Assignment Content
Write a 700- to 1,050-word paper in which you:
Analyze a financial and economic issue in the health care industry.
Choose a current financial or economic issue in the health care industry. Consider the following:
What are the economic trends of the health care payment system?
What are the supply and demand challenges for health care services?
Why are costs increasing in the health care system?
What regulatory issues are affecting, or will affect, the health care industry?
Analyze the issue and its financial impact on the health care industry.
Provide recommendations for improving the issue. Consider current strategies being used or presented for improving the issue.
Include what you believe would be the outcome of these recommendations if implemented.

The APA template is extra…you can use if you want…

LEARNING OBJECTIVES

• • Explain the financial objectives of health care providers.
• • Evaluate various capital investment alternatives.
• • Calculate and interpret net present value (NPV).
• • Calculate and interpret the internal rate of return (IRR).

Capital investment decisions involve large monetary investments expected to achieve long-term benefits for an organization. Such investments, common in health care, fall into three categories:

• • Strategic decisions: Capital investment decisions designed to increase a health care organization’s strategic (long-term) position (e.g., purchasing physician practices to increase horizontal integration)
• • Expansion decisions: Capital investment decisions designed to increase the operational capability of a health care organization (e.g., increasing examination space in a group practice to accommodate increased volume)
• • Replacement decisions: Capital investment decisions designed to replace older assets with newer, cost-saving ones (e.g., replacing a hospital’s existing cost-accounting system with a newer, cost-saving one)

Capital Investment Decision

A decision involving a high-dollar investment expected to achieve long-term benefits for an organization.

Strategic Decision

A capital investment decision designed to increase a health care organization’s strategic (long-term) position.

Expansion Decision

A capital investment decision designed to increase the operational capability of a health care organization.

A capital investment decision has two components: determining if the investment is worthwhile, and determining how to finance the investment. Although these two decisions are interrelated, they should be separated. This chapter focuses on the first component: determining whether a capital investment should be undertaken. It is organized around three factors important to analyzing capital investment decisions: the objectives of capital investment analysis, three techniques to analyze capital investment decisions, and technical concerns in capital budgeting. Chapter Eight focuses on capital financing alternatives. Perspectives 7.1 and 7.2 offer some examples of capital investments.

Replacement Decision

A capital investment decision designed to replace older assets with newer (often cost-saving) ones.

Caution: Although the issues of whether an investment is worthwhile and how to finance that investment are interrelated, they should be considered separately.

Objectives of Capital Investment Analysis

A capital investment is expected to achieve long-term benefits for the organization that generally fall into three categories: nonfinancial benefits, financial returns, and the ability to attract more funds in the future (see Exhibit 7.1). Clearly, these three objectives are highly interrelated. In the following discussion, it is important to keep in mind that investors are not just those external to an organization. When an organization purchases new assets or starts a new program, it is also an investor: it is investing in itself.

PERSPECTIVE 7.1 TYPES OF CAPITAL BUDGETING DECISIONS TO BE MADE IN THE FUTURE UNDER HEALTH REFORM

A managing director for Navigant consulting firm observes that a health care system will require some capital investment in the plant and equipment of its hospitals in order to improve patient outcomes and patient safety, which are critical elements of health reform requirements. He notes that a health care system that renovates and redesigns the physical layout of its hospitals to achieve technology integration as well as process improvement will do a better job in coordinating care, especially among its critical services such as emergency department care, diagnostics, and therapeutic services. Strategically, he notes that health care systems will more than likely invest more in ambulatory care services while investing less in inpatient services. However, the external planning of these decisions will require financial analysis to support them.

The consultant also believes that health care systems’ strategic growth initiatives going forward will include the following:

• 1. Growing ambulatory care offerings while scaling back on inpatient services
• 2. Renovating an inefficient hospital in its current location or building a newer one with higher capital investment but greater long-term operational benefits
• 3. Eliminating or consolidating duplicative services to reduce costs
• 4. Optimizing locations by identifying and developing a retail orientation, which will include having more ambulatory settings to make preventive and primary care more accessible, which will in turn reduce costs

However, to finance these capital decisions, health care systems and hospitals will need capital. The consultant also underscores that hospitals without access to capital may need to find capital partners through mergers, affiliations, joint ventures, or other third-party sources.

Source: Adapted from L. Dunn, Don’t overlook facilities’ role in meeting health reform’s imperatives, Becker’s Hospital Review, November 22, 2011, www.beckershospitalreview.com/hospital-management-administration/dont-overlook-facilities-role-in-meeting-health-reforms-imperatives.html.

PERSPECTIVE 7.2 CONSTRUCTION SURVEY GIVES INSIGHT ON FUTURE HOSPITAL REVENUE AND NONREVENUE CAPITAL PROJECTS

The 2012 annual construction survey by Healthcare Facilities Management and the American Society for Healthcare Engineering provides insight on the type of capital investments hospitals will be making in the future. The survey found that only 19 percent of the 531 hospitals completing the survey are planning on new hospital construction. However, 26 percent of the responding hospitals also indicated that these plans are being reevaluated; 19 percent of the responding hospitals are less likely to proceed and 23 percent of the hospitals will definitely not proceed. In addition, almost 75 percent of the hospitals indicated that they will revise, review, or possibly not go ahead with capital projects for facility renovation. This downturn in capital investment stems from the uncertainty associated with health care reform and a downturn in profit margins. In addition, hospitals have indicated that they are placing a greater emphasis on the return on investment of their projects. As one respondent hospital stated, in its capital decisions it is putting “more focus on ROI and justification of all costs.” In terms of future capital allocation, hospitals are allocating just 16 percent for new construction, which is half of what they did in the prior year, and 21 percent for renovation projects.

A greater allocation is being budgeted for non-revenue-generating capital projects related to infrastructure, such as chillers, boilers, and air handlers, because equipment of this nature is deteriorating and its use is being extended beyond its expected life. In terms of revenue-generating building projects, hospitals are focused on constructing interventional suites, which combine surgery and imaging, as well as tech-laden emergency departments. They are also focused on capital investments in laboratories, as science and technology are playing an increasingly strong role in medicine. Projecting allocation out by type of capital expenditures: 17 percent of responding hospitals mentioned emergency departments, 16 percent medical office expansion, and 16 percent primary care clinics. The hiring of physicians, especially specialists, is an underlying reason for the construction of medical office buildings.

Source: Adapted from D. Carpenter and S. Hoppszallern, Time to build? Reform uncertainties drive financial scrutiny for new projects, Health Facilities Management, 2012;25:2:12–18, 20, www.unboundmedicine.com/medline/citation/22413615/Time_to_build_Reform_uncertainties_drive_financial_scrutiny_for_new_projects.

EXHIBIT 7.1 THE OBJECTIVES OF THE CAPITAL INVESTMENT DECISION

Nonfinancial Benefits

How well an investment enhances the survival of the organization and supports its mission, patients, employees, and the community is a primary concern in many capital investment decisions. A particularly interesting movement in health care is the increasing number of governmental agencies with taxing authority asking for proof of community benefit. Community benefits include increased access to different types of care, higher quality of care, lower charges, the provision of charity care, and the employment of community members, as illustrated in Perspective 7.3.

Financial Returns

Direct financial benefits are a primary concern not only to health care organizations but also to many—if not all—investors who invest in health care organizations and their projects. Direct financial benefits to investors can take two forms. The first is periodic payments in the form of dividends to stockholders or interest to bondholders, or both. (Bonds are discussed in Chapter Eight.) Dividends represent the portion of profit that an organization distributes to equity investors, whereas interest is a payment to creditors, those who have loaned the organization funds or otherwise extended credit.

PERSPECTIVE 7.3 MAYO CLINIC: AN EXAMPLE OF COMMUNITY BENEFIT IN CAPITAL DECISIONS

The CFO of the Mayo Clinic presents his perspective on the clinic’s nonprofit mission and its capital decisions on how to expend its profits in terms like these: “As a humanitarian not-for-profit organization, Mayo Clinic is not in the business of making money for money’s sake,” and, “All earnings are reinvested into programs and initiatives that are aimed at advancing our mission.” Over the next five years Mayo is expected to spend $700 million per year in capital projects. Sixty percent of its capital dollars are earmarked for internal renewal and replacement projects and 40 percent for external strategic efforts. It is noteworthy that some projects in prior years were not viewed as ones that would generate a return on investment. Mayo has started building two proton beam therapy facilities, which are experimental cancer treatment centers that intend to target cancer cells without affecting healthy tissue. Critics argue that a project of this nature is expensive and the proton beam therapy’s clinical benefits are unproven. However, the CEO of Mayo supported the investment, stating that the proton beam therapy facility is “motivated by the best interests of our patients, not ‘profit’ or competitiveness.”

Source: Adapted from B. Herman, Mayo Clinic earnings rise 18 percent, large capital project plans announced, Becker’s Hospital Review, February 23, 2012, www.beckershospitalreview.com/racs-/-icd-9-/-icd-10/mayo-clinic-earnings-rise-18-large-capital-project-plans-announced.html.

The second type of benefit to an investor comes in the form of retained earnings, the portion of the profits the organization keeps in-house to use for growth and to support its mission. This describes the plowing back or investing of funds (including retained earnings) into capital projects that appreciate in value. Capital appreciation takes place whenever an investment is worth more when it is sold than when it was purchased. For investor-owned organizations, this appreciation in value increases the value of investors’ stock.

Although almost all organizations can make periodic payments to their investors in the form of interest, by law only investor-owned health care organizations can distribute dividends outside the organization.

Retained Earnings

The portion of profits an organization keeps for itself to use for growth and to support its mission.

Capital Appreciation

A gain that occurs when an asset is worth more when sold than when purchased. Common examples of assets that may produce capital appreciation are land, property, and stocks.

