Capital Budgeting Decisions

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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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XYZ Corporation Comparative Balance Sheet (000s)
ASSETS YEAR ONE YEAR TWO
Current assets
Cash 20 30
Accounts receivable (net) 95 95
Inventory 130 110
Total current assets 245 235
Fixed assets
Land 10 10
Building and equipment (net) 120 100
Total fixed assets (net) 130 110
Other assets
Goodwill and organizational costs 10 10
Total Assets 385 355

LIABILITIES
Current liabilities
Accounts payable 50 40
Estimated income taxes payable 10 10
Total current liabilities 60 50
Long-term liabilities
Mortgage bonds, 10 percent 50 50
Long-term debt 275 255
Total Liabilities 385 355
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XYZ Corporation Income Statement (000s)
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
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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 / (10.10)1 0.909 PV
1.00 / (10.10)2 0.826 PV 1.00 /
(10.10)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 (1Discount 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. Whi
ch one would be better?