principles of capital budgeting

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

Principles of Capital Budgeting

Project classifications

Role of financial analysis

Cash flow estimation

Breakeven and profitability measures

The post audit

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What is capital budgeting?

Analysis of potential additions to a business’ fixed assets.

Such decisions:Typically are long-term in nature.Often involve large expenditures.Usually define strategic direction.

Thus, such decisions are very important to a business’ future.

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Project Classifications

For analysis purposes, projects are classified according to purpose and size. For example,Mandatory replacementExpansion of existing servicesExpansion into new services

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Role of Financial Analysis

For investor-owned firms, 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’ financial condition.

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Overview of Capital Budgeting Financial Analysis

1. Estimate the capital outlay.

2. Forecast the cash inflows:Operating flowsTerminal flows

3. Assess the project’s riskiness.

4. Estimate the cost of capital.

5. Measure the financial impact.

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Key Concepts in Cash Flow Estimation

Incremental cash flows:

Inc. CF = CF(w/ project) - CF(w/o project).

Cash flow versus accounting income

Cash flow timing

Project life

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Key Concepts (Cont.)

Sunk costs

Opportunity costs:For capitalFor other resources

Effects on other business lines

Shipping and related costs

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Key Concepts (Cont.)

Working capital effects:Current assetsCurrent liabilities

Inflation effects

Strategic value

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Cash Flow Estimation Example

Assume Northwest Healthcare, a not-for-profit hospital, is evaluating a new piece of diagnostic equipment

Cost:$200,000 purchase price$40,000 shipping and installation

Expected life = 4 years.

Salvage value = $140,000.

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Utilization = 5,000 scans/year.

Charge = $80 per scan.

Variable cost = $40 per scan.

Fixed costs = $100,000.

Corporate cost of capital = 10%.

Cash Flow Estimation Example (Cont.)

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Time Line Setup

0 1 2 3 4

OCF1 OCF2 OCF3 OCF4InitialCosts(CF0)

+Terminal CF

NCF0 NCF1 NCF2 NCF3 NCF4

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Equipment $200

Installation & Shipping 40

Net investment outlay $240

Investment at t = 0 (000s)

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Operating cash flows (000s)

1 2 3 4Revenues $400 $400 $400 $400Total VC 200 200 200 200

Depreciation 25 25 25 25BT op. inc. $ 75 $ 75 $ 75 $ 75

Taxes -- -- -- --$ 75 $ 75 $ 75 $ 75

Depreciation 25 25 25 25Net op. CF $100 $100 $100 $100

AT op. inc.

Fixed costs 100 100 100 100

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Should the CFs on the previous slide have included interest expense

or dividends?

No. Financial costs are accounted for by discounting the net cash flows at the 10% corporate cost of capital. Thus, deducting interest or dividends from the estimated cash flows would be “double counting” financing (capital) costs.

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Terminal cash flows at t = 4 (000s)

Salvage value $140Tax on SV 0 Net terminal CF $140

How are salvage value taxes determined for investor-owned firms?

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Suppose $5,000 had been spent last year to improve the space for the new

diagnostic equipment. Should this cost be included in the analysis?

No. This is a sunk cost. The money has already been spent, so project acceptance would have no effect on that flow. Cash flows in the analysis must be incremental to the project.

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Suppose the space could be leased out for $12,000 a year. Would this

affect the project’s cash flows?

Yes. Accepting the project means that Northwest Healthcare is foregoing a $12,000 cash inflow. This is an opportunity cost that should be charged to the project.

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If the new equipment would decrease patient utilization of existing services,

would this affect the analysis?

Yes. The effect on other CFs within the business is an “externality.”

The net CF loss each year on other services would be a cost to this project.

Externalities can be either positive or negative.

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0

100

1

100

2

100

3

100

4

-240140240

Net cash flows (000s)

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If this were a replacement rather than a new (expansion) project, would the

analysis change?

The relevant operating CFs would be the difference between the CFs on the new and old equipment.

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 breakevenInput variable breakeven

• Utilization• Charge

We will focus on payback (or payback period), a measure of time breakeven.

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What is the project’s payback?

0

100

1

100

2

100

3

240

4

-240

Cumulative CFs:

60-240 -40-140 300

Payback = 2 + 40 / 100 = 2.4 years.

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Strengths of Payback:

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores time value.

2. Ignores all CFs occurring after the payback period.

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Profitability Analysis

Profitability analysis focuses on a project’s 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 dollar return.Internal rate of return (IRR) measures a

project’s rate of return.

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Net Present Value (NPV)

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. If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%.

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What is the project’s NPV?

0

100

1

100

2

100

3

240

4

-240.00

10%

90.9182.6475.13

163.93172.61 = NPV

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Financial Calculator Solution

Enter in CFj registers:

-240

100

100

100

240

CF0

CF1

NPV

CF2

CF3

I

Then:

= 10

And solve for:

CF4

= 172.61

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Interpretation of the NPV

NPV is the 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.

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Internal Rate of Return (IRR)

IRR measures a project’s percentage (rate of) return.

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.

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What is the project’s IRR?

0

100

1

100

2

100

3

240

4

-240.00????

0.00 = NPV

IRR = ?

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What is the project’s IRR? (Cont.)

0

100

1

100

2

100

3

240

4

-240.0073.8454.5340.2771.36

0.00 = NPV

IRR = 35.4%

Therefore, IRR = 35.4%.

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Calculator Solution

Enter in CFj registers:

-240

100

100

100

240

CF0

CF1IRR

CF2

CF3

And solve for:

CF4

= 35.4%

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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 = 35.4% and the project cost of capital is 10%, so the project is expected to enhance Northwest’s financial condition.

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k > IRRand NPV < 0.

Value is decreased.

NPV ($)

Cost ofCapital (%)

IRR

IRR > kand NPV > 0.

Value is increased.

Comparison of NPV and IRR

Here, k = project cost of capital.

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Capital Budget Decision Making

Responsibility resides with:Senior-level management/GB for

expansion-type capital projectsMid-level management for replacement-

type capital projectsDecision criteria summary

Strategic importance of project“Appropriate” project returns anticipated“Manageable” level of project risk

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Evaluating projects with unequal livesMutually exclusive projects having different

useful life periodsComparing apples to oranges

Evaluation methodsReplacement chain analysis method

• “Force” projects to have equal lives by allowing unlimited replication

• Assumes that cash flow projections and cost of capital won’t change upon replication

• Difficulty in finding “lowest common denominator” for similar project lives (5 vs. 6)

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Equivalent Annual Annuity MethodGiven projected project NPV, estimate

“implied” annuity (PMT) associated with stream of cash flows

Enter NPV as PV in calculator, cost of capital as ‘I’, and # of years as N, find PMT

Project with highest estimated EAA is preferred

Like RCA method, assumes that projects can be costlessly replicated indefinitely.

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Capital Budgeting in NFP Businesses

Measures thus far have focused on the financial impact of a project.

Presumably, NFPs have important goals besides financial ones. Other considerations can be incorporated into the analysis by using:The net present social value (NPSV)

model.

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Capital Budgeting in NFP Businesses

TNPV = NPV (fin.) + NPSV (social)Preferred projects have high TNPVNo investments in projects where

NPSV < 0 (regardless of NPV)Average TNPV for all projects = 0Estimation of NPSV -- willingness to

pay methodology (conceptual)The “social” cost of capital

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Post Audit

The post audit is a formal process for monitoring a project’s performance over time.

It has several purposes:Improve forecastsDevelop historical risk dataImprove operationsReduce losses

principles of capital budgeting

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