Ability to Attract Funds in the Future

Without new capital funds, many health care organizations would be unable to offer new services, support medical research, or subsidize unprofitable services. Therefore, another objective of capital investment is to invest in profitable projects or services that will attract debt (borrowing) and equity financing in the future by external investors. (Capital financing is discussed at length in Chapter Eight. Capital financing includes funds from a variety of sources, such as governmental entities, foundations, and community-based organizations.)

Analytical Methods

An investment decision involves many factors (see Perspectives 7.4 and 7.5). Three commonly used financial techniques to analyze capital investment decisions for health care organizations are

• • Payback method
• • Net present value method
• • Internal rate of return method

Key Point

Until now, this book has stressed the accrual method of accounting. However, the techniques introduced in this chapter—payback, net present value (NPV), and the internal rate of return (IRR)—use only cash flows. Therefore, when only accrual information is available (such as information from financial statements), accrual items must be converted into cash flows. An example is shown in the discussion of net present value.

Suppose Marquee Valley Hospital has $1 million available to invest in a new business (Exhibit 7.2, rows 1 and 3). After examining the marketplace, the hospital has narrowed its possibilities to two promising options, each of which would expend the full amount of money available: it could buy an existing physician practice, or it could build its own small satellite clinic. If it buys the physician practice, it would expect to generate new net cash inflows of $333,333 each year for six years (Exhibit 7.2, row 2). By investing in its own satellite clinic, Marquee Valley could expect to generate net cash flows of $200,000, $250,000, $300,000, $350,000, $450,000, and $650,000 over the next six years (Exhibit 7.2, row 4).

PERSPECTIVE 7.4 EXAMPLE OF A REPLACEMENT PROJECT WITH COST SAVINGS AND PAYBACK

A hospital in Queens, New York, installed an energy efficient central chiller plant. In addition, the new chiller system was intended to produce an overall improvement in the efficiency of the hospital’s air-conditioning system. The previous chiller had an annual utility cost of $500,000, while the newer, efficient version costs $350,000 to operate, which results in a cash savings of $150,000 in utility costs. In addition, the hospital expects to achieve maintenance savings of $15,000 per year. To purchase and install the new system was expected to require a capital outlay of $1.9 million. Taking into account the operational savings, along with an energy rebate from the state, this New York hospital expected a payback period of just over ten years.

Source: New York Hospital Queens, Chiller replacement project 2011, www.nyhq.org/oth/Page.asp?PageID=OTH001604.

PERSPECTIVE 7.5 PUBLICLY TRADED HOSPITAL MANAGEMENT COMPANY JOINT VENTURES WITH AN ACADEMIC MEDICAL CENTER TO HELP BOTH COMPANIES EXPAND STRATEGICALLY

On January 2011, LifePoint Hospitals, Inc., a publicly traded hospital management company on the New York Stock Exchange, developed a joint venture arrangement with Duke University Health System to own and operate community hospitals. The Duke-LifePoint partnership is willing to consider an array of arrangements with hospitals, ranging from full ownership to joint ventures and shared governance.

Partnering hospitals will have access to the clinical expertise of world-renowned physicians and specialists from Duke and the operational and management expertise of LifePoint, which focuses on nonurban facilities. More importantly Duke can depend upon capital funding from LifePoint to finance replacement facilities and renovations of older facilities as well as the purchase of new health care technology and imaging equipment, such as 64-slice CT machines, MRI machines, and digital mammography machines. In terms of type of hospitals, LifePoint seeks to acquire ones located outside major urban markets, in areas with a growing population base and diversified employment base.

For example, for one hospital acquisition, Duke and LifePoint’s capital investment called for building an outpatient surgery center and comprehensive cancer center. In addition, the partnership’s capital plans included renovating to create private rooms and investing in new IT infrastructure, especially in emergency departments, so patients would be treated with the proper care and the department would achieve accurate coding and charges for services.

Source: Adapted from Investment Weekly News, Duke LifePoint Healthcare: Marquette General signs memorandum of understanding with Duke LifePoint, Investment Weekly News, March 24, 2012, www.verticalnews.com/article.php?articleID=6696017.

Key Point

The term cash flow is used interchangeably with net cash flow. Net cash flow is the result of subtracting cash outflows from cash inflows.

EXHIBIT 7.2 CASH FLOWS FOR TWO ALTERNATIVE PROJECT INVESTMENTS

Payback Method

A method to evaluate the feasibility of an investment by determining how long it would take to recover the initial investment, disregarding the time value of money.

Payback Method

One way to analyze these investments is to calculate the time needed to recoup each investment. This is called the payback method, and it is illustrated in Exhibit 7.3, which builds on Exhibit 7.2.

Analysis

Exhibit 7.3 shows four rows for each investment: the initial investment, the beginning balance for each year, the cash flow for each year, and the cumulative cash flow for each year, in rows A through D, respectively. Although the satellite clinic begins the fourth year with a $250,000 deficit (row B), it has a positive net cash flow of $350,000 during the year (row C), resulting in a cumulative cash flow by the end of the fourth year of $100,000. Thus, as shown in row D, during the fourth year, the hospital would have recouped its investment. By bringing in $333,333 each year, the physician practice recoups its $1 million investment by the end of the third year. Under either scenario, the hospital would be tying up its money for at least three years.

The actual month that breakeven occurs can be obtained by dividing the deficit at the end of the year before breaking even by the average monthly inflow in the break-even year. For example, the deficit at the end of the third year for the satellite clinic is $250,000, with an average monthly inflow during the fourth year of $29,167 ($350,000 / 12). Thus, Marquee Valley would break even midway through September ($250,000 / $29,167 = 8.6 months) of the fourth year. If it bought the physician practice, it would break even at the end of the third year because it ends year 3 with no deficit.

EXHIBIT 7.3 CALCULATION OF PAYBACK YEAR FOR TWO ALTERNATIVE INVESTMENTS

If net cash inflows are equal each year (as with the physician practice), the number of years for an investment to break even simply equals the initial investment divided by the annual net cash flows resulting from the investment, and use of a more detailed analysis, such as in Exhibit 7.3, is unnecessary. Thus the payback time for the physician practice would be $1,000,000 / $333,333, which equals three years, the same answer derived in Exhibit 7.3.

Key Point

The formula to calculate the break-even point in years when cash flows are equal each year is: Initial Investment / Annual Cash Flows.

Strengths and Weaknesses of the Payback Method

The strengths of the payback method are that it is simple to calculate and easy to understand (see Exhibit 7.4). There are three major weaknesses of the payback method, however: it gives an answer in years, not dollars; it disregards cash flows after the payback time; and it does not account for the time value of money. Each of these is discussed briefly in this section.

• • The payback is in years, not dollars. Knowing that a project has a payback of three years does not provide certain key financial information, such as the size of the dollar impact on the organization in future years.
• • The payback method disregards cash flows after the payback time. For example, the physician practice has equal annual cash inflows and a payback of three years, whereas the satellite clinic has unequal annual cash inflows and does not reach payback until year 4. Thus the physician practice, with its shorter payback, would appear to be the better investment. However, the satellite clinic has better cash flows in later years, and by the end of year 6, it brings in $200,000 more than does the physician practice. Hence, in addition to time until payback, it is important to consider the cash flows after the payback date when making an investment.

EXHIBIT 7.4 STRENGTHS AND WEAKNESSES OF THE PAYBACK METHOD

• • The payback method does not account for the time value of money. Chapter Six demonstrated that a dollar received sometime in the future is not worth the same as a dollar received today. The two evaluation methods discussed in the remainder of this chapter, net present value and internal rate of return, take the time value of money into account, whereas the payback method does not.

Net Present Value

The difference between the initial amount paid for an investment and the future cash inflows the investment brings in, adjusted for the cost of capital.

Discounted Cash Flows

Cash flows adjusted to account for the cost of capital.

Cost of Capital

The rate of return required to undertake a project; the cost of capital accounts for both the time value of money and risk (also called the hurdle rate or discount rate).

Net Present Value

Because of the deficiencies of the payback method, a preferred alternative for analyzing capital investments is a net present value analysis. Net present value (NPV) is the difference between the initial amount paid for an investment and its associated future cash flows that have been adjusted (discounted) by the cost of capital. The cost of capital includes two costs: first, investors (bondholders and stockholders) are being asked to delay the consumption of their funds by investing in the project (time value of money); and second, these investors face a risk that the investment may not generate the revenues and net cash flows anticipated, leaving them with an inadequate rate of return, or the project may fail altogether, leaving the investors with perhaps nothing other than a tax loss.

On the one hand, if the sum of the discounted cash flows resulting from the investment is greater than the initial investment itself, then the NPV is positive. Thus, from a purely financial standpoint, the project is acceptable, all else being equal. On the other hand, if the sum of the discounted cash flows resulting from the investment is less than the initial investment, then over time the investment brings in less than what was initially paid out, the NPV is negative, and the investment should be rejected.

Example of a Net Present Value Analysis: The Satellite Clinic

In the example used earlier the annual cash flows were provided (Exhibit 7.3), but in real-world situations, organizations may not always have such information readily available. Therefore, in the following example (Exhibit 7.5), the same annual cash flows are used as in the previous example ($200,000, $250,000, $300,000, $350,000, $450,000, and $650,000), but these numbers had to be derived using additional information commonly found in a budget forecast (revenues, expenses, depreciation, etc).

EXHIBIT 7.5 COMPUTATION OF NPV FOR THE SATELLITE CLINIC

^aPresent value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually.

Key Point

The following terms are used interchangeably: cost of capital, discount rate, and hurdle rate.

