HCA312 Healthcare Finance- Break Event

Capital Investment Decisions 10 .welcomia iStock/Thinkstock Learning Outcomes By the end of this chapter, you will be able to:

• Understand the role of financial analysis for capital investments • Describe a capital investment process • Prepare cash flow estimates • Classify projects for investment analysis • Conduct cash flow analysis, using net present value, internal rate of return, and payback period decision rules smi81240_10_c10_245-268.indd 245 3/10/14 4:55 PM 246 Section 10.1 Financial Analysis for Capital Investments Introduction Chamberlin Skilled Nursing, Inc. is concerned about its viability as a stand-alone skilled nurs - ing facility. One plan that has been put forward is to acquire Soniat Skilled Nursing, Inc., a company with a similar mission and set of services, though in a different geographic market.

The purchase of Soniat would be a substantial capital expenditure for Chamberlin. Soniat’s owners are agreeable to a plan of being acquired, if the price is right. Determining how much Chamberlin would be willing and able to pay for Soniat will require a careful capital expendi - ture analysis.

Not all capital expenditure decisions are as large and difficult as purchase of an entire business.

Many capital expenditure decisions are routine and involve the renovation or replacement of existing buildings and equipment. In any particular year, there may be many requirements for new or replacement equipment, and organizations must make decisions about which capital expenditures to make right now, and which to defer to future years. This chapter provides a financial framework for capital expenditure decision-making.

10.1 Financial Analysis for Capital Investments For the day-to-day activity of the organization, planning and budgeting focus on the oper - ating budget, as described in Chapter 7. The operating budget should be consistent with both short-run and long-run aims of the organization and be guided by the strategic plan.

It is important to have a good sense of what the aims of the organization are and how they translate into services that are offered to the community. In the short run, the plan includes expected volumes of services, expected revenues, and expected expenses. The end result of short-run planning is a pro forma income statement.

Buildings, clinical space, and medical equipment are all necessary for providing healthcare services. For short-run planning, existing facilities are taken as fixed, which may place capac - ity limits on the volume or availability of programs or services. Further, in the short run, many clinical program offerings may also be fixed. Hiring of specialized clinical personnel and rear - ranging clinical space doesn’t happen overnight. In the long run, plans are open to changing the assets and programs of the organization. The end result of long-run planning is the pro forma balance sheet of the organization.

The asset side of the balance sheet is planned through a process of capital investment deci - sion making, or capital budgeting , as the acquisition of assets requires the use of equity capi - tal or debt. Capital budgets indicate dollar amounts approved for the purchase, construction, or development of assets or programs. In aggregate, total expenditures for physical assets for healthcare organizations in the United States exceeded $103 billion in 2011. Expenditures for buildings for healthcare organizations were more than $45 billion in 2011, of which more than 80% came from private sources (as opposed to federal, state, or local governments).

Expenditures for equipment in healthcare organizations were more than $58 billion in 2011, of which more than 70% came from private sources (Centers for Medicare & Medicaid Ser - vices, 2012). The total amounts of private spending for healthcare buildings and equipment over the last decade are presented in Figure 10.1. The recession and concerns over healthcare reform have slowed the increase in private capital spending that occurred in the years leading up to 2008. Still, $75 billion in expenditures is a lot of money. Each of these dollars spent on smi81240_10_c10_245-268.indd 246 3/10/14 2:27 PM 247 Section 10.1 Financial Analysis for Capital Investments buildings and equipment for healthcare organizations was the end result of a capital invest - ment process.

Figure 10.1: Private expenditures, healthcare buildings and equipment, 2002 22011 Source: Centers for Medicare & Medicaid Services (2012). Medicare & Medicaid Statistical Supplement . Retrieved from h t t p : // www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-Reports/MedicareMedicaidStatSupp/index.html Each item in a capital budget is a capital investment. The key idea behind capital investments, each being an asset or a program, is that there is an expectation of a cash outflow in the near term, and net income from the resulting activities facilitated in the long term. For some capital investments, like a renovation to expand a clinic, expenditures may happen quickly, and net income may be earned in the same year. For other capital investments, like the con - struction of a new outpatient building, expenditures may occur over several years, with sev - eral more years of creating programs that eventually result in positive net income. For some capital investments, there are only expenses without any net income, as is the case with new information systems.

As noted in Chapter 8, corporate finance involves preparation of information for making deci - sions about asset acquisition and other long-term investment decisions. Therefore, the analy - sis of individual capital investments, the capital budget, and the planned balance sheet are important products of corporate finance. This chapter will present the finance contributions toward capital investment decisions and budgeting. It will present a framework for consid - ering capital investments, focusing on cash flow analysis and decision rules for undertaking investments. The full capital expenditure budget will then be developed, with a focus on capi - tal budgeting in not-for-profit organizations that may face financing constraints. Year 10 0 2009 2008 2002 2003 2004 2005 2006 2 011 2 010 2007 30 80 50 20 40 60 70 90 10 0 Equipment Buildings Dollars (in Billions) smi81240_10_c10_245-268.indd 247 3/10/14 2:27 PM 248 Section 10.2 A Capital Investment Process For Review: 1. What is the focus on capital investment decision making?

Capital investments are long-run decisions. The focus is on the acquisition of assets or programs that will involve expenses in the short run and, for many investments, net income in the long run. The financial statement of importance is the balance sheet. 10.2 A Capital Investment Process Just as organizations develop processes for operating budgets, processes are required for capital investments. A depiction of the process for capital investments is provided in Figure 10.2. All investments start with strategy. A strategy is a pattern of decisions that organizations make over time. The key to effective long-run strategy is that the pattern of decisions is con - sistent and positions an organization to be unique in the marketplace. Long-run strategy is highlighted in the next section. With a strategy in mind, the next step in capital investments is to identify assets and programs, collectively called projects, in which the organization might make long-term investments. For certain large-scale projects, such as the purchase of a com - pany in the same general business, the idea for the capital expenditure may be a direct result of the strategic planning process. Chamberlin Skilled Nursing’s plan for the purchase of Soniat Skilled Nursing is a direct result of a strategic intent to grow and diversify its facility hold - ings. For other projects, the source may be a department’s need to replace aging or outdated equipment, or a clinical group’s interest in having more space or equipment, or offering a new service. Given the multitude of ways in which individuals, departments, and groups of depart - ments might generate ideas for projects, organizations generally define a process for making decisions on the use of scarce resources for capital expenditures.

