Healthcare Finance CT10

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Capital Budgeting Justification

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Capital Budgeting Justification (110 points)
Capital budgeting is an essential process for healthcare organizations. The challenge in quality and
patient safety organizations is proving return on the capital investment without revenue impacts.
Select a capital investment that you would recommend making for a patient safety concern. In a 12 slide
PowerPoint Presentation address the following requirements:
• Describe the capital item in detail:
o Item description
o Rationale for selection
o Cost-benefit analysis
• Complete a capital budget with projected financial benefit:
o Revenue or positive financial impact
o Capital equipment cost
o Personnel cost
o Supply cost
• Review financial ratios
o Return on investment
o Net Present Value
o Cash Payback period
• Make a recommendation to lease or finance the capital item. Please support your decision with
financial data.
Your presentation should meet the following structural requirements:
• Be 12 slides in length, not including the title or reference slides.
• Be formatted according to Saudi Electronic University and APA writing guidelines.
• Provide support for your statements with citations from a minimum of 8 scholarly articles. These
citations should be listed in the Notes section of the slide in which they appear. Two of these
sources may be from the class readings, textbook, or lectures, but four must be external.
Each slide must provide detailed speaker’s notes to support the slide content. These should be
a minimum of 150 words long (per slide) and must be a part of the presentation. The presentation cannot
be submitted in PDF format, which does not make notes visible to the instructor. Notes must draw from
and cite relevant reference materials
CHAPTER 10
Capital Structure
In chapter 9, we noted that the weights used in the cost
of capital estimate represent the optimal (target) mix
of debt and equity financing. These weights are
established by the capital structure decision, which
requires managers to analyze a number of quantitative
and qualitative factors to establish the business’s
optimal capital structure.
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The Capital Structure Decision
• Capital consists of the funds used to finance a
business’s assets.
• Capital structure is the financing mix on the right side
of the balance sheet. It is the proportion of debt (and
hence equity) used by a business.
• The capital structure decision involves identifying the
optimal mix of debt and equity.
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Impact of Capital Structure on
Risk and Return
• Consider a new for-profit walk-in clinic that needs
$200,000 in assets to begin operations.
• The business is expected to produce $150,000 in
revenues and $100,000 in operating costs during the first
year.
• The clinic has only two capital structure alternatives:
• No debt financing (all equity)
• $100,000 of 10% debt (50/50 mix)
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Projected Balance Sheets
Current assets
Fixed assets
Total assets
Bank loan (10% cost)
Total equity
Total claims
All Equity
$100,000
100,000
$200,000
Debt/Equity
$ 100,000
100,000
$ 200,000
$
$ 100,000
100,000
$ 200,000
0
200,000
$ 200,000
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Projected Income Statements
Revenues
Operating costs
Operating income (EBIT)
Interest expense
Taxable income
Taxes (30%)
Net income
All Equity
$ 150,000
100,000
$ 50,000
0
$ 50,000
15,000
$ 35,000
Debt/Equity
$ 150,000
100,000
$ 50,000
10,000
$ 40,000
12,000
$ 28,000
Based on net income, should we use debt financing?
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Return on Equity (ROE)
Net income
Total equity
Return on equity
All Equity
$ 35,000
$200,000
17.5%
Debt/Equity
$ 28,000
$100,000
28%
Based on ROE, should we use debt financing?
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Conclusions
■ Although the use of debt financing lowers net
income, it increases the return to
equityholders.
■ Debt financing allows more of a business’s
operating income to flow through to investors.
■ Because debt financing levers up (increases)
return, its use is called financial leverage.
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Business Risk Versus Financial Risk
• A business has some overall level of risk.
• In a stand-alone risk sense, it can be measured by the
standard deviation of ROE.
• In a market risk sense, it can be measured by the stock’s
beta.
• This overall (total) risk can be decomposed into
business risk and financial risk.
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Business Risk
■ Business risk is the uncertainty inherent in a business’s
operating income (EBIT)—that is, how well can managers
predict EBIT?
