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?