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Chapter 13

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					Capital Budgeting




    Capital Budgeting
    Importance of Capital Budgeting

• 6-10 percent of operating expenses.
• Capital costs included in the DRG formula
  (OBRA of 1990).
• Tax-deductibility of charitable gifts lowered
  (Tax Reform Act of 1986).
• Access to tax-exempt markets restricted.




                     Capital Budgeting
    Importance of Capital Budgeting

Starting in 1988, the typical hospital should be
  viewed as a more risky venture, and will pay
  higher interest rates unless it can
  demonstrate DRG profitability. Hospitals shall
  no longer have government as a “Sugar
  Daddy” paying the interest on their debt
  coupon by coupon. One thousand hospitals
  may close.


                    Capital Budgeting
     Importance of Capital Budgeting

“We view such hospitals as „cross-eyed javelin
  throwers‟ in that they will not win any awards,
  but they will keep the attention of their fearful
  audience.”
(quote from investment banker in Eastaugh‟s
  Financing Health Care, 1987, p. 600)




                      Capital Budgeting
     Defining Capital Expenditures

• Purchases of land, buildings, and equipment
  (for operations, not resale).
• Useful life of more than one year.
• Cost of $500 or more.
• Subject to depreciation.




                   Capital Budgeting
    Classifying Capital Expenditures

• Land
• Land improvements
• Buildings
• Fixed equipment
• Major movable equipment (useful life of three
  years or more)
• Major repairs that benefit future periods or
  extend useful life

                   Capital Budgeting
Steps in Capital Budgeting




         Capital Budgeting
       Steps in Capital Budgeting

17) Identify and prioritize requests using
  community need and strategic plan as initial
  criteria.




                    Capital Budgeting
       Steps in Capital Budgeting

18) Project cash flows.
  -replacement equipment
  -new equipment




                    Capital Budgeting
        Steps in Capital Budgeting

19) Perform financial analysis
  -payback period
  -discounted payback period
  -net present value (NPV)
  -internal rate of return (IRR)




                       Capital Budgeting
Payback Period Problem




       Capital Budgeting
        Payback Period Problem

ABC Day Surgery Center wants to buy
 equipment for $10,000 with projected cash
 flows (net revenues minus expenses) of
 $3,000 per year during the equipment‟s five-
 year useful life. Assuming no salvage value,
 what is the payback period?




                   Capital Budgeting
      Payback Period Problem

Year        Cash Flow ($)         Cumulative Cash
                                     Flow ($)
cf0           (10,000)              ($10,000)
cf1             3,000                 (7,000)
cf2             3,000                 (4,000)
cf3             3,000                 (1,000)
cf4             3,000                  2,000
cf5             3,000                  5,000
              Capital Budgeting
        Payback Period Problem

By looking at the table, the day surgery center
  will recover the cost of the equipment during
  year 4. Assuming an even distribution of cash
  flows during the year, the following equation
  can be used to determine exactly when
  during year 4 the center will recover the
  equipment cost:



                   Capital Budgeting
            Payback Period Problem

Payback period

= year before recovery + unrecovered cost at beginning of year
                              cash flow during the year

= 3 + (1,000 / 3,000)

= 3.33 years




                           Capital Budgeting
                 Discounting

• Discounting is a way of looking at a future
  amount of money, called future value, and
  calculating the present amount of money,
  called present value.




                    Capital Budgeting
Discounting Formula



              FV
     PV =
            (1 + i) n




     Capital Budgeting
           Discounting Problem

• What is the present value of $100,000,
  discounted at 5 percent annually for five
  years?




