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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