchases per day = Days Payables Inventory Turnover is important to management Inventory turnover = cost of sales / average inventory

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Solvency Ratios These ratios generate insight into a companys ability to meet long-term debt payment schedules Times Interest Earned is Operating profit (before interest expense) / Long-term debt interest What is XYZ Corporations Times Interest Earned Ratio? The ratio indicates the extent to which operating profits can decline without impairing the companys ability to pay the interest on its long-term debt.

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Solvency Ratios Debt-to-equity ratios – relationship of borrowed funds to ownership funds is an important solvency ratio. Capital from debt and other creditor sources is more risky for a company than equity capital. One common ratio is Total Liabilities / Total Assets What is XYZ Corporations Debt-to-equity ratio?

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Funds Management Ratios The financial situation of a company is affected in large measure on how its investments in accounts receivable, inventories, and fixed assets are managed Receivables to Sales: Accounts receivable (net) / Net sales Average Collection Period: Accounts receivable / Net sales x Days in the annual period = Collection period Average Accounts Payable Period: Accounts payable / Purchases

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Profitability Ratios Profit margin (Gross or Net) ROI

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Making The Right Decision Life of capital assets Meeting the expected demand Investment of cash

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Types of Investments Replacement of damaged equipment Replacement of obsolete equipment Expansion New technology, services and markets Safety improvement Others

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5 Steps in Capital Budgeting Identify the initial cost Forecast operating cash flows Assess the risk Measure the investments worth Assess the profitability

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4 Questions - Initial Cost Analysis What is the invoice price? Additional expenses? Revenues from sales of old equipment? How tax is owed?

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Case Study – Identifying the Projects Initial Costs East Oz Community Hospital is planning to buy an ultrasound unit for $200,000. The unit has a straight-line depreciation life of 5 years. The old ultrasound unit is being sold for $50,000. It was bought by the Hospital brand new 3 years ago for $100,000. The hospital must pay $2,000 for delivery and $11,000 for training and calibration. The tax rate for capital gains is 34 percent. Net working capital for the hospital does not change with this purchase. What is the initial cost for the project?

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Forecasting the Cash Flows Calculate additional net earnings Calculate tax benefits of depreciation Incremental cash flow = additional net earnings + additional tax benefits

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Case Study – Forecasting Cash Flows East Oz Community Hospital is considering replacing their CT scanner with a newer, multi-slice, highly efficient, higher resolution state-of-the-art CT scanner. The existing scanner was purchased 3 years ago for $500,000. The new machine is $750,000. For each machine assume a 5-year straight-line depreciation. The capital gains tax rate is 34 percent. What are the incremental cash flows associated with the purchase of the new CT scanner?

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Payback Analysis The payback is the number of years needed to recover the initial investment

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Payback Analysis Easy to use Easy to understand The shorter the payback time, the less risky is the investment Ignores the time value of money Ignores the cash inflows produced after the initial investment is recovered

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Net Present Value (NPV) NPV = Present value - Initial Investment Positive or zero NPV, accept the project Negative NPV, reject project Importance on determining the right discount rate

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NPV Uses cash flows instead of earnings Recognizes the time value of money Positive NPVs increases the value of the organization Future cash predictions are difficult to make NPV assumes the same discount rate throughout the life of the project In a capital budget, go for the NPV with the greatest (+) In a operating budget, go for the NPV with the greatest (-)

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NPV PV = Future Value / (1 + Discount Rate) ** (# of years) PV = $1.00 / (1+0.10)**1 = 0.909 PV = $1.00 / (1+0.10)**2 = 0.826 PV = $1.00 / (1+0.10)**3 = 0.751

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Case Study - NPV A project will have an annual cash flow over the first 3 years of $6,000, $4,000 and $2,000. If the discount rate is 10% and the initial investment is $15,000, do you recommend funding this project?

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Discount Rate Prediction Riskier projects have a higher discount rate When interest rate and inflation rates are up, the discount rate will be higher Longer life of the project, higher the discount rate

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Risk Assessment - Sensitivity Analysis The purpose is to find out how sensitive various indicators are to change A riskier project is more sensitive to change

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Case Study – Sensitivity Analysis East Oz Community Hospital is considering two short- term projects. The first project has a cash flow of $1,000 in Year One of the project and $1,500 for Years Two and Three. Correspondingly, the second project has a cash flow of $1,800 in Year One and $700 in Years Two and Three. The initial investment for each project is $1,600. If the discount rate changes from 10 percent to 12 percent, which project is riskier?

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Average Rate of Return (ARR) Measures the relationship between the new earnings of a project to the average investment. ARR = Average annual future net earnings / One-half of initial investment

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ARR Easy to Use Easy to understand The higher the ARR, the less risky the investment Ignores the time value of money Uses earnings instead of cash flow Ignores depreciation Ignores value of salvage Ignores time sequence of net earnings

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Case Study – Average Rate of Return The net earnings for a project over the next 5 years are $10,000 per year. If the initial investment is $60,000, what is the average rate of return?

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Internal Rate of Return IRR is a discount rate that makes the present value of cash flows equal to the initial investment The rate below where projects are rejected is called the cutoff rate. Predicts a firms opportunity to reinvest future cash flows from the project

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IRR Simple to use Takes into account the time value of money May give unrealistic rates of return

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Case Study – Internal Rate of Return The nursing department projected an annual cash flow for a new outreach program to be $2,500 for 6 years. The initial investment for the program is $17,500. What is the IRR and should the program be accepted if the cutoff rate is 10 percent?

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Profitability Index PI = Present value of cash flows / Initial investment Project with a PI greater than one is accepted

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Case Study – Profitability Index East Oz Community Hospital is considering a project with an annual cash flow of $5,000 for the next 5 years. The initial investment is $20,000. Using the PI method and a discount rate of 10 percent, should the project be accepted?

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Equivalent Annual Cost Equivalent Annual Cost = Present value of operating cost + Present value of investment cost Present value of annuity

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Equivalent Annual Cost Comparison of 2 alternate projects with different lives Be aware of changing conditions Equivalent annual cost is not identical to reportable accounting costs, such as depreciation costs

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Present Value of an Annuity When faced by a steady and constant stream of future payments or receipts, decision makers want to evaluate the present value of these figures. Employ a present value annuity factor NOTE = An annuity is a series of equal payments (or receipts) made at any regular interval of time.

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Present Value of Annuity Present value of an annuity = Amount of Annuity (1+Discount Rate)**N N = Number of years or periods

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Case Study – Equivalent Annual Cost East Oz Community Hospital would like to replace their fire sprinkler system. One system cost $5,000 with an annual maintenance cost of $500 over the 10-year life to the system. The second system cost $10,000 and requires only $200 per year for maintenance. However, this second system has a 20-year life. The discount factor is 10 percent and ignores cost reimbursement. Which one would be better?

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