To calculate the net present value (NPV) of the satellite clinic alternative (Exhibit 7.5), follow these steps:

• Step 1. Identify the initial cash outflow.
• Step 2. Determine revenues and expenses (net operating income):
  • a. Identify annual net revenues.
  • b. Identify annual cash operating expenses and depreciation expense.
  • c. Compute annual net income.
• Step 3. Add depreciation expense back in to get net operating cash flows.
• Step 4. Add (subtract) any nonannual cash flows.
• Step 5. Adjust for working capital.
• Step 6. Determine the present value of each year’s cash flow.
• Step 7. Sum the present values of all cash flows.
• Step 8. Determine the net present value of the project.
  • a. Identify the initial cash outflow (row A).
    • • The initial investment in the satellite clinic is $1,000,000.
  • b. Determine net operating income (rows B, C, D, and E):
    • • Identify annual cash inflows (revenues). Use net revenues rather than gross revenues, to account for discounts and allowances that will not be collected.
    • • Identify annual cash operating expenses and depreciation expense.
    • • Compute annual net operating income.
  • c. Add depreciation back in to compute net operating cash flows (rows F and G).
• The annual expenses (Step 2b) include depreciation expenses, estimated at $145,000 annually. However, depreciation is an expense that does not require any cash outflow. Therefore, to calculate actual cash flows, an amount equal to depreciation expense is added back into net income, resulting in a higher cash flow.
  • d. Add (subtract) any nonannual cash flows (rows H and I).

Salvage Value

The amount of cash to be received when an asset (e.g., equipment) is sold, usually at the end of its useful life (also called terminal value, residual value, or scrap value).

At times, various nonannual cash flows may occur during a project. In this example, the only nonannual cash flow is a cash inflow in year 6 resulting from selling some assets of the investment project. The salvage value is estimated to be $130,000.

Key Point

In deriving the annual cash flows from pro forma operating statements that include depreciation expense, the depreciation expense, and/or any other noncash expense (e.g., amortization of goodwill), is added back to the bottom line (operating income).

Key Point

Interest expense should not be included as a cash flow because it is part of financing flows and is included in the discount rate. Therefore, if interest expense is included in the operating expenses, then for the nontaxpaying entity, it should be added back into revenues in excess of expenses or earnings.

• e. Adjust for working capital.
• Some projects affect working capital, and to the extent that this effect is material, it must be considered. This particular example assumes there are no material working capital effects. (This concept is discussed in depth in Appendix D at the end of this chapter.)
  • f. Determine the present value of each year’s cash flow (rows I, J, K, and L).
• Steps 1 through 5 estimate cash flows that will occur each year. Step 6 discounts these cash flows with an assumed discount rate of 10 percent, using the methods discussed in Chapter Six. The $200,000 received at the end of year 1 (row I) is worth $181,818 in today’s dollars (row L). The $250,000 received two years from now (row I) is worth only $206,612 today (row L). The cash flows received in years 3 through 6 are discounted similarly.
  • g. Sum the present values of all cash flows (row M).
  • h. Determine the net present value of the project (rows A, M, and N).

Goodwill

The value of intangible factors such as brand reputation, customer or supplier relationships, employee competencies, and the like that are expected to affect an entity’s future earning power. An acquiring entity may pay cash and assume liabilities in excess of the fair value of the assets acquired in order to account for this value.

The net present value of the project is the difference between the discounted annual cash flows and the initial investment. The net present value (NPV), $499,202, is computed by adding the initial investment, $1,000,000, a cash outflow, to the present value of the annual cash flows, $1,499,202. If this were the only investment alternative, because the NPV is positive, this investment would be accepted based only on financial criteria.

Key Point

The terms present value and net present value should not be confused. Whereas present value is the sum of discounted future cash flows, net present value is equal to the present value net (less) the cost of the initial investment. Hence, the outcome shown in Exhibit 7.5. Although the present value of the cash flows is $1,499,202 (the sum of the cash flows for years 1 through 6), the net present value is only $499,202 (the cash flows from years 1 through 6 less the cost of the initial $1,000,000 investment).

It is also possible to calculate the NPV of the physician practice introduced in Exhibit 7.2. Because the cash flows from this investment are equal in both amount and timing, they can be treated as an ordinary annuity of $333,333 for six years at 10 percent. The present value factor for this ordinary annuity is 4.3553. Thus the present value of the cash flows is $1,451,765 (4.3553 × $333,333), and the net present value of the physician practice would be $451,765 ($1,451,765 – $1,000,000).

Decision Rules When Using NPV

As noted in Exhibit 7.5, the net present value of the satellite clinic investment, after adjusting for depreciation and salvage value, is $499,202.

• • The general decision rule when using NPV is
  • • If NPV > 0, accept the project.
  • • If NPV < 0, reject the project.
  • • If NPV = 0, then accept or reject.

Given this rule, the satellite clinic should be purchased because it has a positive NPV of $499,202. This rule applies in most cases; however, the rule is modified for two other possible situations.

• • If two or more mutually exclusive projects are being considered, the one with the higher or highest positive NPV should be chosen. Thus, if a second project were being considered, such as the purchase of the physician practice, the satellite clinic project would be selected for having the higher NPV ($499,202 versus $451,765). Only if the physician practice NPV were higher than the $499,202 would that project be selected instead.
• • If two or more mutually exclusive projects are being considered and one must be selected regardless of NPV, then the one with the higher or highest NPV should be chosen, even if its NPV is negative. Suppose a health care organization is considering developing either a burn unit or a school-based education program. An analysis determines that one project has an NPV of –$4,000,000, whereas the other has an NPV of –$1,500,000. If it had been decided in advance that one of the two projects will be undertaken, then the one with the higher NPV (lesser loss) should be chosen. In this case, –$1,500,000 would be the better choice.

Using Spreadsheets to Calculate NPV

Any popular spreadsheet is an ideal platform to calculate net present value because most, if not all, spreadsheets have built-in functions that simplify the determination of NPV. Exhibit 7.6 shows how the NPV function in Excel can be used to compute the present value, $1,499,202, of the annual cash flows in Exhibit 7.5 (cash flows for all six years are entered, although only cash flows for the first four years are shown). Excel’s NPV function is similar to its PV function, but allows the use of unequal cash flows. Finally, the initial investment, –$1,000,000, must be added outside the NPV function formula, which computes the present value of the annual project cash flows, $1,499,202, to obtain the NPV of $499,202. (A common mistake among users of the NPV function is to include the initial investment as a value in the NPV function formula. The initial investment must be added outside the function and needs to represent the negative outflow for the initial investment.)

EXHIBIT 7.6 USING EXCEL TO CALCULATE THE NET PRESENT VALUE (NPV) OF UNEQUAL ANNUAL CASH FLOWS, ASSUMING A 10 PERCENT DISCOUNT RATE

Key Point

When using the Excel NPV function, the initial investment value must be added to the NPV function result and not entered as a value within the function itself.

Strengths and Weakness of the NPV Method

The NPV method has a number of strengths and weaknesses (Exhibit 7.7). Its strengths are that it provides an answer in dollars, not years; it accounts for all cash flows in the project, including those beyond the payback period; and it discounts the cash flows by the cost of capital. Its main difficulties are developing estimates of cash flows and the discount rate.

Conceptually, NPV is strong because it accounts for all cash flows in a project and discounts at the cost of capital. However, the cost of capital can be difficult to determine, as discussed in Appendix C.

EXHIBIT 7.7 STRENGTHS AND WEAKNESSES OF AN NPV ANALYSIS

Internal Rate of Return

The rate of return on an investment that makes the net present value equal to $0, after all cash flows have been discounted at the same rate. It is also the discount rate at which the discounted cash flows over the life of the project exactly equal the initial investment.

Internal Rate of Return

The internal rate of return (IRR) on an investment can be defined and interpreted several ways. It can mean the discount rate at which the discounted cash flows over the life of the project exactly equal the initial investment, the discount rate that results in a net present value equal to zero, or the percentage return on the investment. (In contrast, NPV is the dollar return on the investment.) The method used to solve for the IRR depends on whether the cash flows are equal or unequal.

Equal Cash Flows

When the cash flows are equal in each period, the IRR can be determined by first finding the present value factor for an annuity and then converting the answer to a discount rate depending on the number of years. Because the physician practice example used earlier has equal cash flows in each period, its IRR can be found by

• • Computing the present value factor for an annuity (PVFA) (see Chapter Six):
• • Finding the interest rate that yields this PVFA factor for six periods. In the present value of an annuity table (Appendix B, Table B.4), in the row for six time periods (because the investment is over six years), the column heading for the number closest to 3.0 (the PVFA factor) is the IRR. In this case, the PVFA factor of 3.0 lies somewhere between the 24 percent and 25 percent columns; thus the IRR is approximately 24.5 percent.

Unequal Cash Flows

Business calculators and computer programs make finding the IRR for unequal cash flows relatively easy. Excel’s function is called IRR (see Exhibit 7.8). Either all the operating cash flow values of the project, including the initial investment, are entered individually or an array of cells containing these values is referenced (the initial investment must be a negative value in either case because it is a cash outflow). As shown in Exhibit 7.8, the IRR appears at the bottom of the box.

EXHIBIT 7.8 USING EXCEL TO CALCULATE THE IRR FOR A $1 MILLION INVESTMENT WITH UNEQUAL OPERATING CASH FLOWS RECEIVED AT THE END OF EACH OF SIX SUCCESSIVE YEARS

Note: The values in the array A1:A7 = −1000000; 200000; 250000; 300000; 350000; 450000; 650000.

Key Point

In contrast to Excel’s NPV function, Excel’s IRR function requires the initial investment as one of the entries in the function.

Decision Rules When Using the IRR

When an organization chooses a project according to the IRR method, its financial decision depends on the value of the IRR relative to the required rate of return on the investment (which is also called the cost of capital or hurdle rate).

• • If the IRR is greater than the required rate of return, the project should be accepted.
• • If the IRR is less than the required rate of return, the project should be rejected.
• • If the IRR is equal to the required rate of return, the facility should be indifferent about accepting or rejecting the project.

