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CHAPTER 7 THE INVESTMENT DECISION 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 longterm 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-overlookfacilities-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_uncertain ties_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-18large-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 DukeLifePoint 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 64slice 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 realworld 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). (Zelman 301-313) Zelman, William N., Michael McCue, Noah Glick, Marci Thomas. Financial Management of Health Care Organizations: An Introduction to Fundamental Tools, Concepts and Applications, 4th Edition. Jossey-Bass, 2013-12-30. VitalBook file. Payback, Present Value, and Internal Rate of Return Explain the payback method, net present value method, and the internal rate of return. How are they similar and how are they different? 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The payback method, Internal rate of return and the net present values

The Payback Method, Internal Rate of Return and the Net Present Values
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The payback method, Internal rate of return and the net present values

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