Figure 10.2: Capital investment process Strategy Identify Monitor Estimate Decide smi81240_10_c10_245-268.indd 248 3/10/14 2:27 PM 249 Section 10.2 A Capital Investment Process Step 1: Identify A traditional capital investment process in healthcare organizations includes four steps: iden - tify, estimate, decide, and monitor. The first step is to identify and classify projects for con - sideration. For larger healthcare organizations that have a large number of potential projects, this step may involve the submission of proposals. At Bixby Hospital, a capital request form is required for all potential capital expenditures. The cover page for the request form is pre - sented as Exhibit 10.1. The form starts with the identification of the department making the request, and the name of the equipment being proposed for purchase or the title of the proj - ect being proposed for development. Preparation of a full proposal may generate substantial information for decision makers. For purposes of initial review and ultimate presentation of an approved project, a brief description is also required.

Exhibit 10.1 Capital request form, cover page, Bixby Hospital, 2012 Department:

Name of Equipment or Title of Project:

Brief Description: (maximum 1 page if attached) Amount Requested Cost of Project/Equipment: $ Cost of Internal Installation Costs (current employees): $ Cost of Marketing (if new services): $ Total Amount Requested: $ Purchasing Review of Quotes for Price Comparison? Date: Expected Useful Life (Years):

Maintenance Annual Expense: $ Disposable Components Annual Expense: $ Justification New Purchase/Replacement:

Disposition of Current Equipment: Trade-in/Parts/Sale: $ Purpose (Patient Care, Productivity, Financial, Other):

Brief Description (maximum 1 page if attached):

Capital Investment Decision Equipment/Project Approved in Capital Budget If YES, Total Amount Approved: $ If NO, Brief Reason:

Approvals Administrator Physical Plant Committee Biomedical Engineering Committee Supply Chain Committee Infection Control Committee Regulatory Affairs (certificate of need) Marketing and Planning Other Source: Author. smi81240_10_c10_245-268.indd 249 3/10/14 2:27 PM 250 Section 10.2 A Capital Investment Process An ideal description also classifies each project as being dependent upon the approval of other projects, independent of other projects, or mutually exclusive of other projects under consideration. Dependent projects should clearly indicate the nature of the relationships with other projects and any timing issues. For example, the purchase of magnetic resonance imag - ing (MRI) equipment is dependent upon having an appropriate location in the building. The space for an MRI requires lead shielding for radio frequency, vibration resistance, appropri - ate electrical power, heating, ventilation, and air conditioning, and plumbing for an MRI cool - ing unit. If the purchase of the MRI and space renovation are separate projects for approval purposes, their connection as dependent projects must be clearly identified. And space reno - vation needs to occur first.

Independent projects do not have identified relationships to other capital expenditures.

Independence among projects doesn’t necessarily mean independence from other budget decisions. Purchase and installation of an MRI requires the hiring of technicians and per - haps other personnel, which may be dependent upon the operating budgeting process. An important note here is that after capital expenditures have been made, the resulting activity becomes part of the operations of the organization, and all financial results become part of the operating budget. For this reason, approval of capital budgets often occurs before the approval of operating budgets, permitting time for the financial implications of new projects to be included in the operating budget.

Mutually exclusive projects are those that involve selection of one proposed project or another, or neither, not both. Proposals for the purchase of used MRI equipment and new MRI equipment, for an existing space, is a case of mutually exclusive projects. The organi - zation may select between the two projects. Some instances of mutually exclusive projects may be less obvious. A proposed sleep lab and an additional MRI might each seek to use the same space in the building. Unless both proposals are quite specific in their identification of the space in the building to be used, it may be possible to approve both projects, purchase equipment, and then discover that both projects aren’t feasible because the space has been approved for two purposes.

Step 2: Estimate The second step in the capital investment process is to estimate cash flows and the riskiness of the cash flows. Again, most capital investments involve the purchase of equipment or other assets and expenditures for project development early in the timeline. The cover sheet of the form includes amounts for the initial cost of the project, including amounts associated with the use of current Bixby employees to install the equipment or otherwise get the project started. The cost of current employees isn’t a new expenditure. The costs of current employ - ees are included on the form to indicate the opportunity cost of other activities that those employees could be pursuing were it not for the new project.

To satisfy good control procedures, healthcare organizations may have purchasing depart - ments that coordinate all purchasing activities and obtain price quotes for all purchases above a stated threshold. For small organizations, multiple quotes may be requested for comparison purposes at a level of $1,000. For large organizations, thresholds may be $5,000, $10,000, or more. For the purchase of MRI equipment, it may be required that several quotes for prices be obtained for equipment within certain specifications (magnetic power and other issues). smi81240_10_c10_245-268.indd 250 3/10/14 2:27 PM 251 Section 10.2 A Capital Investment Process Development of estimates of cash flows on the revenue side involves coordination with mar - keting and planning personnel. Finance personnel can be expected to have good insights on the expenses associated with new equipment and programs. They can’t always be expected to have expertise in forecasting the volumes of services associated with new equipment and programs. This is the area of expertise of personnel in marketing and planning.

The riskiness of the cash flows can be incorporated into analyses in two ways. First, orga - nizations may prepare alternative forecasts of cash flows to understand the sensitivity of alternative assumptions about the functioning of a project on its cash flows. Second, the dis - count rate used to evaluate future cash flows may be adjusted to account for the riskiness of a project. These methods are discussed further in this chapter.

Step 3: Decide The third step in the capital investment process is the decision. Organizations often have dif - ferent criteria for decision making with new projects, as opposed to replacement projects. If the useful and technologically appropriate life span for an MRI is 10 years (perhaps with a life span of seven years in depreciation for financial accounting), an organization nearing the 10-year point may examine the costs of new equipment. If new equipment will merely replace existing equipment, there may be little uncertainty about other cash flows, and the decision may be made without much additional information.