Required Rate of Return

The minimal internal rate of return on any investment that will justify that investment (also called cost of capital or hurdle rate).

Strengths and Weaknesses of IRR Analysis

IRR has three major strengths as a decision criterion (Exhibit 7.9): it considers all the relevant cash flows related to the investment project, it is a time value of money–based approach, and managers are accustomed to evaluating projects by their respective rates of return. IRR also has three weaknesses as a decision criterion: it assumes that proceeds are reinvested at the internal rate of return, which may or may not be equal to the cost of capital; developing estimates of cash flows is difficult; and the IRR sometimes generates multiple rates of return, if future cash flows are estimates. Still, this method is widely used in industry as the preferred way to make responsible investment decisions.

EXHIBIT 7.9 STRENGTHS AND WEAKNESSES OF THE IRR ANALYSIS

Using an NPV Analysis for a Replacement Decision

The previous analyses have focused on situations in which an organization was interested in either expanding its existing services or offering a new service altogether. However, a common and more complicated analysis is the replacement decision, which must be made by an organization when it contemplates replacing an older, existing asset with a newer, more cost-efficient one. There are two ways to undertake this problem, both using a net present value (NPV) approach and both yielding the same result. The first approach is to compare the NPV of continuing as is with the NPV of the replacement alternative, with the preferred investment alternative being the one yielding the higher NPV. The second approach is to perform a single NPV analysis using the incremental differences brought about by replacing an asset. If the single NPV is positive, then the replacement alternative is preferred.

Example

Assume that a radiology department in a not-for-profit hospital is considering renovating its X-ray processing area with new equipment that is faster and produces better, more reliable images. The existing equipment was purchased five years ago for $1,150,000 and is being depreciated on a straight-line basis over a ten-year life to a $150,000 salvage value. The old equipment can be sold now for its current book value of $650,000 ($1,150,000 original cost less $500,000 in accumulated depreciation).

The new equipment can be purchased for $1,500,000 and is estimated to have a five-year life. It would be depreciated on a straight-line basis to a $750,000 salvage value. The radiology department is a revenue-producing center. Presently, forty-five patients per day, 260 days per year, can be screened by one radiology technologist at an average reimbursement of $75 per test, but a significant portion of these patients must be given a second test at no additional charge because the first image is inconclusive. The new equipment, because it is not only faster but produces images of better quality, can process sixty patients per day. (The hospital believes that sufficient demand exists to fully utilize the higher capacity of the new equipment.) An in-depth discussion of how to estimate future cash flows is found in Appendix C.

The old equipment costs $60,000 per year in utilities and maintenance. The new equipment would cost $30,000 per year in utilities and maintenance. The annual labor expenses will not change because one radiology technologist is needed to operate either piece of equipment. Cost of capital for this organization is 9 percent.

Straight-Line Depreciation

A depreciation method that depreciates an asset an equal amount each year until it reaches its salvage value at the end of its useful life.

Solution

Exhibits 7.10a and 7.10b present the comparative approach to solving this problem. This approach employs the same eight steps outlined in Exhibit 7.5. An NPV is calculated for each alternative, and then the NPVs are compared to determine which is higher. Exhibit 7.11 uses an alternative method, the incremental approach, to solve the same problem. Instead of calculating two NPVs and comparing them, this approach calculates a single NPV based on marginal differences for each cash flow. The results are exactly the same.

Using the comparative approach, the net present value (NPV) over the next five years for the new equipment, $4,071,651 (Exhibit 7.10b, row N), is higher than that of the old equipment, $3,277,280 (Exhibit 7.10a, row N). Therefore, the decision in this case would be to renovate the X-ray department with the new equipment. Similarly, using the incremental approach, the NPV is $794,371 (Exhibit 7.11, row N). Thus, because the NPV is positive, the replacement decision should be made. Incidentally, note that the $794,371 NPV using the incremental method is exactly the difference between the two alternatives ($4,071,651 – $3,277,280) using the comparative approach. Thus the results are the same using either method; it is just the method of calculation that differs.

EXHIBIT 7.10a NPV COMPARATIVE ANALYSIS OF A REPLACEMENT DECISION: OLD EQUIPMENT

EXHIBIT 7.10b NPV COMPARATIVE ANALYSIS OF A REPLACEMENT DECISION: NEW EQUIPMENT

EXHIBIT 7.11 NPV INCREMENTAL ANALYSIS OF A REPLACEMENT DECISION

Before the hospital makes a final decision, however, several issues must be considered:

• • The purchase of a new asset typically requires a large up-front expenditure, which may not always be feasible.
• • Future cash flows are difficult to determine and may not always be accurate, especially in the salvage value.
• • The exact cost of capital is difficult to determine.
• • Although not the case here, replacement of an old asset with a new asset may be more expensive (i.e., NPV_New < NPV_Old), but replacement may be necessary for other reasons, such as to remain competitive by being able to offer the latest technology to consumers.

Summary

This chapter introduced three methods to evaluate large-dollar, multiyear investment decisions: payback, net present value, and internal rate of return. The payback method measures how long it will take to recover the initial investment. The strengths of the payback method are that it is simple to calculate and easy to understand. Its major weaknesses are that it does not account for the time value of money; it provides an answer in years, not dollars; and it disregards cash flows after the payback.

The NPV method overcomes the weaknesses of the payback method by accounting for cash flows after payback and discounting these cash flows by the project’s cost of capital. The project’s cost of capital is the rate of return that compensates investors for the time value of money and for the risk of the investment. The NPV measures the difference between the present value of the operating cash flows generated by the investment and the initial cost of that investment. The NPV technique measures the dollar return on the investment.

The general decision rule regarding NPV is: if NPV > 0, accept the project; if NPV < 0, reject the project; if NPV = 0, then accept or reject. If two or more mutually exclusive projects are being considered, then the one with the higher or highest positive NPV should be chosen. If two or more mutually exclusive projects are being considered and one must be undertaken regardless of the NPV, then the one with the higher or highest NPV should be chosen, even if the NPV is negative.

The strengths of the NPV method of capital investment analysis are that it provides an answer in dollars, not years; it accounts for all cash flows from the project, including those beyond the payback period; and it discounts these cash flows at the cost of capital. The major weakness of the NPV method is that the discount rate is often difficult to determine and may be hard to justify. NPV can be calculated by following these eight steps:

• Step 1. Identify the initial cash outflow.
• Step 2. Determine revenues and expenses (net income):
  • a. Identify annual net revenues.
  • b. Identify annual cash operating expenses and depreciation expense.
  • c. Compute annual net income.
• Step 3. Add depreciation expense back in to get net operating cash flows.
• Step 4. Add (subtract) any nonannual cash flows.
• Step 5. Adjust for working capital.
• Step 6. Determine the present value of each year’s cash flow.
• Step 7. Sum the present values of all cash flows.
• Step 8. Determine the net present value of the project.

The IRR method determines the actual percentage return on the investment. When an organization chooses a project according to the IRR method, its decision depends on the value of the IRR relative to the required rate of return on the investment (also called the cost of capital or hurdle rate).

• • If the IRR is greater than the required rate of return, the project should be accepted.
• • If the IRR is less than the required rate of return, the project should be rejected.
• • If the IRR is equal to the required rate of return, the facility should be indifferent about accepting or rejecting the project.

KEY TERMS

• a. Beta
• b. Cannibalization
• c. Capital appreciation
• d. Capital investment decisions
• e. Capital investments
• f. Cost of capital
• g. Discount rate
• h. Discounted cash flows
• i. Dividends
• j. Expansion decision
• k. Goodwill
• l. Hurdle rate
• m. Incremental cash flows
• n. Interest
• o. Internal rate of return
• p. Internal rate of return method
• q. Net present value
• r. Net present value method
• s. Nonregular cash flows
• t. Operating cash flows
• u. Opportunity costs
• v. Payback method
• w. Regular cash flows
• x. Replacement decision
• y. Required rate of return
• z. Residual value
• aa. Retained earnings
• bb. Salvage value
• cc. Scrap value
• dd. Straight-line depreciation
• ee. Strategic decision
• ff. Sunk costs
• gg. Terminal value
• hh. Weighted average cost of capital

Key Equation

Payback in years if cash flows are equal each year:

REVIEW QUESTIONS AND PROBLEMS

Note that these questions and problems ask readers to use materials from Appendices C, D, E, and F, which are to be found at the end of this chapter.