Probabilit
y
Low business risk
High business risk
0
E(EBIT)
EBI
T
■ Business risk does not consider how the business is financed.
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Factors That Influence Business Risk
• Demand (volume) variability
• Sales price variability
• Input cost variability
• Ability to respond to changing market conditions
(operating flexibility)
• Liability exposure uncertainty
• Operating leverage (proportion of fixed
versus variable costs)
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Financial Risk
• Financial risk is the additional risk placed on owners (or
noncreditor stakeholders in NFP businesses) when debt
financing is used.
• The greater the proportion of debt financing, the greater
the financial risk.
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Self-Test
Which of the following statements is most correct?
a. A firm’s business risk is determined solely by the financial
characteristics of its industry.
b. A firm’s financial risk can be minimized by diversification.
c. A firm with low business risk is more likely to increase its use of
financial leverage than a firm with high business risk, assuming all
else equal.
d. Home health agencies typically have more operating leverage than
hospitals.
e. An increase in operating leverage normally leads to a decrease in the
standard deviation of its expected EBIT.
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Capital Structure Theory
■ Capital structure theory attempts to define the
relationship between the use of financial
leverage and a business’s equity value.
■ The most widely accepted theory is the tradeoff theory:
● There are tax-related benefits to debt financing.
● But there are also costs, primarily those associated
with financial distress.
■ But first, we need to discuss MM.
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Modigliani and Miller (MM)
• MM published theoretical papers that changed the
way people thought about financial leverage (and
dividend policy).
• They won Nobel prizes in economics because of
their work.
• MM’s papers were published in 1958 and 1963.
Miller had a separate paper in 1977. The papers
differed in their assumptions about taxes.
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MM Assumptions
• Firms can be grouped into homogeneous classes
based on business risk.
• Investors have identical expectations about firms’
future earnings.
• There are no transactions costs, so securities can be
bought and sold with no fees or commissions.
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MM Assumptions (cont.)
• All debt is riskless, and both individuals and
corporations can borrow unlimited amounts of money
at the risk-free rate.
• All cash flows are perpetuities. This implies perpetual
debt is issued, firms have zero growth, and expected
EBIT is constant over time.
• There are no agency or financial distress costs.
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MM Without Taxes (1958)
Proposition I:
VL = VU.
Proposition II:
R(ReL) = R(ReU) + [R(ReU) – R(Rd)](D/E).
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MM Without Taxes Graph
Cost of
Capital (%)
R(Re)
CCC
R(Rd)
Proportion
of Debt
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MM Without Taxes
Conclusions
• The more debt the firm adds to its capital structure, the
riskier the equity becomes and thus the higher its cost.
• Although the cost of debt remains constant (by
assumption), the cost of equity increases with leverage
at a rate that is exactly sufficient to keep the CCC
constant.
What is the optimal capital structure if this theory holds?
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Value Versus Leverage Graph
Firm Value
VL =
VU
Proportion
of Debt
Under MM without taxes, the firm’s value is not affected by debt financing.
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MM with Corporate Taxes (1963)
When corporate taxes are added, the MM
propositions become:
Proposition I:
VL = VU + TD.
Proposition II:
R(ReL) = R(ReU) + [R(ReU) – R(Rd)](1 – T)(D/E).
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MM with Corporate Taxes Graph
Cost of
Capital (%)
R(Re)
CCC
R(Rd)(1 – T)
Proportion
of Debt
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MM with Corporate Taxes Conclusions
■ When corporate taxes are added,
VL ≠ VU. VL increases as debt is added to the
capital structure, and the greater the debt usage,
the higher the value of the firm.
■ The cost of equity increases with leverage at a
slower rate when corporate taxes are
considered because of the (1 – T) term in
Proposition II.
What is the optimal capital structure if this theory
holds?
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Value Versus Leverage Graph
Firm Value
V
TD
L
V
U
Proportion
of Debt
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.
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Miller later (1977) modified the MM
with corporate taxes model to
incorporate individual (personal) taxes.
Miller’s Proposition I:
[
]
(1 – Tc)(1 – Te)
VL = VU + 1 D.
