Chapter 14 Capital Investment Decisions

Question 1

Capital budgeting: Overall process of choosing capital investments

**Basics of Capital budgeting **

For long-term (fixed) asset acquisition

Project Categories

• Category 1: Mandatory replacement:
  
  • Necessary to the operations of the hospital.
  • Minimum analysis and decision process
• Category 2: Discretionary replacement:
  
  • Replace serviceable bu obsolete equipment
  • lower costs or to provide more clinically effective services
  • More detailed decision process is required
• 3: Expansion of existing services or markets:
  
  • Increase capacity
• 4: Expansion into new services or markets
• 5: Environmental projects: Comply with government orders, labor agreements, and accreditation requirements
  
  • Treated as category 1 unless expenditure is large
• 6: Other:

Question 2

Overview: 4 Steps

1. Estimate the project’s expected cash flows
   
   • The capital outlay
   • The operating cash flows
   • The terminal (ending) cash flows
2. The riskiness of hte estimated cash flows
3. The project’s cost of capital
4. Financial impact of the project

Question 3

Cash flow estimation

• Estimate the investment outlays
• the annual net operating flows expected when the project goes into operation
• Cash flow estimated with project termination

Incremental Cash flows

• Business’s cash flows in each period if the project is undertaken minus the cash flows if the project is not undertaken:

Incremental CF_t= CF_{t(with project)} - CF_{t(without project)}

t = Time period CF_0, CF₁ etc.

Early CF, especially CF₀ are cash outflows.

Answer 3

Sunk costs / Nonincremental cash flow:

Invested cash that cannot be recovered even if the project is scrapped. / Cash flow that is irrelevant to the analysis.

Cash flow vs. Accounting Income

Cash flow timing

Project LIfe

Opportunity Costs

**Effects of existing business lines **

• Cannibalization

Shipping, Installation, Related costs

Changes in Net working Capital

• Current assets - Current liabilities
• Current assets and current liabilities will increase or decrease
• • Net working Capital: the project must be charged an additional amount
• • Net working capital: the cash flow offsets the cost of the asset being acquired
• Ignoring chnages in Net working capital can result in an overstatement of the project’s profitability

Question 4

Inflation Effects

Inflation can have a significant effect on a project’s profitability

• Debt and equity investors add an inflation premium
• Not including inflation effects can understate the project’s profitability

Strategic Value

• Stems from future investment opportunities that can only be undertaken only if the project currently under consideration is accepted.
• Consider the value of follow-on projects, estimate their probabilities of occurrence

Question 5

Cash Flow estimation Example

For-Profit Business

• Depreciation expense must be modified to reflect tax depreciation rather than book depreciation.
• Modified Accelerated Recovery System (MACRS)
• MACRS 5-year class specified by IRS tax code = .20, .32, .19, .12, .11, .06 for years 1 - 6 respectively
• Depreciation year 1 = (Cost + related expenses)(.20) etc.
• 5 - year life salvage value =

1. year 6 dep. = (Cost + related expenses)(.06)
2. Estimated salvage value - value found in 1. above
3. Tax rate (value found in 2. above)
4. Estimated salvage value - tax (step 3 above)

Question 6

Many different breakeven analysis available:

Focus on Time breakeven: Measured in payback period

Payback: Expected number of years required to recover the investment in a project

Drawbacks of the Payback period approach:

1. Ignores all CF that occure after payback period
2. Ignores the opportunity cost of the capital employed

Characteristics:

• Shorter the payback period, the more liquid the project
• Cash flows expected in the distant future are more risky
• Used as a quick measure of liquidity and risk

Question 7

**Profitability analysis **

Expressed by Return on investment (ROI)

ROI is measured in dollars or % rate of return

Net Present Value (NPV)

Dollar ROI measure that uses discounted cash flow techniques

Calculate the NPV using Financial Calculaor

Characteristics:

• If the NPV is positive, the project expected to be profitable
• The higher the NPV, the more profitable the project
• If NPV is 0, project is expected to break even

Answer 7

Measure of ROI in % rate of return

IRR (expected rate of return)

• Discount rate that equates the present value of the project’s expected cash inflow to the present value of he project’s expected cash outflow
• Discount rate that forces NPV of the project to equal zero
• Ex: 11.1%
• The project is expected to generate 11.1% rate of return.
• If the Expected rate of return is > the projected cost of capital, surplus will remian
• In project with a 0 NPV, the IRR = Cost of capital

Question 8

Modified Internal Rate of Return (MIRR)

• Both the NPV and IRR, because they’re discounted cash flow techniques, require an assumption about the rate at which project cash flows can be reinvested
• NPV assumes reinvestment at cost of capital (better option)
• IRR assumes reinvestment at IRR
• MIRR < IRR when IRR > Cost of capital
• MIRR > IRR when IRR < Cost of capital

Question 9

Capital budgeting in Not-for-profit must include charitable mission:

Net Present Social Value (NPSV)

Total NPV (TNPV) = NPV + NPSV

A project is acceptable if its TNPV >= 0

• No project should be accepted if its NPSV is negative regardless of its TNPV value
• Sum of all of the conventional NPVs of all projects initiated in a planning period must be >= 0

1. Estimate in dollar terms the social value of the service provided in each year