• 1. Definitions. Define the key terms listed previously.
• 2. Comment on the following statement: When a not-for-profit facility receives a contribution from a member of the community, the cost of capital is inconsequential when deciding how to use this contribution because it is, in effect, free money.
• 3. From a capital investment point of view, what are the goals of a health care facility?
• 4. What are the primary drawbacks of the payback method as a capital budgeting technique?
• 5. When using the IRR approach, when can the internal rate of return be determined simply by dividing the initial outlay by the cash flows?
• 6. Why do pro forma income statements adjust for depreciation expense when developing projected cash flows for a project?
• 7. If a hospital were considering a new women’s health initiative, what spillover cash flows might result?
• 8. When performing a capital budgeting analysis, what costs should be included and what costs should be excluded as part of an initial investment?
• 9. Why are financing flows such as interest expense and dividend payments excluded from the computation of cash flows?
• 10. Would a decision that is based on NPV ever change if it were based on IRR instead? Why or why not?
• 11. Alameda Hospital is expecting its new cancer center to generate the following cash flows:
  • a. Determine the payback for the new cancer center.
  • b. Determine the net present value using a cost of capital of 15 percent.
  • c. Determine the net present value at a cost of capital of 20 percent, and compute the internal rate of return.
  • d. At a 15 percent cost of capital, should the project be accepted? At a 20 percent cost of capital, should the project be accepted? Explain.
• 12. Washington Community is expecting its new dialysis unit to generate the following cash flows:
  • a. Determine the payback for the new dialysis unit.
  • b. Determine the NPV using a cost of capital of 15 percent.
  • c. Determine the NPV at a cost of capital of 20 percent and compute the IRR.
  • d. At a 15 percent cost of capital, should the project be accepted? At a 20 percent cost of capital, should the project be accepted? Explain.
• 13. St. Rose Hospital expects Projects A and B to generate the following cash flows:
  • a. Determine the NPV for both projects using a cost of capital of 20 percent.
  • b. Determine the NPV for both projects using a cost of capital of 10 percent.
  • c. At a 10 percent cost of capital, which project should be accepted? At a 20 percent cost of capital, which project should be accepted? Explain.
• 14. Valley Care Medical Center expects Projects X and Y to generate the following cash flows:
  • a. Determine the NPV for both projects using a cost of capital of 17 percent.
  • b. Determine the NPV for both projects using a cost of capital of 12 percent.
  • c. At a 12 percent discount rate, which project should be accepted? At a 17 percent discount rate, which project should be accepted? Explain.
• 15. Kaiser Oakland Practice expects Projects 1 and 2 to generate the following cash flows:
  • a. Determine the payback for both projects.
  • b. Determine the IRR.
  • c. Determine the NPV at a cost of capital of 12 percent.
• 16. Colusa Regional Medical Center expects Alpha Project and Beta Project to generate the following:
  • a. Determine the payback for both projects.
  • b. Determine the IRR.
  • c. Determine the NPV at a cost of capital of 20 percent.
• 17. Biggs-Gridley Memorial Hospital, a nontaxpaying entity, is starting a new inpatient heart center on its third floor. The expected patient volume demands will generate $5,000,000 per year in revenues for the next five years. The new center will incur operating expenses, excluding depreciation, of $3,000,000 per year for the next five years. The initial cost of building and equipment is $7,000,000. Straight-line depreciation is used to estimate depreciation expense, and the building and equipment will be depreciated over a five-year life to their salvage value. The expected salvage value of the building and equipment at year five is $800,000. The cost of capital for this project is 10 percent.
  • a. Compute the NPV and IRR to determine the financial feasibility of this project.
  • b. Compute the NPV and IRR to determine the financial feasibility of this project if this were a tax-paying entity with a tax rate of 30 percent. (Hint: see Appendix E. Because the hospital is depreciating to the salvage value, there is no tax effect on the sale of the asset.)
• 18. Marshall Healthcare System, a nontaxpaying entity, is planning to purchase imaging equipment, including an MRI and ultrasonogram equipment, for its new imaging center. The equipment will generate $3,000,000 per year in revenues for the next five years. The expected operating expenses, excluding depreciation, will increase expenses by $1,200,000 per year for the next five years. The initial capital investment outlay for the imaging equipment is $5,500,000, which will be depreciated on a straight-line basis to its salvage value. The salvage value at year five is $800,000. The cost of capital for this project is 12 percent.
  • a. Compute the NPV and IRR to determine the financial feasibility of this project.
  • b. Compute the NPV and IRR to determine the financial feasibility of this project if this were a taxpaying entity with a tax rate of 40 percent. (Hint: see Appendix E. Because the organization is depreciating to the salvage value, there is no tax effect on the sale of the asset.)
• 19. Due to rising utility costs, Los Medanos Community Hospital wants to replace its existing computer-controlled heating, ventilation, and air-conditioning (HVAC) system with a more efficient version. The existing system was purchased three years ago for $240,000 and is being depreciated on a straight-line basis over an eight-year life to a salvage value of $0. Although the current book value for the existing system is $150,000, this system could be sold for only $80,000 today. The new system would cost $600,000 and would be depreciated on a straight-line basis over a five-year life to a salvage value of $0. The new heating and cooling system would reduce utility costs by $200,000 per year for five years and would not affect the level of net working capital. The economic life of the new system is five years, and the required rate of return on the project is 8 percent.
  • a. Should the existing HVAC system be replaced? Use the incremental NPV approach to evaluate the decision; assume the hospital is a not-for-profit facility.
  • b. If the facility were a taxpaying entity with a tax rate of 30 percent, should the existing HVAC system be replaced? Use the incremental NPV approach to evaluate the decision. (Hint: see Appendix F.)
• 20. Because of its inability to control film and personnel costs in its radiology department, Sanger General Hospital wants to replace its existing picture archive and communication (PAC) system with a newer version. The existing system, which has a current book value of $2,250,000, was purchased three years ago for $3,600,000 and is being depreciated on a straight-line basis over an eight-year life to a salvage value of $0. This system could be sold for $800,000 today. The new PAC system would reduce the need for staff by eight people per year for five years at a savings of $40,000 per person per year, and it would reduce film costs by $2,000,000 per year. The project would not affect the level of net working capital. The new PAC system would cost $9,000,000 and would be depreciated on a straight-line basis over a five-year life to a salvage value of $0. The economic life of the new system is five years, and the required rate of return on the project is 7 percent.
  • a. Should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision; assume the hospital is a not-for-profit facility.
  • b. If the facility were a taxpaying entity with a tax rate of 30 percent, should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision. (Hint: see Appendix F.)
• 21. Calexico Hospital plans to invest in a new MRI. The cost of the MRI is $1,800,000. The machine has an economic life of five years, and it will be depreciated over a five-year life to a $200,000 salvage value. Additional revenues attributed to the new machine will amount to $1,500,000 per year for five years. Additional operating costs, excluding depreciation expense, will amount to $1,000,000 per year for five years. Over the life of the machine, net working capital will increase by $30,000 per year for five years.
  • a. Assuming that hospital is a nontaxpaying entity, what is the project’s NPV at a discount rate of 8 percent, and what is the project’s IRR? Is the decision to accept or reject the same under either capital budgeting method, or does it differ?
  • b. Assuming that this hospital is a taxpaying entity and its tax rate is 30 percent, what is the project’s NPV at a cost of capital of 8 percent, and what is the project’s IRR? Is the decision to accept or reject the same under either capital budgeting method, or does it differ? (Hint: see Appendices C, D, and E.)
• 22. Glenn Medical Center has seen a growth in patient volume since its primary competitor decided to relocate to a different area of the city. To accommodate this growth, a consultant has advised Glenn Medical to invest in a positron-emission tomography (PET) scanner. The cost to implement the unit would be $4,000,000. The useful life of this equipment is typically about six years, and it will be depreciated over a six-year life to a $400,000 salvage value. Additional patient volume will yield $3,000,000 in new revenues the first year. These first-year total revenues will increase by $600,000 each year thereafter, but the unit is expensive to operate. Additional staff and variable costs, excluding depreciation expense, will come to $2,200,000 the first year, but these expenses are expected to rise by $400,000 each year thereafter. Over the life of the machine, net working capital will increase by $18,000 per year for six years.
  • a. Assuming that Glenn Medical Center is a nontaxpaying entity, what is the project’s NPV at a discount rate of 9 percent, and what is the project’s IRR? Depending on the method used, what is the investment decision?
  • b. Assuming that Glenn Medical Center is a taxpaying entity and its tax rate is 40 percent, what is the project’s NPV at a discount rate of 9 percent, and what is the project’s IRR? Depending on the method used, what is the investment decision? (Hint: see Appendices C, D, and E.)
• 23. Long-Term Acute-Care Hospital (LTAC) owns an abandoned warehouse. The after-tax value of the land is $800,000. The furniture and fixtures of the warehouse have been fully depreciated to an after-tax market value of $70,000. The two options LTAC faces are either to sell the land and furniture and fixtures or to convert the building into a forty-bed, free-standing new facility. To refurbish and renovate the facility would cost $4,500,000. The new building and equipment would be depreciated on a straight-line basis over a ten-year life to a $700,000 salvage value. At the end of ten years, the land could be sold for an after-tax value of $3,500,000. The new rehab facility’s pro forma income statement for the next ten years is shown below. Net working capital will increase at a rate of $20,000 per year over the life of the project. LTAC has a 30 percent tax rate and a required rate of return of 7 percent. Use both the NPV technique and IRR method to evaluate this project. (Hint: see Appendices C, D, and E.)
• 24. Heart Hospital is in possession of a nonoperational, fifty-bed hospital. The after-tax value of the land is $2,500,000. The equipment and the building are fully depreciated and have an after-tax market value of $3,500,000. The hospital could either sell off its property or convert it into a new state-of-the-art acute-care hospital. An analysis of the market reveals that the facility could attract 9,000 discharges per year, a number expected to increase at a rate of 3 percent per year. Projected net patient revenue per discharge is $10,000 for the first year, increasing annually by 4 percent thereafter. Projected operating expense per discharge is $8,400 for the first year, increasing annually by 6 percent thereafter. Renovation costs to create a plush facility would be $45,000,000. The new facility would be depreciated on a straight-line basis over a ten-year life to a $12,000,000 salvage value. At the end of ten years, the land is expected to be sold for an after-tax value of $6,000,000. Net working capital will increase at a rate of $3,000,000 per year over the life of the project. Heart Hospital has a 35 percent tax rate and a required rate of return of 9 percent. Use the NPV technique and IRR method to evaluate this project. (Hint: see Appendices C, D, and E.)
• 25. Kern Valley Hospital, a taxpaying entity, wants to replace its current labor-intensive telemedicine system with a new automated version that would cost $3,500,000 to purchase. This new system has a five-year life and would be depreciated on a straight-line basis to a salvage value of $350,000. The current telemedicine system was purchased five years ago for $1,600,000, has five years remaining on its useful life, and would be depreciated similarly to a salvage value of $300,000. This current system could be sold in the marketplace now for $350,000. The new telemedicine system has annual labor operating costs of $185,000, whereas the current system has annual labor operating costs of $1,000,000. Neither system will change patient revenues. The hospital has a 40 percent tax rate and a required rate of return of 7 percent. The financial analysis will be projected over a five-year period. Use the NPV approach to determine if the new telemedicine system should be selected. (Hint: see Appendix F.)
• 26. Topping Medical Center, a for-profit institution, wants to replace its film-based mammography equipment with new digital models. The cost of the new digital models is $3,500,000. The current models were purchased three years ago for $1,400,000. The new digital models have a five-year life and will be depreciated on a straight-line basis to a salvage value of $600,000. The current models have five years remaining on their useful lives and will be depreciated on a straight-line basis to a salvage value of $400,000. The current models could be sold in the marketplace for $1,200,000. The new models are expected to generate annual cash cost savings on film of $400,000 per year relative to the current models. Neither system will change patient revenues. The imaging center has a 40 percent tax rate and required rate of return of 5 percent. The financial analysis will be projected over a five-year period. Use the NPV approach to determine if the new digital model should be selected. (Hint: see Appendix F.)
• 27. Sutter Lakeside Hospital, a taxpaying entity, is considering a new ambulatory surgical center (ASC). The building and equipment for the new ASC will cost $5,500,000. The equipment and building will be depreciated on a straight-line basis over the project’s five-year life to a $2,500,000 salvage value. The new ASC’s projected net revenue and expenses are as follows. Net revenues are expected to be $5,000,000 the first year and will grow by 9 percent each year thereafter. The operating expenses, which exclude interest and depreciation expenses, will be $4,500,000 the first year and are expected to grow annually by 3 percent for every year after that. Interest expense will be $700,000 per year, and principal payments on the loan will be $1,000,000 a year. In the first year of operation, the new ASC is expected to generate additional after-tax cash flows of $600,000 from radiology and other ancillary services, which will grow at an annual rate of 5 percent per year for every year after that. Starting in year 1, net working capital will increase by $350,000 per year for the first four years, but during the last year of the project, net working capital will decrease by $250,000. The tax rate for the hospital is 40 percent, and its cost of capital is 15 percent. Use both the NPV and IRR approaches to determine if this project should be undertaken. (Hint: see Appendices C, D, and E.)
• 28. Garfield Medical System, a taxpaying entity, is considering a new orthopedic center. The building and equipment for the new center will cost $7,500,000. The equipment and building will be depreciated on a straight-line basis over its five-year life to a $2,500,000 salvage value. The new orthopedic center’s projected net revenue and expenses are listed below. The project will be financed partially by debt capital. Interest expense is expected to be $600,000 per year, and principal payments on the bank loan are expected to be $1,250,000 per year for the first five years of the loan. The new orthopedic center is expected to take away after-tax cash profits of $1,000,000 per year from inpatient orthopedic services. The tax rate for the institution is 40 percent, and its cost of capital is 10 percent. Two years ago, a $100,000 financial feasibility study was conducted and paid for. Pro forma working capital projections are listed below. These are the permanent account balances for inventory, accounts receivable, and accounts payable. Use the NPV and IRR approaches to determine if this project should be undertaken. (Hint: see Appendices C and E.)