(1 – Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Te = personal tax rate on stock income.
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Assume Tc = 30%, Td = 35%, and Te = 20%.
VL
[
(1 – 0.30)(1 – 0.20)
= VU + 1 (1 – 0.35)
= VU + (1 – 0.86)D
]D
= VU + 0.14D.
Value rises with debt; each $100 increase in debt
raises L’s value by $14.
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How does this gain compare to the gain in the
MM model with corporate taxes?
If only corporate taxes, then
VL = VU + TcD = VU + 0.30D.
Here, $100 of debt raises value by $30. But with
personal taxes added, firm value increases by only
$14. Thus, personal taxes lower the gain from
leverage, but the net effect depends on relative tax
rates.
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Impact of Personal Taxes
■ Corporate tax laws favor debt over
equity financing because interest
expense is tax deductible while
dividends are not.
■ However, personal tax laws favor equity
over debt because stocks provide tax
deferral, a lower capital gains tax rate,
and a lower dividend tax rate.
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Impact of Personal Taxes (Cont.)
■ This increases the attractiveness of stock
investments (lowers the cost of equity) and
hence decreases the spread between debt and
equity costs.
■ Thus, some of the advantage of debt
financing is lost, and debt financing is less
valuable to businesses.
What is the optimal capital structure if the
Miller theory holds?
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What does capital structure theory
prescribe for corporate managers?
■ MM, No Taxes: Capital structure is irrelevant—
no impact on firm value.
■ MM, Corporate Taxes: Value increases, so
firms should use (almost) 100% debt financing.
■ Miller, Personal Taxes: Value increases, but less
than under MM, so again firms should use
(almost) 100% debt financing.
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Do firms follow the recommendations
of capital structure theory?
• Firms don’t follow MM/Miller to 100% debt. Debt
ratios average about 40%.
• However, debt ratios did increase after MM. At the
time, many thought debt ratios were too low, and MM
led to changes in financial policies.
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Financial Distress Costs
As firms use more and more debt financing, they face a
higher probability of future financial distress, which
brings with it lower sales, higher costs, lower earnings,
and the greater potential of incurring bankruptcy costs.
These effects, called financial distress costs, lower the
values of stocks and bonds.
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Agency Costs
As more and more debt is used, managerial actions
become more restricted due to restrictive covenants and
oversight by creditors. Furthermore, debtholders tend to
increase monitoring activity as more debt is used, which
raises the cost of debt. Such costs, called agency costs,
also lower the values of stocks and bonds.
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How do financial distress and
agency costs change the MM and
Miller models?
• MM/Miller ignored these costs; hence their models
show firm value increasing continuously with
leverage.
• Because financial distress and agency costs increase
with leverage, such costs reduce the value of debt
financing.
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Self-Test
The major contribution of the Miller model is that it
demonstrates that:
a. Personal taxes increase the value of corporate debt.
b. Personal taxes decrease the value of corporate debt.
c. Financial distress and agency costs reduce the value of
corporate debt.
d. Equity costs increase with financial leverage.
e. Debt costs increase with financial leverage.
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The trade-off theory includes financial
distress and agency costs.
PV of agency
PV of expected
VL = VU + XD –
–
.
costs
fin. distress costs
• X represents either Tc in the MM model or the more complex
Miller term.
• Now, optimal financial leverage involves a trade-off between
the tax benefits of debt and financial distress and agency costs.
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Trade-Off Theory
%
R(Re
)
CCC
R(Rd)(1 – T)
D/A
What is the optimal capital structure?
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Trade-Off Theory Implications
■ Both too little or too much debt is bad.
■ There is an optimal, or target, capital structure
for every business that balances the costs and
benefits of debt financing.
■ Unfortunately, capital structure theory cannot
be used in practice to find a business’s optimal
structure.
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Trade-Off Theory Implications (cont.)
• Firms should borrow more if they:
• Have low business risk
• Employ tangible assets (buildings and
equipment)
• Expect to pay taxes at a high rate
• Firms should borrow less if they:
• Have high business risk
• Employ intangible assets (intellectual capital and
goodwill)
• Expect to pay taxes at a low rate
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Asymmetric Information Theory
• MM assumed that investors and managers have the
same information.