For new projects, justification for the project must be included. The ideal justification includes consideration of how the project enables the healthcare organization to fulfill its aims and technical information on the proposed expenditure. Among the goals of a healthcare organi - zation are those related to patient care, which would be justification for new medical equip - ment or clinical program expenditures. Enabling new or better ways to treat patients is often a good justification for medical projects.

Productivity improvement and purely financial reasons are also reasonable justifications for new projects. Information system upgrades that permit faster data entry or retrieval, which can reduce the time spent by clinical personnel, may be good projects to improve productiv - ity. Accounts receivable system upgrades that accelerate payments may be justified purely on the basis of positive net cash flows.

Healthcare organizations may also have criteria for project approval beyond improving patient care, productivity, and financial results. Other justifications for project acceptance may include improving patient satisfaction, improving provider satisfaction, and providers’ financial results, independent from the finances of the organization, and improving commu - nity goodwill. A key aspect of good financial management is to be clear about the criteria for project approval. Projects that are proposed on the basis of financial results, that are actually accepted to keep one particular provider satisfied, may result in many wasted hours of analy - sis during the monitoring phase as they fail to provide expected financial results.

The final part of the decision-making step is the decision. Capital investment decisions are sometimes clearly yes or no, but they more often involve the use of a scoring system. Based upon an organization’s mission and strategy, the elements of a scoring system might include categories that represent the highest priorities: ensure patient/employee health and safety, smi81240_10_c10_245-268.indd 251 3/10/14 2:27 PM 252 Section 10.2 A Capital Investment Process improve quality (clinical outcomes, patient satisfaction), improve productivity, increase vol - ume and market share, and ensure financial health (Lyons, Gumbus, & Bellhouse, 2003). Proj - ects may be ranked by a scoring system and funded starting at the top of the list and going down until available funds are exhausted.

If a project is approved, project timing, the dollar amount of the approval, and the specifica - tion of any additional constraints on the use of funds are included in the communication of the decision. If a project is denied, good management practice dictates that a brief reason be provided. In some cases, there may be financial constraints that led to a denial for the current capital budget and permit the project to be reconsidered for a future capital budget. The score for a project may have been good, but there were other projects with higher scores. In other cases, the project may not be viewed as a good fit with the organization’s strategy, or it may be determined that it does not provide an adequate financial return on investment. The score for a project may be sufficiently low and would never be funded. In these cases, the project is simply denied.

Providing honest reasons for project denial may require tact. Suppose that a project for the renovation of a waiting area is proposed with the justification of improving satisfaction with a particular clinician. A denial of the project does not necessarily mean that the organization is not interested in the satisfaction of the provider. It may be that provider satisfaction is very important and that in the current year purchases of replacement medical equipment were a higher priority. Nobody likes to hear that something, or someone else, is a higher priority, so tact is important. Analyze This How would you explain to an important physician that a project to renovate the waiting room outside of her clinic was denied? What information would you share with the physician? Step 4: Monitor The decision is the end of the third step, and the start of the fourth step in the capital invest - ment process. Before budgetary approval, approval by other aspects of management and perhaps outside parties may also be required. Department administrators, who may be held accountable for the achievement of project goals, must approve projects. Individual program managers may be permitted to propose projects, but not without the approval of the lead administrator. Once approved, monitoring and control of the budget falls under the control of the administrator. Similarly, a host of other managers may be required before approval.

For example, if a project requires specialized supplies, the office of procurement or a supply chain committee may be asked if the plan for supplies can be provided as stated in the plan and whether the plan has any implications for current use of supplies.

For projects that involve large purchases or construction that fall under the authority of state- level certificate of need programs, there may be a series of official approvals that are also required. Certificate of need programs still operate in many states as a means to limit con - struction and purchases of equipment as a means of controlling the growth in healthcare costs (Cauchi, 2009). smi81240_10_c10_245-268.indd 252 3/10/14 2:27 PM 253 Section 10.2 A Capital Investment Process Postapproval reviews are a component of the capital budgeting process in many organiza - tions and may be used as additional opportunities for decision making on the continuation of projects. They may also be used as analyses of the capital budgeting process itself. Based upon postapproval reviews, organizations may learn more about what should be included on the capital budget request form, so the right questions are asked early in the process.

Organizations may also learn how to improve on cash flow estimation techniques. Too often, projects are approved with no follow-up to determine whether the capital budget process is working properly and leading toward a more effective healthcare organization.

The finance contributions to the second and third steps are expanded upon in later sections.

Estimating cash flows is perhaps the most important role for financial managers, and the most difficult. Decision making typically involves an assessment of financial results, even if they are not the primary justification for a project. Before these finance contributions are explained, an explanation of long-run strategy is presented.

Long-Run Strategy The strategy of a healthcare organization is the plan by which it intends to achieve its aims.

The term plan does not refer to the operating budget or the capital budget. A strategy, or a strategic plan, refers to the patterns of decisions that the organization will make over time.

The key to effective long-run strategy is that the pattern of decisions will be consistent and position an organization to be unique in the marketplace. Effective long-run strategies often involve not following what all other organizations are doing but doing something unique.

Among the decisions to be made in the development of an organization’s strategy are the strategic positions to be taken. At least three strategic positions are available, each with unique implications for capital budgeting: need-based, variety-based, and access-based (Porter, 1996). Briefly, needs-based positioning involves addressing the specific needs of a target population. To some extent, most healthcare organizations adopt needs-based posi - tioning by focusing on those persons in a population in ill health. Needs-based positioning will lead toward decision making based upon having a range of medical services and address - ing community needs that go beyond narrowly defined medical needs to consider the health status of the community.

As with each strategic position, needs-based positioning involves making trade-offs among projects. Needs-based positioning is a challenge for any organization, as there are limits on the extent to which the complete set of needs of any population can be met, even the complete set of medical care needs. For a healthcare organization following a needs-based position - ing strategy, some projects that would provide a higher level of medical service for a narrow population may be denied in favor of a project that addresses a broader population. It can be difficult to make decisions among clinical areas on the basis of which is more appealing to a broader population, as it is not often clear which clinical area is more appealing, as appeal may well go beyond frequency of occurrence. One provision of the Patient Protection and Afford - able Care Act is that every not-for-profit must conduct a community health needs assessment and create a plan to meet these identified health needs. This assessment can solicit informa - tion on community interests and need, beyond traditional medical needs.