Appendix C: Technical Concerns in Calculating Net Present Value

This appendix addresses three commonly asked questions about performing a net present value analysis:

• • How does an organization determine the amount of the initial investment?
• • How does an organization determine the annual cash flows?
• • How does an organization determine a discount rate?

How Does an Organization Determine the Amount of the Initial Investment?

Included Costs

Expenditures for plant, property, and equipment are usually the primary initial investment items in a capital project. The amount recorded for these items is the purchase price plus all costs related to making the investment “ready to go,” including costs of labor, renovation of space, rewiring, and transportation, and any investment in working capital (cash, inventory).

Sunk Costs

Costs incurred in the past. (They should not be included in NPV-type analyses.)

Along with these relatively tangible costs, the initial investment amount should include any planning costs incurred specifically for the project after it has been selected. General planning costs incurred to decide which capital project to undertake are not included because they are sunk costs (costs incurred before a specific project has been selected).

Opportunity Cost

Proceeds lost by forgoing or delaying opportunities other than the opportunity chosen.

The final cost category to include in the initial cost estimate is the opportunity cost, which is proceeds lost by forgoing other opportunities in order to pursue a particular project. For example, suppose a health care facility has a plot of land which it could either sell for $150,000 or build a long-term care facility. If it builds on the land, it will be earning a profit from the new facility; even though no cash is changing hands, yet losing the chance to collect that $150,000 from the sale of the land. Thus $150,000 would be included as part of the initial outlay, as an opportunity cost or a cash outflow, if the organization chose to build the new facility.

Excluded Costs

In an NPV analysis, several cost categories explicitly should not be included as initial investment costs. For example, though the purchase price of assets should be included in the initial cost, interest paid as a result of borrowing money to finance those assets should not be included because interest costs are financing flows and are reflected in the cost of capital.

Costs that have already occurred in the past are sunk costs and should not be included in the analysis. For example, $50,000 already spent by the health care organization to renovate a building should not be included as part of the cost for a new project. The initial investment should include only the cost of plant, property, and equipment; investment in working capital; additional planning costs; and opportunity costs (see Exhibit C.1).

EXHIBIT C.1 INITIAL COSTS OF AN INVESTMENT

How Does an Organization Determine the Annual Cash Flows?

An NPV analysis evaluates the relationship between an initial investment and the incremental cash flows in the future resulting from that investment. There are three types of incremental cash flows: operating, spillover, and nonregular.

Incremental Cash Flows

Cash flows that occur solely as a result of a particular action, such as undertaking a project.

Operating Cash Flows

Incremental operating cash flows are the new, ongoing cash flows that occur solely as a result of undertaking a project. They include payments received for services rendered and expenditures for such things as labor, materials, marketing, utilities, and taxes. Excluded from NPV analyses are principal and interest payments made on loans to finance the project and any dividends that may result from the project. The purpose of maintaining this separation is to assess whether a project can generate enough positive cash flows from operations on its own merits to pay off its financing costs (interest, principal payments, and dividends).

Key Point

Operating flows are kept separate from financing flows. Operating cash flows include revenues, labor and supply expenses, and so forth. Financing cash flows include interest expenses, principal payments, and dividends.

To realize these flows under the cash basis of accounting, the revenue and expense accounts are converted to a cash basis by changes in the net working capital. These adjustments are discussed under the example of computing cash flows in Appendix D.

Key Point

If a health care provider is a for-profit organization, a project’s positive net cash flows also entail tax payments according to the organization’s tax rate. Therefore, operating cash flows are calculated after tax. Appendix E provides a detailed example of how to generate appropriate cash flows for taxable entities.

Spillover Cash Flows

Spillover cash flows, which can be classified into two types, are increases or decreases in cash flows that occur elsewhere in an organization once a project is undertaken. The first type occurs when a new service produces additional cash flow to other departments. For example, if a facility were expanding its emergency department, additional revenues could be generated by ancillary support services, such as radiology or laboratory. The second type occurs when a new service diminishes cash flow elsewhere, sometimes called cannibalization. For example, if a facility were evaluating the development of an outpatient diagnostic center, it would have to consider the expected loss in cash flow for the existing inpatient diagnostic center. This loss in cash profits for inpatient services is a cash outflow.

Cannibalization

What occurs when a new service or product decreases the revenues from other services or product lines; this result is considered a cash outflow.

Operating Cash Flows

Cash flows that occur on a regular basis, often following implementation of a project (also called regular cash flows).

Non-regular Cash Flows and Terminal Value Cash Flows

As opposed to operating cash flows, which by definition occur on a regular basis, non-regular cash flows are incremental cash flows that occur on an irregular basis, typically at the end of the life of a project. One of the most common nonregular cash flows is salvage value, the money received from selling an asset at the termination of a project. Another typical cash flow at the end of a project’s life is recovery of working capital, typically a cash inflow. Exhibit C.2 describes cash flows to be included or excluded, and Appendix D discusses the recovery of working capital.

EXHIBIT C.2 THE COMPONENTS OF INCREMENTAL CASH FLOWS

Accuracy of Cash Flow Estimates

Because cash flows occur at some point in the future, they cannot be measured precisely. Expected revenues or projected cost savings can only be estimated, based on a market analysis and the current operations of the organization. On the one hand, unforeseeable events, such as new competition or an unexpected rise in energy prices, could significantly cut back on positive cash inflow. On the other hand, an investment such as a convenient new visitor parking deck may be so popular that it draws in unexpected patient volume, which would increase revenues. Given that the future cash flows must be present to offset the cost of the initial investment, marked variation in these cash flows could alter the final NPV decision.

Nonregular Cash Flows

Cash flows that occur sporadically or on an irregular basis. A common nonregular cash flow is salvage value, the receipt of funds following a one-time sale of an asset at the end of its useful life.

How Does an Organization Determine a Discount Rate?

Although commonly thought of as an adjustment for the time value of money, the discount rate also accounts for capital project risk. The discount rate, or cost of capital, marks the required rate of return for investors who fund the project to compensate them for the risk of the investment opportunity and the temporary loss of these funds being used for the project. Investors who provide primary sources of debt financing for health care providers include bondholders and private lenders such as banks. Investors who provide sources of equity financing for health care providers are stockholders. For-profit health care providers have stockholders who expect a return on the providers’ stock. Nonprofit health care providers do not have stockholders; however, they should operate as if their community expects returns, or benefits, in the form of higher quality health care, lower charges, and the provision of charity care. Operating under this assumption will force nonprofits to accept capital projects that can generate positive cash flow not only to pay the interest expense on debt but also, and more importantly, to earn additional cash flows to fund future capital expenditures and support these community benefits.