• But managers often have better information. Thus, they
would:
• Sell stock if stock is overvalued
• Sell bonds if stock is undervalued
• Investors understand this, so they view new stock sales
as a negative signal.
What are the implications for managers?
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Asymmetric Information Theory (cont.)
• In general, mature firms follow a “pecking order” when
financing:
• First, use internal funds.
• Next, draw on marketable securities.
• Then, issue new debt.
• Finally, and only as a last resort, issue new common stock.
• This behavior is consistent with the asymmetric
information theory.
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Summary of Capital Structure Theory
■ Both too little or too much debt is bad.
■ There is an optimal (target) capital structure for every
investor-owned business that balances the costs and
benefits of debt financing.
■ Specific financing conditions are influenced by
asymmetric information.
■ Unfortunately, capital structure theory cannot be used
in practice to find a business’s optimal structure.
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Not-For-Profit Businesses
• The same general concepts of capital structure apply to
not-for-profit businesses:
• Benefit to debt financing—cost of debt is lower because it is
tax exempt
• Cost to debt financing—increased risk of financial distress
• However, not-for-profit firms do not have the same
financial flexibility as do investor-owned businesses.
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Factors That Influence Capital
Structure Decisions in Practice
• Long-run viability
• Managerial conservatism
• Lender and rating agency attitudes
• Reserve borrowing capacity
• Industry averages
• Control of investor-owned corporations
• Asset structure
• Growth rate
• Profitability
• Taxes
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Implications of the
Capital Structure Decision
• The estimated optimal capital structure becomes the
business’s target capital structure.
• It is an important factor in financial decision making
because:
• It defines the weights that are used in the corporate cost of
capital estimate.
• It plays a role in future financing decisions.
• Note that the target weights are market (as opposed to
book) value weights for FP businesses.
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Self-Check
Other things held constant, which of the following events
is most likely to encourage a firm to increase the amount
of debt in its capital structure?
a. Its sales become less stable over time.
b. Management believes that the firm’s stock has become
overvalued.
c. The corporate tax rate increases.
d. The costs that would be incurred in the event of bankruptcy
increase.
e. Its degree of operating leverage increases.
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Three Key Learning Points
• The use of debt financing increases the rate of return to owners,
but it also increases their risk.
• Debt financing provides benefits because of the tax deductibility
of interest. However, beyond some point, financial distress and
agency costs offset the tax advantage of debt.
• Capital structure theory does not provide answers to the optimal
capital structure question. Thus, many factors must be
considered when actually choosing a firm’s target capital
structure, and the final decision will be based on both analysis
and judgment.
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CHAPTER 10 EXTENSION
This chapter extension focuses on the debt maturity decision.
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The Debt Maturity Decision
• Once the capital structure decision is made, another decision is necessary.
Given the optimal amount of debt financing, what is the optimal maturity
mix of that debt?
• This decision is based on the business’s mix of permanent and temporary
assets.
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Alternative Debt Maturity Policies
• Maturity Matching: Matches the maturity of the assets
with the maturity of the financing.
• Aggressive: Uses short-term (temporary) capital to
finance some permanent assets.
• Conservative: Uses long-term (permanent) capital to
finance some temporary assets.
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Maturity Matching Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
What are “permanent” assets?
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Year
s
Aggressive Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Year
The lower the dashed line, the more aggressive. s
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Conservative Financing Policy
$
Marketable
Securities
Zero S-T
debt
Perm C.A.
Fixed Assets
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L-T Fin:
Stock,
Bonds,
Spon. C.L.
Year
s
Conclusion Regarding Debt Maturities
• The choice of debt maturities is a classic risk/return
trade-off.
• The aggressive policy promises the highest return but
carries the greatest risk.
• The conservative policy has the least risk but also the
lowest expected return.
• The moderate (maturity matching) policy falls
between the two extremes.
