Capital Budgeting Decisions

Clifton Louie, RPh, DPA, FACHEMay 2003

So You Want To Purchase Something……….

The available alternativesCash availableCost InformationBenefit InformationRisk Profile

Which Project to Fund?

SolvencyIncremental management time requiredPublic imageMedical staff approval

Which to Fund - UCSF Style

Required by code or regulationsPatient or employee safetyRevenue generation or cost avoidanceReplacement

Justification

Need - relative to attainment of mission and goalsEconomic feasibilityAcceptability (vis-à-vis established priorities or other criteria)

Sources of Cash

From Operations Collections from A/R Cash sales

From InvestmentsFrom DebtFrom Charitable donationsFrom selling assets

Uses of Cash

PayrollAccounts PayablesPayment on debtCapital purchasesInvestment

Liquidity Concerns

Increase the level of cash and investment reservesRestructure debtArrange a line of credit against a collateralShorten A/R CycleLengthen Payment Cycle

Working Capital

Relationship between Current Assets Current Liabilities

Current Assets

Cash and investmentsA/RInventoriesOther current assets

A Balance Sheet Parameter

Current Liabilities

A/PAccrued salaries and wagesAccrued expensesNotes payableCurrent position on long term debt

A Balance Sheet Parameter

Management of the A/R

Minimize lost chargesMinimize late chargesMinimize write-offsMinimize the A/R days to an acceptable level

Management of A/P

Minimize the amount of vendorsTrack the invoice to purchase order to the receiverMaximize payment cycle or gain financial incentive for shorter payment cycle

Cash Budget - 4 Activities

Purchasing of resources (Capital equipment)Production/sale of serviceBillingCollection

Rule of Thumb

Minimize the A/R cycle and lengthen the A/P cycle within limits. By doing so, there is usually a positive cash flow within the organization

Financial Ratio Analysis

Are the fundamental analytical tools for interpreting financial statements Four classes of ratios:

Liquidity Solvency Funds management Profitability

Liquidity Ratios

Liquidity is measured by its ability to raise cash from all sources (credit, sale of assets, and operations)Used to appraise a company’s ability to meet its current obligations using existing cash and current assetsTypically, it is assumed that the higher the ratio, the more protection the company has against liquidity problems

Liquidity Ratios

Current Ratio is current assets / current liabilities What is the current ratio for XYZ Corporation?

Acid-Test or Quick Ratio is quick assets / current liabilities Measures the ability of a company to use its

“near-cash” or quick assets to meet its current liabilities

What is the acid-test ratio for XYZ Corporation?

ASSETS YEAR ONE YEAR TWO

Current assets:

Cash 20 30

Accounts receivable (net) 95 95

Inventory 130 110

Total current assets 245 235

Fixed assets:

Land 10 10

Building and equipment (net) 120 100

Total fixed assets (net) 130 110

Other assets:

Goodwill and organizational costs 10 10

Total Assets 385 355

LIABILITIES

Current liabilities:

Accounts payable 50 40

Estimated income taxes payable 10 10

Total current liabilities 60 50

Long-term liabilities

Mortgage bonds, 10 percent 50 50

Long-term debt 275 255

Total Liabilities 385 355

XYZ CorporationComparative Balance Sheet ($000’s)

Gross Sales $11,516

Less: Returns and allowances

10

Net Sales 1,506

Less: Cost of goods sold 1,004

Gross profit 502

Operating expenses 400

Operating profit 102

Interest 5

Profit before taxes 97

Income tax expense 47

Net income 50

XYZ Corporation Income Statement ($000’s)

Accounts Payable Management

The day’s payables ratio becomes meaningful when compared to the credit terms given by the suppliers.To calculate the day’s payables:

Purchases / Day Then, Accounts payable / Purchases per day = Day’s

Payables

Inventory Turnover is important to management Inventory turnover = cost of sales / average inventory

Solvency Ratios

These ratios generate insight into a company’s ability to meet long-term debt payment schedules“Times Interest Earned” is Operating profit (before interest expense) / Long-term

debt interest

What is XYZ Corporation’s Times Interest Earned Ratio?

The ratio indicates the extent to which operating profits can decline without impairing the company’s ability to pay the interest on its long-term debt.

Solvency Ratios

Debt-to-equity ratios – relationship of borrowed funds to ownership funds is an important solvency ratio. Capital from debt and other creditor sources is more risky for a company than equity capital.

One common ratio is Total Liabilities / Total Assets

What is XYZ Corporation’s Debt-to-equity ratio?

Funds Management Ratios

The financial situation of a company is affected in large measure on how its investments in accounts receivable, inventories, and fixed assets are managed

Receivables to Sales: Accounts receivable (net) / Net sales

Average Collection Period: Accounts receivable / Net sales x Days in the annual

period = Collection period Average Accounts Payable Period:

Accounts payable / Purchases

Profitability Ratios

Profit margin (Gross or Net)ROI

Making The Right Decision

Life of capital assetsMeeting the “expected demand”Investment of cash

Types of Investments

Replacement of damaged equipmentReplacement of obsolete equipmentExpansionNew technology, services and marketsSafety improvementOthers

5 Steps in Capital Budgeting

Identify the initial costForecast operating cash flowsAssess the riskMeasure the investment’s worthAssess the profitability

4 Questions - Initial Cost Analysis

What is the invoice price?Additional expenses?Revenues from sales of old equipment?How tax is owed?