To estimate the required rate of return for capital projects, with risk similar to the current risk associated with the health care organization, a facility can use its current cost of capital, calculated in terms of its weighted average cost of capital, or WACC. For example, if a hospital plans to build a replacement hospital, the WACC can be used because the risk associated with this project is similar to the operating risk for the hospital. However, if the hospital were investing in a health insurance company, the operating risk for that business would not be the same as the hospital’s risk, and the WACC would not be used. Instead the cost of capital for insurance companies would be used in the NPV analysis. The WACC formula defines a hospital’s cost of capital as the sum of its cost of debt (Kd) and its cost of equity (Ke); these costs are weighted by their respective proportions of debt (D / V) and equity (E / V):

The cost of equity, or the return that stockholders should expect to earn when investing in a share of stock, has three components. This analysis will focus only on common stock (and not on preferred stock). The first component is the risk-free rate (Rf), which typically is measured by the long-term, thirty-year U.S. Treasury bond and represents the floor. Since stocks are riskier than government securities, stock investors expect to earn more on stocks than they would on the risk-free asset. The second component is the added premium, or expected return, that accounts for the risk of investing in the general stock market, which is called the market risk premium. This risk premium is the difference between the return on the entire stock market (Rm) and the risk-free rate of return (Rm – Rf). The historical performance of a specific stock market index, such as Standard & Poor’s index, is used to project future returns on the stock market. Using historical data, Standard & Poor’s index projects an expected return between 8 percent and 11 percent. If the risk-free rate equals 4 percent, then the market risk premium, or the added return for investing in the stock market, equals 4 percent (8% − 4%). The final component, beta, measures the risk potential of the individual company relative to the risk potential of the overall stock market. The beta of the market, or the average company risk, is 1, so a company with a beta of 2 is considered twice as risky as the market in general. Thus, if the stock market increases by 10 percent, then the return on this company may increase by 20 percent. Recently, hospital management companies’ betas ranged from .87 for Life-Point, Inc., to 1.84 for Community Health Systems, Inc. A health care company’s beta is influenced by the risk for the hospital industry in general and the individual company’s amounts of fixed operating costs and debt. Health care companies with higher fixed costs (or greater operating risk) and higher amounts of debt (or greater financial risk) will incur greater variability in the earnings and produce higher beta values. It is beyond the scope of this textbook to discuss the details of how beta is measured. Web sites such as Value Pro (www.valuepro.net) and That’s WACC! (thatswacc.com) tell investors the specific beta value for a company’s stock and its WACC. For nonprofit hospitals and health systems, which have no stock and thus no beta, one could use the average beta for all hospital management companies as a proxy for this component of the WACC.

Combining all the components results in the final model, called the capital asset pricing model (CAPM), which can be used to find the expected return on equity or stock (Ke), as follows:

Given this model, Community Health System’s stock return can be estimated, which is equal to the risk-free rate (4 percent) and its market risk premium (4.0 percent) times its beta value of 1.84. Given these values, Community Health System’s expected stock or equity return is 11.4 percent:

For the weighted average cost of capital, the weights can be estimated from the market or balance sheet value of debt and equity, while total value (V) can be estimated from total assets, or the sum of the market values of debt and equity. Market value of equity equals total shares outstanding times current share price, while market value of debt equals the hospital’s market value of any outstanding debt borrowings. Proxy measures for the cost of debt can be based on interest rates for its expected bond rating or the market rates of existing debt.

The cost of debt for tax deduction of interest expense is also adjusted if the hospital is a taxpaying entity. For example, assuming a cost of debt of 6 percent and a debt weight of 60 percent, and given a corporate tax rate of 40 percent, the cost of debt will be adjusted to 3.6 percent and accounts for the after-tax cost of debt. Given the Community Health System’s cost equity of 11.4 percent and equity weight of 40 percent, its WACC equals 6.72 percent:

Key Point

The discount rate is also called the opportunity cost of capital to the company undertaking the capital investment project. It is the cost of the next best alternative, those returns the company would be forgoing by making this investment as opposed to another. From the lenders’ or investors’ points of view, it is the return they forgo by investing their money in this project rather than alternative projects of similar risk. For example, if an investor-owned hospital chain were issuing stock to purchase a health insurance business, investors considering buying this stock would expect at least the return on the stocks of other publicly held health insurance companies, such as Cigna or Aetna.

Appendix D: Adjustments for Net Working Capital

To the extent that new projects affect working capital, adjustments in cash flows must be made. If working capital increases, then the organization has invested additional resources in working capital: that is, the project requires the organization to increase both its current asset accounts, which result in cash outflows, and current liability accounts, which are cash inflows, because they delay the use of cash (see the example below). The difference between current assets and current liabilities is called net working capital, as discussed in Chapter Five. The effects of changes in net working capital must be accounted for each year. If there is an increase in net working capital, the amount is subtracted from net operating cash flows; likewise, for a decrease, the amount is added to net operating cash flows.

Key Point

Increases in net working capital mean cash outlays. Decreases in net working capital mean cash inflows.

Exhibit D.1, continuing the example of building a satellite hospital, illustrates how to adjust for changes in net working capital. Assume that the organization had balance sheet results as shown in rows 7 to 9 of Exhibit D.1. In row 9, its net working capital (Current assets – Current liabilities) is shown as $1,000, $1,300, $1,800, $600, $400, and $300 in years 1 through 6, respectively.

The change in net working capital is the difference between the current year’s net working capital and that from the previous year (row 10). For example, the change in net working capital the first year was $1,000 ($1,000 in year 1 – $0 in year 0). The second year’s change in net working capital was $300 ($1,300 in year 2 – $1,000 in year 1). The same procedure is followed for years 3 through 6. As noted earlier, if net working capital increases, then cash decreases, which must be subtracted from the cash flows. If net working capital decreases, then cash increases, and that amount must be added to cash flows. Because net working capital increased by $1,000 in year 1 (row 10), $1,000 (row I) is subtracted from the net operating cash flows (row G). This process is continued for the remaining years.

EXHIBIT D.1 COMPUTATION OF NET PRESENT VALUE FOR A SATELLITE HOSPITAL, INCLUDING WORKING CAPITAL ADJUSTMENTS

Key Point

Increases in net working capital are cash outflows. Decreases in net working capital are cash inflows.

In the first three years, cash outflows occurred, and net working capital for the project increased (row 10). But in year 4 and thereafter, the decreases in net working capital constituted cash inflows for those years. The facility is no longer investing cash in current assets and current liabilities. It is decreasing its investment in cash, collecting at a higher rate on its receivables, or reducing its outstanding payables (or all of these).

Once the changes in net working capital have been calculated, they are entered into the NPV calculation to adjust for changes in cash flows due to changes in net working capital (rows I and J).

Key Point

Interest-bearing, short-term debt (notes payable) should be excluded from calculations of changes in net working capital because it represents financing flows and is accounted for in the cost of capital.

When a project ends, it is assumed that the total amount of net working capital investment has been recaptured and accounted for as a cash inflow, and that plant and equipment will be sold or disposed of. In regard to the recapture of net working capital, typically all project receivables are collected, all project inventory gets sold, and all project payables are paid. The recapture of changes in net working capital is the sum of all the changes in net working capital during the life of the project. In the case of the satellite hospital, this amount is –$300 [($1,000) + ($300) + ($500) + $1,200 + $200 + $100]. The negative $300 indicates an ending excess balance of $300 in net working capital to sell off; therefore, $300 in net working capital becomes a cash inflow that can be recaptured or recovered (see Exhibit D.1, row J).

Appendix E: Tax Implications for For-Profit Entities in a Capital Budgeting Decision and the Adjustment for Interest Expense

This appendix introduces an NPV analysis for a for-profit entity. The total number of for-profit hospitals in the United States at the turn of the century represented less than 15 percent of the total number of short-term community hospitals. In contrast, there were more than 7,000 skilled- and intermediate-care nursing homes nationwide, of which more than two-thirds were for-profit entities. Also, more than two-thirds of the managed care insurers were tax-paying entities. Therefore, it is imperative to consider the tax effects that can take place in a for-profit investment analysis. Appendix C discussed the separation of financing flows from the operating cash flow analysis for an NPV analysis. When computing a cash flow analysis from a projected income statement for a for-profit entity, interest expense needs to be taken out in order to adjust for the tax effect. The following analysis shows what the calculations would be if the satellite hospital project were a for-profit endeavor.

The two most important tax adjustments that must be made for for-profit entities are accounting for the effect of taxes on operating income and accounting for the tax effect from the gains or losses resulting from the sale of assets at the expected end of the project’s life. This example focuses only on the first adjustment because gains and losses, like most other tax effects, are complicated and therefore only introduced in this text.

As shown in Exhibit E.1, the analysis looks nearly identical to that for not-for-profit entities (Exhibit D.1), except for the tax expense and interest expense accounts and the inclusion of a new line for payment of taxes (Exhibit E.1, row G, which assumes that the organization has a 40 percent tax rate on its net income). In year 1, the organization had earnings before taxes of $30,000 (row F). Because the tax rate is 40 percent, it must pay an additional $12,000 in taxes ($30,000 × 0.40). In year 2, it pays $32,000 in taxes on earnings before tax of $80,000 (rows F and G). A similar analysis is conducted for years 3 through 6.

At this point, an adjustment must be made for interest because interest expense affected net income (and thus the amount of taxes paid), but interest expense is not itself an operating cash flow. Thus, interest expense must be added back at the amount of (1 − Tax rate) to determine true cash outflows. This is done in row J, where $15,000 is added back [$25,000 × (1 − 0.40)]. In effect, the interest expense provided a tax deduction of $10,000 ($25,000 × 0.40 saved), which represents a cash inflow. Thus the true cash outflow is only $15,000 ($25,000 − $10,000), which matches the value in row J. For nonprofit entities with interest expense in the projected income statement, the full amount of the interest expense is added back in because the tax rate is zero. The remainder of the analysis remains the same. Overall, the NPV for the hospital as a taxpaying entity equals $181,116 (row T), versus $498,838 as a not-for-profit hospital (Exhibit D.1, row P); so the NPV for the for-profit is much less than that for the not-for-profit.