                    Capital Budgeting
        Discounting Problem



         FV          100 , 000        100 , 000
PV =             =                =             = $78, 351
       (1+ i)5       (1+ .05 )5        1 .2763




                         Capital Budgeting
         Present Value Table

             Discount Rate

           10%                   20%     30%

Year 1     .909                   .833   .769

Year 2     .826                  .694    .592

Year 3     .751                  .579    .455




                  Capital Budgeting
 Discounted Payback Period Problem
Year   Cash Flow   Th Discount          Discounted   Cumulative
                     Factor             Cash Flow    Discounted
                                                     Cash Flow
cf0    (10,000)       1.000             ($10,000)    ($10,000)

cf1      3,000        0.909               2,727       (7,273)

cf2      3,000        0.826               2,478       (4,795)

cf3      3,000        0.751               2,253       (2,542)

cf4      3,000        0.683               2,049        (493)

cf5      3,000        0.621               1,863        1,370

                    Capital Budgeting
Discounted Payback Period Problem


Payback period

= year before recovery + unrecovered cost at beginning of year
                              cash flow during the year

= 4 + (493 / 1,863)

= 4.265 years




                         Capital Budgeting
        Net Present Value (NPV)

• NPV is a dollar answer
• NPV of zero means that the capital
  expenditure is generating discounted cash
  flows equal to the original investment.




                   Capital Budgeting
      Net Present Value Formula




                cf 1           cf 2               cf n
NPV = cf 0 +            +              + .....
               (1+ k)1 (1+ k)2                   (1+ k)n



                   Capital Budgeting
       Net Present Value Problem

ABC Day Surgery Center wants to buy
 equipment for $10,000 with projected cash
 flows of $3,000 per year during the
 equipment‟s five-year useful life. What is the
 NPV of the equipment at a discount rate of 10
 percent?




                   Capital Budgeting
Net Present Value Problem


                 cf 1cf           cf ncf
  NPV = +
NPV = cf 0cf 0 + 1 ......
                       1
                             ......        n
               (1+ k) k) (1+ k )nk n
                  (1+ 1             (1+
                        3, 000                3, 000
NPV = (10(10, 000 ) + 3, 000 ...... 3,
  NPV =   , 000 ) +                  ......
                      (1+(1+ . )1 ) (1+ .10. )5
                            .10 10 1             (1+ 10
                        3, 00                3, 000
NPV = (10(10, 000 ) + 3, 000 ...... 3,
  NPV =   , 000 ) +                 ......
                      (1.100 ) ) (1 .610 ) )
                           (1. 100              (1 . 610
  NPV = , 000 ) + ) + 2, 727 ...... 1, 863
NPV = (10(10, 000 2, 727 ...... 1, 863
       =, 372
NPV = $1 $1  ,


                       Capital Budgeting
      Internal Rate of Return (IRR)

• IRR is a percent answer
• IRR is the discount rate of a capital
  expenditure where the NPV is zero.




                    Capital Budgeting
Internal Rate of Return Formula




               cf 1             cfn
      cf0 +           ......            =0
            (1+ irr)1        (1+ irr) n




                Capital Budgeting
                 NPV/IRR Problem
    Year         Cash Flow           Discounted   Discounted
                                        Rate      Cash Flow
     cf1           3,000                 0.909      2,727
     cf2           3,000                 0.826      2,478
     cf3           3,000                 0.751      2,253
     cf4           3,000                 0.683      2,049
     cf5           3,000                 0.621      1,863
    Total                                           11,370
Discounted cf
Minus Original                                     -10,000
 Investment
 Equals NPV                                         1,370
                           Capital Budgeting
                         NPV/IRR Problem
                              10% Discounted           20% Discounted
   Year      Cash Flow    Discounted    Discounted   Discounted   Discounted
                             Rate       Cash Flow       Rate      Cash Flow
   cf1         3,000        0.909           2,727      0.833        2,499
   cf2         3,000        0.826           2,478      0.694        2,082
   cf3         3,000        0.751           2,253      0.579        1,737
   cf4         3,000        0.683           2,049      0.482        1,446
   cf5         3,000        0.621           1,863      0.402        1,206
   Total                                   11,370                   8,970
Discounted
    cf




                                Capital Budgeting
          NPV/IRR Problem

         PV of cf @ low rate - investment
3)   PV of cf @ low rate - PV of cf @ high rate


             11, 370 - 10, 000
                               = . 5708
              11, 370 - 8, 970