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CHAPTER 11
Capital Budgeting
In recent chapters, we focused on capital
acquisition, cost of capital, and capital
structure—in other words, decisions that provide
a business with its capital (funds). Now, we turn
our attention to the capital allocation decision, or
how those funds can be deployed (used) in the
most economically efficient manner.
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Capital Budgeting Basics
• Capital budgeting is the analysis of potential
additions to a business’s fixed assets.
• Such decisions:
• Typically are long-term in nature
• Often involve large expenditures
• Usually define strategic direction
• Thus, capital budgeting decisions are very important
to businesses.
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Project Classifications
• Proposed projects are classified according to purpose
and size (cost). For example,
• Mandatory replacement
• Expansion of existing services
• Less than $1 million
• $1 million or more
• Expansion into new services
• Less than $1 million
• $1 million or more
How are such classifications used?
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Role of Project Financial Analysis
• For investor-owned businesses, financial analysis
identifies those projects that are expected to contribute
to shareholder wealth.
• For not-for-profit businesses, financial analysis
identifies a project’s expected effect on the business’s
financial condition.
Why is this important?
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Overview of Capital Budgeting
Financial Analysis
1. Estimate the project’s cash flows:
• Capital outlay
• Operating flows
• Terminal flow
2. Assess the project’s riskiness.
3. Estimate the project cost of capital.
4. Measure the financial impact.
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Key Concepts in Cash Flow Estimation
• Identifying the relevant cash flows
Inc. CF = CF(w/ project) – CF(w/o project)
• Cash flow versus accounting income
• Cash flow timing
• Project life
• Sunk costs
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Key Concepts (cont.)
• Opportunity costs
• Effect on the business’s other projects
• Shipping and installation costs
• Changes in net working capital
• Inflation effects
• Cash flow estimation bias
• Strategic value
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Cash Flow Estimation Example
• Assume Midtown Clinic, a not-for-profit provider,
is evaluating a new piece of diagnostic equipment.
• Cost:
• $200,000 purchase price
• $40,000 shipping and installation
• Expected life = 4 years
• Salvage value = $25,000
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Cash Flow Estimation Example (cont.)
• Volume = 5,000 scans/year
• Net revenue = $80 per scan
• Supplies costs = $40 per scan
• Labor costs = $100,000
• Neutral inflation rate = 5%
• Corporate cost of capital = 10%
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Time Line Setup
0
1
2
3
4
Initial
Costs
(CF0)
OCF1
OCF2
OCF3
OCF4
NCF0
NCF1
NCF3
+
Termina
l
CF
NCF4
NCF2
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Investment at t = 0 (000s)
Equipmen
tInstallation &
$200
40
Shipping
Net cash outlay
$240
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Operating cash flows (000s)
1
2
3
4
Revenues
$400 $420 $441 $463
Supplies costs 20
21
22
23
Labor
10
10
11
11
0
0
1
2
costs
0
5
0
6
Net op. CF $100 $105 $110 $116
How were these values developed?
Why haven’t we included depreciation?
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Terminal cash flows at t = 4 (000s)
Salvage value
Tax on
Net terminal CF
SV
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$25
0
$2
5
Net cash flows (000s)
0
1
2
3
4
($240
)
$100
$105
$110
$116
25
$141
Note that these cash flows are estimates.
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Self-Test
Which of the following factors would not have an impact on the
cash flow estimates?
a. The new equipment would require $5,000 in shipping costs.
b. $25,000 was spent last year to improve the space that will house
the equipment.
c. The space for the equipment could be rented out for $1,000 per
month.
d. The new equipment would reduce the volume of an existing
service line.
e. The new equipment would increase accounts receivable by
$20,000.
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If this were a replacement rather
than a new (expansion) project,
would the analysis change?
■ The relevant operating cash flows would be the
difference between the cash flows on the new and
old project.
■ Also, selling the old equipment would produce an
immediate cash inflow, but the salvage value at the
end of its original life is foregone.