Variety-based positioning involves providing specific and unique services, with a focus on the quality and effectiveness of the service. By definition, healthcare organizations adopt variety-based positioning by providing medical services. The particular health conditions smi81240_10_c10_245-268.indd 253 3/10/14 2:27 PM 254 Section 10.3 Cash Flow Estimation being addressed are the differentiating features of different types of healthcare organizations.

Many organizations, or units within organizations, target a set of services. Variety-based posi - tioning may lead toward decision making based upon having a narrow set of medical services provided in an outstanding manner.

Access-based positioning places the focus of attention on access, which can be broadly defined in healthcare to include affordability, availability, accessibility, accommodation, and acceptability (Wyszewianski & McLaughlin, 2002). Affordability is affected both by charges and insurance coverage. Availability is affected by the presence of providers and resources to meet patients’ needs. Accessibility is the geographic reach of the organization. Accom - modation is affected by how patients’ constraints are met, particularly those related to time of service and waiting times. Acceptability reflects the interpersonal relationships between employees of the organization and patients. Access-based positioning may be associated with efforts to develop exclusive contracts with managed care organizations and efforts to main - tain broadly based facilities. Advertisements concerning emergency department wait times are a reflection of access-based positioning. Even within aspects of access, healthcare organi - zations are faced with trade-offs for capital budgeting.

Again, strategy involves patterns of decisions that are consistent and position an organization to be unique in the marketplace. Some trade-offs among positions are necessary and a key component of strategy. Should the organization focus on the broad interests of the commu - nity and health status, on the focused set of services it is capable of offering, or on the acces - sibility of those services? The ideal answer might be all of the above. The feasible answer is that choices must be made, and it is those choices that reveal strategy. From a purely financial framework, organizations should make choices on the basis of the highest sustainable level of profitability. It is not obvious how choices should be made for not-for-profit healthcare organizations that use other decision-making frameworks. What is often important is that independent of selected sets of positions, operational efficiency results from maintaining a focus on those positions.

For Review: 1. What are the four steps in the capital investment decision-making process? Which step is most important?

The capital investment decision-making process includes identifying possible invest - ments, estimating cash flows, deciding on which to fund, and monitoring results.

These steps should start with and tie back to the organization’s strategy. All steps are important. 10.3 Cash Flow Estimation Cash flow estimation is the tough work of finance and operations personnel in capital invest - ing. The definition of a project and careful assessment of the purchase price and implementa - tion cost enable a clear understanding of the cash outflows required to start a project. Further, requiring a statement on the disposition of current equipment, through trade-in, disassembly to sell parts, or full outright sale, may reduce the cash outflow or generate cash inflow at the start of a project. Still, Time 0 costs are often a small portion of the entire series of cash flows associated with projects. smi81240_10_c10_245-268.indd 254 3/10/14 2:27 PM 255 Section 10.3 Cash Flow Estimation Consider a clinic’s proposed project that will cost $300,000 on renovations to an examination room that will allow more patients to be seen. The next step in cash flow estimation is to con - sider the length of the timeline, which may be specified as part of the proposal. Suppose that the timeline is four years. The first timeline shows that $300,000 may need to be spent right now, at Time 0.

The next step in cash flow estimation is the net cash flow that will occur each year during the lifetime of the examination room project. Part of this estimation may be enabled by informa - tion in the request form. Annual expenses associated with routine maintenance, or a mainte - nance contract, and disposable components may be prespecified. The part of this estimation that requires the most work is the estimation of the volume of services, the price per unit of service, and the cost per unit of service, remembering that there may be both fixed and vari - able costs.

Perhaps the most challenging aspect of cash flow estimation is the volume of patients. For the clinic, marketing and planning personnel may be asked to conduct an extensive analysis of patients in the community and the regional trends in use of services. It was estimated that an average of 30 patient visits per day would be treated in the new examination room, which is 10,950 patient visits per year (30 3 365). The planned charge for clinic services to be provided in the new examination room was estimated to be $100. Discussions with local insurance companies and managed care organizations revealed that they would only be will - ing and able to pay a bit more than 25% of this amount, for an average revenue of $76 per patient. Some portion of the amount approved by payers would be charged to the patient as a copayment, and all copayments would be collected at the point of service. Time 0 ($300,000) Time 1 Time 2 Time 3 Time 4 Analyze This Of the $76 per patient, a copayment of $20 may be expected. If only 80% of patients pay their copayment, what is the expected revenue per patient? How would you increase the percentage of patients who pay their copayment? Revenues and costs for the examination room project can be displayed on the timeline as follows: Element ($300,000) ($300,000) $832,200 ($250,000) ($438,000) $144,200 $832,200 ($250,000) ($438,000) $144,200 $832,200 ($250,000) ($438,000) $144,200 $832,200 ($250,000) ($438,000) $144,200 Revenue Fixed Cost Variable Cost Operating Income Time 0 Time 1 Time 2 Time 4 Time 3 smi81240_10_c10_245-268.indd 255 3/10/14 2:27 PM 256 Section 10.3 Cash Flow Estimation The first row is the revenue per year. For 10,950 patients at $76 per patient visit, total net patient revenue is $832,200 per year. This is a simplification of what a full set of revenues might be for the new examination room. The number of patient visits may increase or decrease, and the revenue per patient is subject to change by governmental payers and nego - tiation by insurance companies and managed care organizations.

The second and third rows are the cost of the new examination room. Costs for operating the room are estimated to be $250,000 per year in fixed costs associated with the clinic manager and other services, and variables costs that average $40 per patient for all other personnel and supplies (10,950 patients 3 $40 per patient 5 $438,000). Costs of salaries and supplies may also change over time.

The third row is the operating income for each year the new examination room is used. At time 0 there is only the initial investment of $300,000. In each year there is an operating income of $144,200.

