capital budgeting decisions clifton louie, rph, dpa, fache may 2003
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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?
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