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Breakeven Analysis
• There are many different approaches to breakeven in
project analysis:
• Time breakeven
• Input variable breakeven
• Volume (4,142 versus 5,000 expected)
• Net revenue ($73.13 versus $80 expected)
• We will focus on time breakeven, which is
measured by payback (or payback period).
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Payback Illustration
0
1
2
3
4
($240
)
$100
$105
$110
$141
($
35)
$
75
$216
Cumulative
CFs:
($240
($140
)
)
Payback = 2 + 35 / 110 = 2.3
years.
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Advantages of Payback:
1. Easy to calculate and understand
2. Provides an indication of a project’s risk
and liquidity
Disadvantages of Payback:
1. Ignores time value
2. Ignores all cash flows that occur after the
payback period
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Healthcare Executives. Not for sale.
Profitability (ROI) Analysis
• Return on investment (ROI) analysis focuses on a
project’s financial return.
• As with any investment, returns can be measured
either in dollar terms or in rate of return (percentage)
terms.
• Net present value (NPV) measures a project’s time value
adjusted dollar return.
• Internal rate of return (IRR) measures a project’s rate of
(percentage) return.
• Modified IRR (MIRR) also measures percentage return.
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Healthcare Executives. Not for sale.
Net Present Value (NPV)
• NPV measures return on investment (ROI) in dollar
terms.
• NPV is merely the sum of the present values of the
project’s net cash flows.
• The discount rate used is called the project cost of capital
(PCC). If we assume that the illustrative project has
average risk, its project cost of capital is the corporate
cost of capital, 10%.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Net Present Value (NPV) Calculation
0
1
2
3
4
$100
$105
$110
$141
10
%
($240.00
) 90.91
86.78
82.64
96.30
$116.63
Thus, the project’s NPV is about $117,000.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Spreadsheet Solution
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Healthcare Executives. Not for sale.
Interpretation of the NPV
■ NPV is the excess dollar contribution of the
project to the equity value of the business.
■ A positive NPV signifies that the project
will enhance the financial condition of the
business.
■ The greater the NPV, the more attractive the
project financially.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Internal Rate of Return (IRR)
• IRR measures ROI in percentage (rate of return)
terms.
• It is the discount rate that forces the PV of the
inflows to equal the cost of the project. In other
words, it is the discount rate that forces the project’s
NPV to equal $0.
• IRR is the project’s expected rate of return.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
IRR Calculation (cont.)
1
0
2
3
4
$105
$110
$141
29.6%
($240.00
$100
) 77.11
62.46
50.48
49.95
$ 0.00 = NPV
Thus, the project’s IRR is 29.6%.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Spreadsheet Solution
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Interpretation of the IRR
■ If a project’s IRR is greater than its cost of
capital, then there is an “excess” return that
contributes to the equity value of the business.
■ In our example, IRR = 29.6 and the project
cost of capital is 10%, so the project is
expected to enhance Midtown Clinic’s
financial condition.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Self-Test
Which of the following statements is most
correct?
a. If NPV > $0, IRR < PCC. b. If IRR > PCC, NPV < $0. c. If NPV = $0, IRR = PCC. d. If IRR < PCC, NPV > $0.
e. If NPV < $0, IRR > PCC.
Copyright © 2020 Foundation of the American College of
Healthcare Executives. Not for sale.
Comparison of NPV and IRR
NPV
($)
IRR > PCC
and NPV > 0.
Value is increased.
IR
R
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Healthcare Executives. Not for sale.
PCC > IRR
and NPV < 0. Value is decreased. Project Cost of Capital (PCC) (%) Modified Internal Rate of Return (MIRR) • Both NPV and IRR require a reinvestment rate assumption. • NPV assumes it is the cost of capital. • IRR assumes it is the IRR rate. • Of the two, reinvestment at the cost of capital is the better assumption. • MIRR is a rate of return measure that forces reinvestment at the cost of capital. Copyright © 2020 Foundation of the American College of Healthcare Executives. Not for sale. MIRR (cont.) 0 1 2 3 $100 $105 $110 4 10% ($240.00 ) ($240.00 ) MIRR = 21.4% Copyright © 2020 Foun