Operating income 5 $832,200 revenues 2 $250,000 fixed costs 2 $438,000 variable costs 5 $144,200 From Chapter 3, the operating margin ratio considers operating income as a percentage of net patient revenues: Operating margin 5 $144,2 00 $8 32,2 00 3 100% 5 17.3% Each of the values in this presentation can be considered in analyses that consider alternative assumptions. For example, the clinic may consider best-case or worst-case alternatives to the volume, revenues, and cost assumptions of the new examination room. Such an analysis may provide more insight to decision makers on the value of this project. Still, the initial set of volume, revenue, and cost projections might be a reasonable starting set of values for a finan - cial analysis. The next step is to determine the type of analysis that will be conducted and the decision rules for the analysis. Analyze This As a worst-case possibility, volume may be only 10,000 patient visits per year in the new exami - nation room. If the revenue per patient, fixed cost, and cost per patient visit projections were accepted, what would be the total revenues, total costs, and operating income for the clinic’s examination room project? For Review: 1. Who should be involved with the estimation of cash flows?

Finance personnel should be involved with the estimation of cash flows, particu - larly the estimation of expenses and revenue per patient. Marketing, planning, and clinical personnel should be involved with the estimation of the number of patients, which directly relates to both revenues and expenses. smi81240_10_c10_245-268.indd 256 3/10/14 2:27 PM 257 Section 10.4 Decision Rules for Capital Investments 10.4 Decision Rules for Capital Investments As you have seen, the third step in capital investing is decision making. After determining which projects to evaluate and preparing estimates of cash flows, a decision must be made.

Has a proposal for a capital investment presented a case that merits approval, or will the proposal be denied? Making capital expenditure decisions requires the selection and applica - tion of a decision rule . Decision rules are criteria for capital project investments that should be fair and transparent, leading to a consistent selection of projects that support the growth and viability of the organization. The unique contribution of finance is the assessment of the financial results of a project.

As introduced in Chapter 8, when the cash amounts are different among time periods, it is necessary to separate them and calculate the values for each one. In the case of capital invest - ments, there may be negative cash flows associated with the initial investments. The timeline and cash amounts each year for the examination room project are presented on the spread - sheet in Exhibit 10.2. The investment of $300,000 is in Time 0. The simple sum of the net income amounts in time periods 0 through 4 is $276,800. This simple sum of the net income amounts in this does not recognize of the time value of money.

Exhibit 10.2 Spreadsheet calculation of cash flows, clinic examination room project A B C D E F 1 2 3 Time Capital Investment Net Patient Revenues Fixed Costs Variable Costs Net Income 4 0 ($300,000) ($300,000) 5 1 $832,200 ($250,000) ($438,000) $144,200 6 2 $832,200 ($250,000) ($438,000) $144,200 7 3 $832,200 ($250,000) ($438,000) $144,200 8 4 $832,200 ($250,000) ($438,000) $144,200 9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000) $276,800 10 11 Source: Author’s calculations.

To recognize the time value of money, the present value of each year’s cash flows can be cal - culated. The inclusion of the cash flow initial investments ( C0) along with the present value of the net cash flows each year ( Ct) yields the net present value (NPV) of a project. This is quite commonly the case, and the equation is written as NPV 5 a T t 5 1 (Ct 4 (1 1 r)t ) 2 C0 where the summation function ( ∑ ) is taken from the first time period (1) until the last time period ( T). For each cash amount, the discounting recognizes the number of time periods involved ( t). From Chapter 9, the appropriate rate ( r) at which to discount the net cash flows smi81240_10_c10_245-268.indd 257 3/10/14 2:27 PM 258 Section 10.4 Decision Rules for Capital Investments of each period is the weighted average cost of capital ( WAC C ). The process of discounting cash flows recognizes the time value of money and the organization’s opportunity cost of the use of funds for investment in projects.

The NPV decision rule is to select projects based upon NPV, with a requirement that NPV be greater than or equal to zero. A project that achieves NPV 5 0 provides a rate of return on the investment of r, the WACC. By using the rule of NPV $ 0, the organization assures that accept - ing projects with accurately estimated cash flows contributes toward financial viability.

The discount rate for the examination room project and the NPV calculation are presented on the spreadsheet in Exhibit 10.3. With a WACC for this clinic of 14% (using the methods devel - oped in Chapter 9), the NPV of the clinic project is $120,157. This amount reflects the NPV of net income in years 1–4, less the capital investment. Again, using the NPV rule to accept proj - ects with NPV $ 0, the clinic should accept the project and move forward to allocate $300,000 for renovation of the space and purchase of the equipment, pending the approval of an overall budget for capital expenditures and the analysis of all other proposed projects.

Exhibit 10.3 Spreadsheet calculation of net present value, clinic examination room project A B C D E F 1 Rate 14% 2 3 Time Capital Investment Net Patient Revenues Fixed Costs Variable Costs Net Income 4 0 ($300,000) ($300,000) 5 1 $832,200 ($250,000) ($438,000) $144,200 6 2 $832,200 ($250,000) ($438,000) $144,200 7 3 $832,200 ($250,000) ($438,000) $144,200 8 4 $832,200 ($250,000) ($438,000) $144,200 9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000) $276,800 10 11 NPV $120,157 5NPV(B1,F5:F8) + F4 Source: Author’s calculations.

The NPV decision rule is useful for making decisions about individual projects, as well as for making decisions among projects when they are mutually exclusive or when there are limits on the total capital budget for the year. Consider the alternative uses of the space that may be considered for the clinic. One use is to increase the size of the waiting room for a neighboring service, thereby increasing the number of patients that can be seen by that service. The wait - ing room project has an initial investment cost of only $135,000. Having additional waiting room space, assuming that there is also sufficient clinical capacity, will permit 10 additional patient visits per day (10 visits per day 3 365 days 5 3,650 visits per year) with average net revenue of $75 per visit and average variable cost of $55 per visit, with no change in fixed costs. The NPV calculation for the waiting room project is presented in Exhibit 10.4. smi81240_10_c10_245-268.indd 258 3/10/14 2:27 PM 259 Section 10.5 Decision Rules Beyond Net Present Value Exhibit 10.4 Spreadsheet calculation of net present value, waiting room project A B C D E F 1 Rate 14% 2 3 Time Capital Investment Net Patient Revenues Variable Costs Fixed Costs Net Income 4 0 ($135,000) ($135,000) 5 1 $273,750 ($200,750) ($0) $73,000 6 2 $273,750 ($200,750) ($0) $73,000 7 3 $273,750 ($200,750) ($0) $73,000 8 4 $273,750 ($200,750) ($0) $73,000 9 Total ($135,000) $1,095,000 ($803,000) ($0) $157,000 10 11 NPV $77,701 5NPV(B1,F5:F8) + F4 Source: Author’s calculations.