Case Study – Identifying the Project’s Initial Costs

East Oz Community Hospital is planning to buy anultrasound unit for $200,000. The unit has a straight-line depreciation life of 5 years. The oldultrasound unit is being sold for $50,000. It wasbought by the Hospital brand new 3 years ago for$100,000. The hospital must pay $2,000 for delivery and $11,000 for training and calibration.The tax rate for capital gains is 34 percent. Networking capital for the hospital does not change withthis purchase. What is the initial cost for the project?

Forecasting the Cash Flows

Calculate additional net earningsCalculate tax benefits of depreciationIncremental cash flow = additional net earnings + additional tax benefits

Case Study – Forecasting Cash Flows

East Oz Community Hospital is considering replacingtheir CT scanner with a newer, multi-slice, highly efficient,higher resolution state-of-the-art CT scanner. Theexisting scanner was purchased 3 years ago for $500,000.The new machine is $750,000. For each machine assumea 5-year straight-line depreciation. The capital gainstax rate is 34 percent. What are the incremental cashflows associated with the purchase of the new CTscanner?

Payback Analysis

The payback is the number of years needed to recover the initial investment

Payback Analysis

Easy to useEasy to understandThe shorter the payback time, the less risky is the investment

Ignores the time value of moneyIgnores the cash inflows produced after the initial investment is recovered

Net Present Value (NPV)

NPV = Present value - Initial InvestmentPositive or zero NPV, accept the projectNegative NPV, reject projectImportance on determining the right discount rate

NPV

Uses cash flows instead of earningsRecognizes the time value of moneyPositive NPV’s increases the value of the organization

Future cash predictions are difficult to makeNPV assumes the same discount rate throughout the life of the project

In a capital budget, go for the NPV with the greatest (+)In a operating budget, go for the NPV with the

greatest (-)

NPVPV = Future Value / (1 + Discount Rate) ** (# of years)

PV = $1.00 / (1+0.10)**1 = 0.909PV = $1.00 / (1+0.10)**2 = 0.826PV = $1.00 / (1+0.10)**3 = 0.751

Case Study - NPVA project will have an annual cash flow over the first 3years of $6,000, $4,000 and $2,000. If the discount rateis 10% and the initial investment is $15,000, do yourecommend funding this project?

Discount Rate Prediction

Riskier projects have a higher discount rateWhen interest rate and inflation rates are up, the discount rate will be higherLonger life of the project, higher the discount rate

Risk Assessment - Sensitivity Analysis

The purpose is to find out how sensitive various indicators are to changeA riskier project is more sensitive to change

Case Study – Sensitivity Analysis

East Oz Community Hospital is considering two short-term projects. The first project has a cash flow of$1,000 in Year One of the project and $1,500 for YearsTwo and Three. Correspondingly, the second projecthas a cash flow of $1,800 in Year One and $700 inYears Two and Three. The initial investment for eachproject is $1,600. If the discount rate changes from10 percent to 12 percent, which project is riskier?

Average Rate of Return (ARR)

Measures the relationship between the new earnings of a project to the average investment.ARR = Average annual future net earnings / One-half of initial investment

ARR

Easy to UseEasy to understandThe higher the ARR, the less risky the investment

Ignores the time value of moneyUses earnings instead of cash flowIgnores depreciationIgnores value of salvageIgnores time sequence of net earnings

Case Study – Average Rate of Return

The net earnings for a project over the next 5 years are$10,000 per year. If the initial investment is $60,000,what is the average rate of return?

Internal Rate of Return

IRR is a discount rate that makes the present value of cash flows equal to the initial investmentThe rate below where projects are rejected is called the cutoff rate.Predicts a firm’s opportunity to reinvest future cash flows from the project

IRR

Simple to useTakes into account the time value of money

May give unrealistic rates of return

Case Study – Internal Rate of Return

The nursing department projected an annual cash flowfor a new outreach program to be $2,500 for 6 years.The initial investment for the program is $17,500. Whatis the IRR and should the program be accepted if thecutoff rate is 10 percent?

Profitability Index

PI = Present value of cash flows / Initial investmentProject with a PI greater than one is accepted

Case Study – Profitability Index

East Oz Community Hospital is considering a project withan annual cash flow of $5,000 for the next 5 years. Theinitial investment is $20,000. Using the PI method anda discount rate of 10 percent, should the project be accepted?

Equivalent Annual Cost

Equivalent Annual Cost =

Present value of operating cost + Present value of investment costPresent value of annuity

Equivalent Annual Cost

Comparison of 2 alternate projects with different lives

Be aware of changing conditionsEquivalent annual cost is not identical to reportable accounting costs, such as depreciation costs

Present Value of an Annuity

When faced by a steady and constant stream of future payments or receipts, decision makers want to evaluate the present value of these figures.Employ a present value annuity factorNOTE = An annuity is a series of equal payments (or receipts) made at any regular interval of time.

Present Value of Annuity

Present value of an annuity =

Amount of Annuity(1+Discount Rate)**N

N = Number of years or periods

Case Study – Equivalent Annual Cost

East Oz Community Hospital would like to replace theirfire sprinkler system. One system cost $5,000 with anannual maintenance cost of $500 over the 10-year lifeto the system. The second system cost $10,000 andrequires only $200 per year for maintenance. However,this second system has a 20-year life. The discountfactor is 10 percent and ignores cost reimbursement.

Which one would be better?