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Capital Budgeting Decisions

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Presentation on theme: "Capital Budgeting Decisions"— Presentation transcript:

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

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

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

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

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

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

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

8 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

9 Working Capital Relationship between Current Assets
Current Liabilities

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

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

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

13 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

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

15 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

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

17 Liquidity Ratios Liquidity is measured by its ability to raise cash from all sources (credit, sale of assets, and operations) Used to appraise a company’s 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

18 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?

19 Comparative Balance Sheet ($000’s)
XYZ Corporation Comparative Balance Sheet ($000’s) ASSETS YEAR ONE YEAR TWO Current assets: Cash 20 30 Accounts receivable (net) 95 Inventory 130 110 Total current assets 245 235 Fixed assets: Land 10 Building and equipment (net) 120 100 Total fixed assets (net) Other assets: Goodwill and organizational costs Total Assets 385 355 LIABILITIES Current liabilities: Accounts payable 50 40 Estimated income taxes payable Total current liabilities 60 Long-term liabilities Mortgage bonds, 10 percent Long-term debt 275 255 Total Liabilities

20 Income Statement ($000’s)
XYZ Corporation Income Statement ($000’s) Gross Sales $11,516 Less: Returns and allowances 10 Net Sales 1,506 Less: Cost of goods sold 1,004 Gross profit 502 Operating expenses 400 Operating profit 102 Interest 5 Profit before taxes 97 Income tax expense 47 Net income 50

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

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

23 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 Corporation’s Debt-to-equity ratio?

24 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

25 Profitability Ratios Profit margin (Gross or Net) ROI

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

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

28 5 Steps in Capital Budgeting
Identify the initial cost Forecast operating cash flows Assess the risk Measure the investment’s worth Assess the profitability

29 4 Questions - Initial Cost Analysis
What is the invoice price? Additional expenses? Revenues from sales of old equipment? How tax is owed?

30 Case Study – Identifying the Project’s 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?

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

32 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?

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

34 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

35 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

36 NPV Uses cash flows instead of earnings
Recognizes the time value of money Positive NPV’s 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 (-)

37 NPV PV = Future Value / (1 + Discount Rate) ** (# of years)

38 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?

39 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

40 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

41 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?

42 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

43 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

44 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?

45 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 firm’s opportunity to reinvest future cash flows from the project

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

47 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?

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

49 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?

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

51 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

52 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.

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

54 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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