                   Capital Budgeting
             NPV/IRR Problem

4) multiply answer found in Step 3 by .10 to
  adjust for using 10 percent increments for the
  discount rate

                .5708 x .10 = .05708




                    Capital Budgeting
            NPV/IRR Problem

5) add answer found in Step 4 to percent low
  discount rate

          .05708 + .10 = .15708          or 15.708%




                     Capital Budgeting
        Steps in Capital Budgeting

20) Identify nonfinancial benefits




                    Capital Budgeting
        Steps in Capital Budgeting

21) Evaluate benefits and make decision
 (see Table 13.2, p. 285, for decision matrix)




                    Capital Budgeting
     Financing Capital Expenditures

• Funded depreciation--used to finance
  replacement equipment.
• Philanthropy, operating surpluses, or debt--
  used to finance new equipment.




                    Capital Budgeting
Credit Worthiness & Bond Ratings




            Capital Budgeting
   Credit Worthiness & Bond Ratings

• Legal provisions of the organization.
• Institutional characteristics and market
  position.
• Medical staff characteristics.
• Management capability.
• Financial indicators.



                    Capital Budgeting
     Moody‟s Top Five Reasons for
       Upgrades/Downgrades

1.   Financial Performance
2.   Market share and physician
     composition
3.   Business decisions
4.   Cash flow and funding capital
     expenditures
5.   Market characteristics


                   Capital Budgeting
  Lease Versus Purchase Decisions

• Operating leases are for periods less than the
  equipment‟s useful life.
• Capital leases are for periods that
  approximate the equipment‟s useful life and
  usually include provisions for purchase at the
  end of the lease.




                    Capital Budgeting
  Lease versus Purchase Decisions

• Lease advantages
  –   Flexibility
  –   Financing for other equipment
  –   Protection against technological changes
  –   Routine maintenance
  –   Tax advantages for for-profits




                       Capital Budgeting
  Lease versus Purchase Decisions

• Lease disadvantages
  – More expensive




                     Capital Budgeting
   Lease versus Purchase Decisions

• See Problem 13.5 on p. 288 of the text




                   Capital Budgeting
  Lease versus Purchase Decisions

• Purchase considerations
  – Borrow $1.3 million at 10 percent
  – Depreciate straight-line over five years
  – Trade-in value of $130,000 at the end of the useful
    life
  – Maintenance expense of $12,000 per year




                      Capital Budgeting
        Lease versus Purchase Decisions

Year    Principle   Interest   Maintenance        Total      PV       PV
        Payment     Payment     Expense          Expense   Factor   Expense
                                                           at 10%
 1      260,000     130,000      12,000          402,000   0.909    365,418

 2      260,000     104,000      12,000          376,000   0.826    310,576

 3      260,000     78,000       12,000          350,000   0.751    362,850

 4      260,000     52,000       12,000          324,000   0.683    221,292

 5      260,000     26,000       12,000          298,000   0.621    185,058

Trade   (130,000)                                          0.621    (80,730)

                                                                    1,264,464
                                 Capital Budgeting
  Lease versus Purchase Decisions

• Lease considerations
  – Lease payments of $26,000 per month for 60
    months (includes maintenance)




                    Capital Budgeting
   Lease versus Purchase Decisions

Lease considerations

  Year      Lease Payment         PV Factor at   PV Expense
                                     10%
   1           312,000                 0.909      283,608
   2           312,000                 0.826      257,712
   3           312,000                 0.751      234,312
   4           312,000                 0.683      213,096
   5           312,000                 0.621      193,752
                                                 1,182,480
                         Capital Budgeting
Evaluating Capital Budgeting
        Performance




          Capital Budgeting
      Evaluating Capital Budgeting
              Performance

• Long-term debt to net assets.




                   Capital Budgeting
       Evaluating Capital Budgeting
               Performance

• Long-term debt to net assets.
• Debt service coverage
(revenue - expenses) + interest expense + depreciation   expense
             interest expense + principal payments




                        Capital Budgeting

				
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