The NPV decision rule indicated accepting the projects with the highest NPV among projects with NPV $ 0. The clinic would like to accept both the clinic project and the waiting room project, as they each provide net present values in excess of zero, in fact in excess of $75,000.

With the limitation that the space can only be used for one of these two projects (mutually exclusive), the NPV of the examination room project is $42,456 more than the waiting room project ($120,157 2 $77,701). For Review: 1. If the net present value of a project is less than half of the sum of the cash flows from the project, does this mean that the project is not worthwhile?

The net present value calculations use the present value function for the cash flows that occur each year. The net present value of a project will be lower than the sum of cash flows whenever the discount rate is greater than zero. The fact that the sum of cash flows might be less than half of the net present value is not important. In the example of the examination room, the sum of the cash flows was $276,800, and the net present value was $120,157, and yet this is a worthwhile project. 10.5 Decision Rules Beyond Net Present Value The net present value rule of accepting projects with NPV $ 0 produces consistent results of accepting projects that sustain or improve the financial results of the organization. It is always recommended that NPV calculations be performed and the results assessed. Three additional financial decision rules are also often used: accounting rate of return (ARR) , internal rate of return (IRR) , and payback period . These rules do not improve upon the NPV rule. Instead, other possible returns provide more information that may be helpful to decision makers. smi81240_10_c10_245-268.indd 259 3/10/14 2:27 PM 260 Section 10.5 Decision Rules Beyond Net Present Value Accounting Rate of Return The accounting return, quite simply, is the nominal net of cash inflows and cash flows. It is equal to an NPV analysis where the discount rate is zero. It should be clear that by not taking into account the time value of money, the accounting return overstates the values of the cash flows from projects. Still, the numbers produced by an organization’s accounting system are clear and defensible. Using the accounting return, the accounting rate of return (ARR) is the average accounting net income per year, divided by the capital investment, as written in the ARR equation: ARR 5 a T t 5 1 (Net income t 4 T) 4 Investment 0 The calculations of the accounting return and ARR for the examination room project are presented in Exhibit 10.5. With an accounting return of $276,800, the sleep center project has an ARR of 37.7%. In this presentation, the capital investment is not included as a cash flow in Time 0. To be consistent with accounting calculations of net income, the depreciation expense associated with the capital investment is included for each year. The depreciation expense is calculated using the straight-line method of depreciation, over the four-year use - ful life of the assets.

Exhibit 10.5 Spreadsheet calculation of the accounting rate of return, examina - tion room project A B C D E F 1 Capital Investment $300,000 2 3 Time Net Patient Revenues Fixed Costs Variable Costs Depreciation Expense Net Income 4 1 $832,200 ($250,000) ($438,000) ($75,000) $69,200 5 2 $832,200 ($250,000) ($438,000) ($75,000) $69,200 6 3 $832,200 ($250,000) ($438,000) ($75,000) $69,200 7 4 $832,200 ($250,000) ($438,000) ($75,000) $69,200 8 Total $3,328,800 ($1,000,000) ($1,752,000) ($300,000) $276,800 9 10 ARR 23.1% 5(F8/A7)/C1 Source: Author’s calculations.

The decision rule for ARR is to select projects that have a calculated ARR greater than or equal to the organization’s required ARR ( ARR R), where the subscript R refers to a particular organization’s required return. What is the ARR R for this clinic? The second limitation on the use of the ARR decision rule, after the failure to account for the time value of money, is the lack of an accepted method of determining an organization’s required ARR. There is no generally accepted method for determination of ARR R; it would have to be a decision made by the board of directors. smi81240_10_c10_245-268.indd 260 3/10/14 2:27 PM 261 Section 10.5 Decision Rules Beyond Net Present Value A third limitation of the ARR decision rule is the use of accounting data. Accounting data fol - low accrual methods that may result in different values than the cash method. To the extent that accrual differs from cash flows, which is potentially the case depending on the timing of investments, other costs, and receipts of payments for services, the results of ARR will differ from those using NPV methods.

A fourth limitation associated with ARR is that it does not provide useful results when select - ing among mutually exclusive projects of different sizes. Consider again the waiting room project. As presented in Exhibit 10.6, the waiting room project has an ARR of 29.1%, which is larger than the 23.1% ARR on the examination room project. If the 23.1% return on the examination room is thought to exceed ARR R, the clinic would prefer to approve both projects. Since there is only enough space for one project, one decision rule must be selected. Again, the NPV of the examination room project is $42,456 more than the waiting room project. Irre - spective of the ARR calculations, the examination room results in more money that the clinic can devote to other purposes.

Exhibit 10.6 Spreadsheet calculation of the accounting return and accounting rate of return, waiting room project A B C D E F 1 Capital Investment $135,000 2 3 Time Net Patient Revenues Variable Costs Fixed Costs Depreciation Expense Net Income 5 1 $273,750 ($200,750) ($0) ($33,750) $39,250 6 2 $273,750 ($200,750) ($0) ($33,750) $39,250 7 3 $273,750 ($200,750) ($0) ($33,750) $39,250 8 4 $273,750 ($200,750) ($0) ($33,750) $39,250 9 Total $1,095,000 ($803,000) ($0) ($135,000) $157,000 10 11 ARR 29.1% 5(F9/A8)/C1 Source: Author’s calculations.

Limitations notwithstanding, the accounting returns and ARR are commonly used measures when describing projects. Postproject reviews may rely upon accounting information and are therefore informed by the financial expectations at the time of approval. Further, communi - cating an ARR can help persons unfamiliar with corporate finance. Earning net present value of $120,157 sounds good, but out of context it may be difficult to interpret how good this is for an investment. When stated as a 23.1% accounting rate of return, it may have an intuitive appeal beyond the dollar amount.

Internal Rate of Return The internal rate of return is another return measure that could be used as a decision rule.