EXHIBIT E.1 NPV DECISION ASSUMING SATELLITE HOSPITAL IS FOR-PROFIT

^aNet working capital (current year) – Net working capital (previous year)

^bThere is no tax effect from selling the asset, because it was depreciated to the salvage value; therefore, salvage value equals book value.

^cPresent value interest factors in the exhibit in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually.

Appendix F: Comprehensive Capital Budgeting Replacement Cost Example

Assume that a cardiology laboratory is considering replacing its manual electrocardiography (EKG) management information system (MIS) with a new, more efficient product. The new system automatically stores EKG and stress records online. The existing system was purchased five years ago for $70,000 and is being depreciated over a ten-year life to a salvage value of $10,000. The old system can be sold now at a market price of $20,000 and has a book value of $40,000 ($70,000 Original cost – $30,000 Accumulated depreciation). The new system can be purchased for $100,000 and is estimated to have a five-year life. It can be depreciated to a salvage value of $20,000. Because the organization is paid on a per procedure basis, there are no new revenues directly associated with the improved EKG system. Thus the focus becomes the cash savings in operational expenses. Annual labor expenses will drop from $50,000 for the old system to $15,000 for the new system, resulting in a labor cash savings of $35,000. Purchasing the new system will increase net working capital by $1,000 each year, compared with a $300 annual increase for the old system, starting in year 1. This appendix provides comparative and incremental NPV analyses of this situation, first assuming that the lab is not-for-profit and then assuming that it is investor owned. In both cases the cost of capital is 5 percent.

Comparative Approach: Not-for-Profit Analysis

As its name implies, the comparative approach compares the cash flows resulting from continuing with the existing alternative to those that would result if the equipment were replaced. The comparative approach does this by separately calculating each of these cash flows and then comparing the end results (Exhibit F.1).

Were the organization to continue with the existing system, there would be no investment at year 0 (it has already been made), and the operating loss would be $56,000 a year (row D), which includes operating expenses (row B) and depreciation expense (row C). However, because operating loss contains depreciation, and depreciation is an expense that does not require a cash outlay, depreciation must be added back in order to derive cash flows from operations. This is done in row F by adding $6,000 (row E) back to the $56,000 operating loss (row D). Although the same result ($50,000, row F) can be derived without first subtracting and then adding back depreciation expense, this approach makes it easier to compare the not-for-profit and for-profit analyses. Because the change in net working capital increases by $300 each year, the resultant cash outflow must be accounted for (row G). However, as explained in Appendix D, this will be recovered at the end of the project (row I). The only other cash flow to account for is the $10,000 salvage value that results in a cash inflow in year 5 (row H). Finally, the cash flows are computed for each of the five years (row J), and then discounted using the cost of capital (rows K and L). This information forms the basis for calculating the NPV of the cash flows attributable to the existing machine: $208,762 (row O).

The initial outlay, expenses, depreciation, salvage value, and working capital effects differ for the purchase of the replacement system (Exhibit F.1, lower half). The initial outlay is computed in row A. Although the new equipment costs $100,000, the organization has to pay only $80,000 from its existing funds because it can allocate $20,000 from the sale of the existing equipment.

Because net working capital increases by $1,000 each year, the resulting cash outflow must be accounted for (rows G and I). The remaining steps in the replacement analysis are the same as those in the previous analysis, and only the amounts differ. Using the comparative approach, the NPV of the replacement alternative is –$129,683 (row O). Thus, because the replacement alternative has the higher NPV (–$129,683 versus –$208,762), the replacement alternative should be undertaken.

Comparative Approach: For-Profit Analysis

The for-profit analysis is exactly the same as that for the not-for-profit analysis, with the two exceptions shown in Exhibit F.2, rows E and F, which arise as a result of the effects of taxes on cash flows and, ultimately, affect NPV. As in the not-for-profit analysis, earnings (or loss) before tax is calculated in row D. Because earnings get taxed at 40 percent, the resulting tax savings would be $22,400 for the existing alternative as compared with $12,400 for the replacement alternative, respectively (row E, both sections). Because earnings before tax is negative, the organization is losing money but will not be incurring negative taxes. However, the tax expense becomes a positive value because this tax loss can be either carried forward to offset future income or carried back to offset prior income to result in a tax refund. This has the same effect as a cash inflow: for each additional $1.00 in expenses, the organization pays $0.40 less in taxes. Therefore these tax savings get added back into the loss in row D. Taking into account the tax effects, the NPV of the existing alternative is –$111,782, and the NPV of the replacement alternative is –$67,998. Again, showing a smaller loss, or a savings of $43,784 (row R, bottom table), the replacement alternative should be undertaken, all else being equal.

EXHIBIT F.1 COMPARATIVE APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION: NOT-FOR-PROFIT ENTITY

^aPresent value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually.

^b–$ 100,000 Purchase of new equipment + $20,000 Sale of old equipment.

^c(–$129,683 Replacement system) – (–$208,762 Existing system) = $79,079.

EXHIBIT F.2 COMPARATIVE APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION: FOR-PROFIT ENTITY

^aPresent value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually.

^b–$100,000 Purchase of new equipment + $20,000 Sale of old equipment + $8,000 in Tax savings from loss on sale of existing equipment (0.40 Tax rate × $20,000 Loss)

^c(–$67,998) – (–$111,782) = $43,784

Incremental Approach: Not-for-Profit Analysis

Exhibit F.3 analyzes the same replacement decision using the incremental approach. It looks at the savings (or lack thereof) for each item that would result if the decision were made to replace the old EKG system with a new product. To make this decision, several aspects of cash flows must be taken into account.

Though the new MIS system costs $100,000, the facility receives $20,000 from the sale of the old system. Thus the initial outlay is $80,000 (row A). The change in operating cash flows produces a net operating cash flow savings of $35,000 per year (row B, $15,000 replacement equipment labor expense versus $50,000 in labor expenses for the existing equipment).

As with the comparative analysis, in this nontaxpaying example, depreciation expense could be disregarded altogether because it has no effect on cash flow. However, to compare the not-for-profit and for-profit examples, operating income (needed to compute taxes in the for-profit example) is first computed by subtracting the $10,000 in depreciation expense (row C) and then adding it back to show that net operating cash flows do not change as a result of depreciation (rows E and F).

The effects of changes in working capital and the salvage value must be added to the analysis as well. Because net working capital increases by $700 annually ($300 for the existing system versus $1,000 for the replacement system), cash flows decrease by $700 each year (rows 5 and G). In year 5, the year in which the investment is assumed to end, salvage value increases by $10,000 (row H, sale of assets), which equals the incremental difference between the salvage value of the new system, $20,000, and the salvage value of the old system, $10,000. Because the project presumably ends at this time, it is also necessary to recapture $3,500 in net working capital (row I: 5 Years × $700 per year).

To determine the NPV, the cash flows each year are discounted at 5 percent and summed (rows J through O), and then the initial outlay (row A) is added. Because the NPV equals $79,079, which represents a positive return due to replacement, from a financial perspective the new EKG system should be purchased. Note that this NPV is the same as the NPV difference derived in Exhibit F.1 (bottom section, row P), as it should be.

Incremental Approach: For-Profit Analysis

Exhibit F.4 presents a similar incremental analysis, but for a for-profit, taxpaying organization. In this case, the new initial outlay is still reduced from $100,000 to $80,000 by the additional $20,000 from the sale of the old system, but it is also reduced another $8,000 (to $72,000) by the tax effect of that sale (row 1). This tax benefit arises because the organization sells a system with a $40,000 book value for $20,000, incurring a $20,000 loss. Assuming a 40 percent tax rate, it will pay $8,000 less in taxes (0.40 × $20,000) than it would have if it had not sold the machine.

EXHIBIT F.3 INCREMENTAL APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION: NOT-FOR-PROFIT ENTITY

EXHIBIT F.4 INCREMENTAL APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION: FOR-PROFIT ENTITY

Taxes also affect operating income and represent a real cash outflow. Because the change in earnings before tax is $25,000 (row D), assuming a 40 percent tax rate, taxes will increase by $10,000 (row E), thereby reducing the change in net income to $15,000 (row F). However, reflected in this $15,000 net income is the $10,000 in depreciation expense that does not require a cash outflow. Therefore this $10,000 must be added back in, and cash flow becomes $25,000 (rows G and H). The remainder of the analysis remains the same as for the not-for-profit analysis, adjusting for the change in net working capital and the terminal value.

After accounting for the sale of the new system at its termination date and discounting at the cost of capital, the decision to make this investment results in a positive NPV of $43,784 (row Q). Because the NPV is positive, the investment should be made. Again, this value expectedly equals that shown in row R in the bottom section of Exhibit F.2.

Appendix Summary

This appendix provided both a comparative and an incremental NPV analysis of purchasing a new EKG MIS system. The analysis was conducted for both a not-for-profit and a for-profit entity. The summary of results presented in Exhibit F.5 shows that the comparative and incremental approaches provide exactly the same answer. Thus the method used depends only on preference and has no effect on the final result. In this case, though tax effects are considerable, they do not change the decision.

EXHIBIT F.5 RESULTS OF THE COMPARATIVE AND INCREMENTAL NPV ANALYSES OF REPLACING AN EXISTING EKG SYSTEM

^aExhibit F.1, comparative approach.

^bExhibit F.2, comparative approach.

^cExhibit F.3, incremental approach.

^dExhibit F.4, incremental approach.

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