1. Budget & Finance Decision Models Decision Making Tools HIT managers will need to make decisions about buying office technology, EHR systems, building renovations, etc. There are financial tools to help Unsophisticated tools  Do not account for the time value of money Sophisticated tools  Do account for the time value of money

2. Budget & Finance Decision Models Unsophisticated Tools Do not consider the Time Value of Money:  Average Rate of Return (ARR)  Average Payback Period (AvgPP)  Actual Payback Period (ActPP)

3. Budget & Finance Decision Models

9. Sophisticated Models DO consider the Time Value of Money:  Net Present Value (NPV)  Benefit/Cost Ratio  Internal Rate of Return (IRR) Considered more accurate than the unsophisticated models

10. Budget & Finance Decision Models Net Present Value Uses the concept of “Present Value”: PV = FV [1 + (i/m)] - nm 1.The projected future profits are each added to the annual depreciation expense. 2.Each sum is multiplied by the interest rate factor. 3.Total the sums from step 2 4.This total is the Present Value of Cash Inflows 5.Present Value of Cash Outflows = Initial Investment Net Present Value = Present Value of Cash Inflows minus Present Value of Cash Outflows

11. Budget & Finance Decision Models Net Present Value Example You wish to purchase a new networked copier/fax for $30,000 for the ROI department. Cost of capital is 9%; life expectancy of the copier is 6 years; thus, annual depreciation expense is $5,000. The projected revenues from the copier are as follows: Year 1: $7,500 Year 2: 6,300 Year 3: 4,200 Year 4: 5,500 Year 5: 7,000 Year 6: 6,500

12. Budget & Finance Decision Models Projected Interest RevenuesDepreciationRate Factor 7,500 + 5,000 = 12,500 x (.9174) = $11,467.50 6,300 + 5,000 = 11,300 x (.8417) = 9,511.21 4,200 + 5,000 = 9,200 x (.7722) =7,104.24 5,500 + 5,000 = 10,500 x (.7084) = 7,438.20 7,000 + 5,000 = 12,000 x (.6499) = 7,798.80 6,500 + 5,000 = 11,500 x (.5963) =6,857.45 Present Value of Cash Inflows = $50,213.40 Present Value of Cash Outflows = $30,000.00 Net Present Value =$20,213.40

13. Budget & Finance Decision Models Decision Factors for NPV If the NPV > 0, acceptable alternative If the NPV < 0, unacceptable alternative If the NPV = 0, border line acceptable alternative Also, if NPV = 0 then:  Internal Rate of Return = cost of capital and  Benefit/Cost Ratio =1  Discussed in next slides

14. Budget & Finance Decision Models

15. Internal Rate of Return (IRR) Defined as: “the rate of interest at which the present value of expected cash inflows equals the present value of expected outflows” If NPV > 0, then IRR > than the cost of capital or interest rate  accept If NPV < 0, then IRR < than the cost of capital or interest rate  do not accept If NPV = 0, then IRR = the cost of capital and B/C ratio = 1  Accept (marginal)

16. Budget & Finance Decision Models Using Excel to Calculate NPV To calculate the NPV, use the Function Wizard. Select Formulas / Financial / NPV. Suppose you want to calculate the NPV for the following investment: An investment in a machine that costs $100,000 Additional cash inflows from the machine will be $40,000, $ 50,000, and $60,000 over the next three years (Value 1 in the Excel function). Cost of capital is 16% (RATE in the Excel function). Suppose you enter the data in an Excel spreadsheet as follows: Cell C1: -100,000 (note: investment is entered as a negative value) Cell C2: 40,000 Cell C3: 50,000 Cell C4: 60,000 For Rate enter 0.16 and for VALUE 1 enter C2:C4 as 40000, 50000, 60000 Run the function (click OK) Subtract the investment from the result = NPV

17. Budget & Finance Decision Models Extra Credit Create one-page Excel spreadsheet that automatically calculates all 6 previous decision tools. Include formulas so that as you change the variables the values are automatically recalculated.