The IRR is the discount rate ( r) that results in a NPV of zero. Using the NPV equation, it is pos - sible through a process of trial and error to find the value of r that yields NPV 5 0. Due to the smi81240_10_c10_245-268.indd 261 3/10/14 2:27 PM 262 Section 10.5 Decision Rules Beyond Net Present Value potentially tedious nature of trial-and-error calculations, specialized financial calculators and electronic spreadsheets include preprogrammed functions to calculate the IRR. Calculation of the IRR for the examination room project is presented in Exhibit 10.7.

Exhibit 10.7 Spreadsheet calculation of internal rate of return, examination room project A B C D E F 1 Rate 14% 2 3 Time Capital Investment Net Patient Revenues Fixed Costs Variable Costs Net Income 4 0 ($300,000) ($300,000) 5 1 $832,200 ($250,000) ($438,000) $144,200 6 2 $832,200 ($250,000) ($438,000) $144,200 7 3 $832,200 ($250,000) ($438,000) $144,200 8 4 $832,200 ($250,000) ($438,000) $144,200 9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000) $276,800 10 11 IRR 40.0% 5IRR(F4:F8) Source: Author’s calculations.

The IRR calculated for the sleep lab is 40.0%. Note that this value is greater than both the ARR (23.1%) and the discount rate (14%). The IRR is greater than the ARR because that determi - nation of accounting income includes depreciation of the investment as an expense, lowering net income. The IRR calculation does not include depreciation expenses. The IRR takes into consideration the time value of money and, therefore, is a lower percentage than would have been calculated by the ARR if depreciation expenses were not included. Analyze This What is the IRR of the waiting room project, using the values provided in Exhibit 10.6? What is the relationship between the ARR and IRR for the waiting room project? From the Front Lines It is important that all investments in our system have a strong internal rate of return and net present value with discount rates of 12215%. We aren’t in a place where we can afford to “swing and miss.” Source: Health system financial manager. The decision rule for IRR is to select projects that have a calculated IRR greater than or equal to the organiza - tion’s required IRR ( IRR R), where the subscript R refers to an organization’s required return. What is the IRR R for Bixby Hospital? A limitation on the use of the IRR decision rule, as with the ARR, is the lack of an accepted method of determining an organization’s required IRR.

If IRR R is the discount rate, as determined by the WACC, then it is not necessary to solve the NPV equation for r. The NPV of the project can be calculated directly. The smi81240_10_c10_245-268.indd 262 3/10/14 2:27 PM 263 Section 10.5 Decision Rules Beyond Net Present Value other limitation associated with IRR is that it does not provide useful results when selecting among mutually exclusive projects of different sizes, just the same as the ARR.

Since the IRR results in a decision rule that is closer to NPV than the ARR decision rule, it is also a commonly used measure when describing projects. Earning net present value of $120,157 sounds good, but out of context it may be difficult to interpret how good this is for an investment. When stated as a 40.0% internal rate of return, it may have an intuitive appeal beyond the dollar amount.

Payback Period Another alternative decision rule for capital expenditure analysis is the payback period (Pay - back). The Payback is that length of time until the net income earned on a project exceeds the initial investment. Calculation of Payback requires preparation of the same cash flows as net present value and internal rate of return. The calculation of net income for the examination room is presented in Exhibit 10.8, along with the calculations of the cumulative amount of net income each year. The examination room earns back the initial investment before the end of year 2.

Exhibit 10.8 Spreadsheet calculation of payback period and discounted payback period, examination room project A B C D E 1 Rate 14% 2 3 Time Net Income Cumulative Net Income Present Value of Net Income Cumulative Net Income 4 0 ($300,000) ($300,000) 5 1 $144,200 ($155,800) $126,491 ($173,509) 6 2 $144,200 ($11,600) $110,957 ($62,552) 7 3 $144,200 $132,600 $97,331 $34,779 8 4 $144,200 $276,800 $85,378 $120,157 9 Total $276,800 $120,157 10 Payback Time 2 Time 3 Source: Author’s calculations.

The cumulative net income is the net income as of each time period. In Time 1 cumulative net income is the net income in Time 1, plus the initial investment ($144,200 1 ($300,000) 5 ($155,800) ). At the end of the first year, the examination room project has almost paid back half of the initial investment cost. In Time 2 cumulative net income is the net income in Time 2, less the amount that has just been calculated as the cumulative net income in Time 1 ($144,200 1 ($155,800) 5 ($11,600) ). At the end of Time 2, the examination room has almost paid back the entire initial investment cost. By the end of Time 3, the project is ahead by $132,600, and by the end of Time 4, the project has earned $276,800.

The cumulative net income associated with the present value amounts followed the same logic of calculations, with the difference that each year’s net income is discounted back to Time 0 using the clinic’s discount rate. smi81240_10_c10_245-268.indd 263 3/10/14 2:27 PM 264 Summary & Resources The decision rule for Payback is to select projects that have a calculated Payback less than or equal to the organization’s required Payback (Payback R), where the subscript R refers to an organization’s required return. What is the Payback R for the clinic? A limitation on the use of the Payback decision rule, as with the IRR and ARR, is the lack of an accepted method of deter - mining an organization’s required Payback. Wanting projects to earn back their investments sooner is a good idea, but it does not result in a clear decision rule. The other limitation asso - ciated with Payback is that it does not provide useful results when selecting among mutually exclusive projects of different sizes, just the same as the IRR and ARR. Analyze This What is the Payback of the waiting room project, using the values provided in Exhibit 10.6? A limitation of Payback that is easily overcome is the failure to account for the time value of money. As demonstrated in Exhibit 10.8, the present value of net income each year can be substituted for the nominal value. Calculation of the adjusted payback period follows the same methods of finding that time period when the cumulative amount of net income earns back the initial investment. In the case of the sleep lab for Bixby Hospital, the adjusted pay - back period is also before the end of year 3.

Since Payback provides interesting information, it is a commonly used measure when describ - ing projects. Again, earning net present value of $120,157 sounds good, but out of context it may be difficult to interpret how good this is for an investment. When stated that the project pays back in the investment in fewer than three years, it may have an intuitive appeal beyond the dollar amount.

For Review: 1. Which of the decision rules, net present value, ARR, IRR or Payback makes the most sense to you?

Different people will provide different answers to this question. The NPV calculation provides a specific dollar amount of value, which may make sense to many people.

