Transcript Generation of Project or Purchase Information

Capital Budgeting Decisions
Clifton Louie, RPh, DPA, FACHE
May 2003
So You Want To Purchase
Something……….
The available alternatives
Cash available
Cost Information
Benefit Information
Risk Profile
Which Project to Fund?
Solvency
Incremental management time required
Public image
Medical staff approval
Which to Fund - UCSF Style
Required by code or regulations
Patient or employee safety
Revenue generation or cost avoidance
Replacement
Justification
Need - relative to attainment of mission
and goals
Economic feasibility
Acceptability (vis-à-vis established
priorities or other criteria)
Sources of Cash
From Operations


Collections from A/R
Cash sales
From
From
From
From
Investments
Debt
Charitable donations
selling assets
Uses of Cash
Payroll
Accounts Payables
Payment on debt
Capital purchases
Investment
Liquidity Concerns
Increase the level of cash and
investment reserves
Restructure debt
Arrange a line of credit against a
collateral
Shorten A/R Cycle
Lengthen Payment Cycle
Working Capital
Relationship between


Current Assets
Current Liabilities
Current Assets
Cash and investments
A/R
Inventories
Other current assets
A Balance Sheet Parameter
Current Liabilities
A/P
Accrued salaries and wages
Accrued expenses
Notes payable
Current position on long term debt
A Balance Sheet Parameter
Management of the A/R
Minimize
Minimize
Minimize
Minimize
level
lost charges
late charges
write-offs
the A/R days to an acceptable
Management of A/P
Minimize the amount of vendors
Track the invoice to purchase order to
the receiver
Maximize payment cycle or gain
financial incentive for shorter payment
cycle
Cash Budget - 4 Activities
Purchasing of resources (Capital
equipment)
Production/sale of service
Billing
Collection
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
assets
Typically, 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?
XYZ Corporation
Comparative Balance Sheet ($000’s)
ASSETS
YEAR ONE
YEAR TWO
Current assets:
Cash
20
30
Accounts receivable (net)
95
95
130
110
245
235
10
10
120
100
130
110
10
10
385
355
Accounts payable
50
40
Estimated income taxes payable
10
10
60
50
50
50
275
255
385
355
Inventory
Total current assets
Fixed assets:
Land
Building and equipment (net)
Total fixed assets (net)
Other assets:
Goodwill and organizational costs
Total Assets
LIABILITIES
Current liabilities:
Total current liabilities
Long-term liabilities
Mortgage bonds, 10 percent
Long-term debt
Total Liabilities
XYZ Corporation
Income Statement ($000’s)
Gross Sales
Less: Returns and
allowances
$11,516
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
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 assets
Meeting the “expected demand”
Investment of cash
Types of Investments
Replacement of damaged equipment
Replacement of obsolete equipment
Expansion
New technology, services and markets
Safety improvement
Others
5 Steps in Capital Budgeting
Identify the initial cost
Forecast operating cash flows
Assess the risk
Measure the investment’s worth
Assess 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 an
ultrasound unit for $200,000. The unit has a
straight-line depreciation life of 5 years. The old
ultrasound unit is being sold for $50,000. It was
bought 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. Net
working capital for the hospital does not change with
this purchase. What is the initial cost for the project?
Forecasting the Cash Flows
Calculate additional net earnings
Calculate tax benefits of depreciation
Incremental cash flow = additional net
earnings + additional tax benefits
Case Study – Forecasting Cash Flows
East Oz Community Hospital is considering replacing
their CT scanner with a newer, multi-slice, highly efficient,
higher resolution state-of-the-art CT scanner. The
existing scanner was purchased 3 years ago for $500,000.
The new machine is $750,000. For each machine assume
a 5-year straight-line depreciation. The capital gains
tax rate is 34 percent. What are the incremental cash
flows associated with the purchase of the new CT
scanner?
Payback Analysis
The payback is the number of years
needed to recover the initial investment
Payback Analysis
Easy to use
Easy to understand
The shorter the
payback time, the
less risky is the
investment
Ignores the time
value of money
Ignores the cash
inflows produced
after the initial
investment is
recovered
Net Present Value (NPV)
NPV = Present value - Initial
Investment
Positive or zero NPV, accept the project
Negative NPV, reject project
Importance on determining the right
discount rate
NPV
Uses cash flows
instead of earnings
Recognizes the time
value of money
Positive NPV’s
increases the value
of the organization
Future cash
predictions are
difficult to make
NPV 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 (-)
NPV
PV = Future Value / (1 + Discount Rate) ** (# of years)
PV = $1.00 / (1+0.10)**1 = 0.909
PV = $1.00 / (1+0.10)**2 = 0.826
PV = $1.00 / (1+0.10)**3 = 0.751
Case Study - NPV
A project will have an annual cash flow over the first 3
years of $6,000, $4,000 and $2,000. If the discount rate
is 10% and the initial investment is $15,000, do you
recommend funding this project?
Discount Rate Prediction
Riskier projects have a higher discount
rate
When interest rate and inflation rates
are up, the discount rate will be higher
Longer life of the project, higher the
discount rate
Risk Assessment - Sensitivity
Analysis
The purpose is to find out how sensitive
various indicators are to change
A riskier project is more sensitive to
change
Case Study – Sensitivity Analysis
East Oz Community Hospital is considering two shortterm projects. The first project has a cash flow of
$1,000 in Year One of the project and $1,500 for Years
Two and Three. Correspondingly, the second project
has a cash flow of $1,800 in Year One and $700 in
Years Two and Three. The initial investment for each
project is $1,600. If the discount rate changes from
10 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 Use
Easy to understand
The higher the ARR,
the less risky the
investment
Ignores the time value
of money
Uses earnings instead
of cash flow
Ignores depreciation
Ignores value of salvage
Ignores 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 investment
The 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 use
Takes 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 flow
for a new outreach program to be $2,500 for 6 years.
The initial investment for the program is $17,500. What
is the IRR and should the program be accepted if the
cutoff rate is 10 percent?
Profitability Index
PI = Present value of cash flows / Initial
investment
Project with a PI greater than one is
accepted
Case Study – Profitability Index
East Oz Community Hospital is considering a project with
an annual cash flow of $5,000 for the next 5 years. The
initial investment is $20,000. Using the PI method and
a 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 cost
Present value of annuity
Equivalent Annual Cost
Comparison of 2
alternate projects
with different lives
Be aware of
changing conditions
Equivalent 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 factor
NOTE = 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 their
fire sprinkler system. One system cost $5,000 with an
annual maintenance cost of $500 over the 10-year life
to the system. The second system cost $10,000 and
requires only $200 per year for maintenance. However,
this second system has a 20-year life. The discount
factor is 10 percent and ignores cost reimbursement.
Which one would be better?