The percentage rates of ARR and IRR will make sense to people who think about how investments are often presented. The payback period will make sense to people who are concerned about when the investment return will occur. Summary & Resources Chapter Summary This chapter has introduced the concepts and tools required for effective capital budgeting.

Capital budgeting is the process by which organizations propose, analyze, and select invest - ments in long-term assets and programs. Some decisions on the total level of long-term assets that can be purchased within a year are made at the highest levels within the organization.

Due to external constraints imposed by lenders or capital markets, or internal constraints imposed by senior managers or the board of directors, many organizations establish capital budgets that represent the total amount that an organization could spend, if there are a suf - ficient number of worthwhile projects. smi81240_10_c10_245-268.indd 264 3/10/14 2:27 PM 265 Summary & Resources Making good capital expenditure decisions is critical to every organization. Capital expendi - ture decisions affect the facility and equipment with which to provide healthcare services, and they affect the development of new programs. These decisions affect the capabilities of the organization for years in the future. As important as it is to have a strategic vision to guide annual operating budgets, it is perhaps even more important that capital budgets fol - low the strategic plan of the organization. Without a strategic plan, it is impossible to know which items to include in the capital budget, other than routine maintenance and equipment replacement.

The analysis of individual capital investments requires a process for how they are to be pre - sented, analyzed, decided upon, and monitored. There is substantial variation among health - care organizations in terms of how they prepare and implement capital budgeting processes.

Some organizations are formal and rigid in the capital budgeting process; others are more flex - ible. It is common in all healthcare organizations to include a number of nonfinancial dimen - sions to decision making. This chapter has focused on the financial dimensions. Measures of patient satisfaction, provider satisfaction, community goodwill, and other dimensions enter into capital budgeting and are beyond the scope of financial management. Financial manage - ment can provide the financial factors and then permit general management to make and implement final decisions.

Perhaps the most difficult aspect of capital budgeting, beyond the creativity required to iden - tify potential projects, is the estimation of cash flows. For plant renovation and equipment replacement projects, existing cash flows may be well known. For new and innovative pro - grams, cash flow projections may involve many assumptions and well-researched guesses.

Tools and techniques for the analysis of cash flows are the key contribution of corporate finance. Applying tools to account for the time value of money (from Chapter 8) at the appro - priate rate (from Chapter 9) permits the calculation of the net present value of a project.

To supplement analyses using net present value, financial analysts can calculate accounting rates of return, internal rates of return, and payback periods for projects. Each analysis pre- sents somewhat different information that can inform decision makers about a project’s value to the organization.

With good analysis on the contribution of potential projects, capital budgets can be prepared, disseminated, and used to monitor and evaluate the financial aspects of projects, and the capital budgeting process itself. Good financial analysis of capital expenditures can be time- consuming and helpful in assuring the financial viability of a healthcar\ e organization.

Discussion Questions 1. Healthcare organizations face numerous requests for capital investments each year.

How should they decide which investments to undertake? 2. Which of the decision rules—net present value, ARR, IRR, or payback—should be included on a capital request form? Please explain your reasoning. 3. If two mutually exclusive projects have nearly the same net present value, and one is for a cosmetic surgery center and the other is for a pediatric cancer center, which one should be adopted and why? smi81240_10_c10_245-268.indd 265 3/10/14 2:27 PM 266 Summary & Resources Exercises 1. An outpatient clinic has proposed a new pediatric service that will require an initial investment of $400,000. Marketing and planning has estimated that 30 patients per day could be seen for each of the 250 days the service would be open each year.

Insurance companies would be willing to pay $150 for each patient visit. Fixed costs are estimated to be $100,000 per year, and variable costs are estimated to be $35 per patient visit. The service can operate for three years before any additional investments would be required. What are the cash flows for three years of this service?

a. What is the payback period for this service?

b. What is the internal rate of return for this service?

c. If the organization’s discount rate is 8%, should the service be approved? 2. The Department of Dermatology has proposed a new laser therapy that appears to be gaining popularity. The cost of the renovation of current space, along with the cost of the new equipment, is $2,100,000. Department personnel estimate that 1,000 patients per year will use the therapy. Since this is for cosmetic purposes, it will not be covered by insurance. Each patient will pay, on average, $250 for the therapy.

The therapy will not affect fixed costs and will add only $25 in variable costs per patient. The department thinks that the equipment will last 10 years. The depart - ment chairman has argued that with a cost of $2,100,000 and net patient revenues of $2,250,000 over 10 years, the project should be approved. If the organization’s discount rate is 6%, should the project be approved? Explain your reasoning. Key Terms accounting rate of return (ARR) The rate of return (percentage) derived from divid - ing the average net income from a project by the initial investment amount.

capital budgeting The practice of identi - fying long-term investment opportunities, estimating cash flows, making decisions about which to adopt, and monitoring results.

certificate of need Regulatory structures in many states that require justification and approval for new healthcare facilities or purchases of equipment.

decision rule A criteria for capital invest - ment project acceptance or rejection. Deci - sion rules should be fair and transparent, leading to a consistent selection of projects that support the growth and viability of the organization. internal rate of return (IRR) The rate of return (percentage) that equates the investment in a project with the net cash flows. The internal rate of return is found by solving the net present value equation for the rate.

mutually exclusive projects Projects that involve selection of one proposed project or another, or neither, not both. Otherwise, projects are independent, and decisions concerning the project do not affect deci - sions on others.

payback period The number of time periods (years) until the net cash flows from a project equal or exceed the initial investment. smi81240_10_c10_245-268.indd 266 3/10/14 2:27 PM 267 Summary & Resources Suggested Websites • For information on healthcare spending, see Medicare and Medicaid Statistical Supplement: http://w w w.cms.gov/Research-Statistics-Data-and-Systems/Statistics -Trends-and-Reports/MedicareMedicaidStatSupp/index.html • For information on state certificate of need requirements, see the National Conference of State Legislatures: ht tp://w w w.ncsl.org/research/health/con-certificate-of-need -state-laws.aspx smi81240_10_c10_245-268.indd 267 3/10/14 2:27 PM smi81240_10_c10_245-268.indd 268 3/10/14 2:27 PM