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Chapter 19

Capital Project Analysis

Learning Objectives

Explain who is involved in the capital investment decision process.
Describe the kinds of decisions that are made in capital investment decision analysis.
Explain the four stages of the capital decision-making process.
List the kind of information that is needed to evaluate a capital investment project.

Learning Objectives, cont.

Calculate a project’s net present value, profitability index, and equivalent annual cost.
Explain the concepts of a discount rate and the weighted average cost of capital.

Capital Project Analysis

Occurs during the programming phase of the management control process
Primarily concerned with new projects
It is also a yearly estimate of resources that will be expended for new programs during the coming year.

FIGURE 19-1 Capital Decision-Making Participants

External Participants

Financing sources: Investment bankers, bond-rating agencies, bankers, feasibility consultants, etc.; collectively, may influence the amount of money that can be borrowed and the terms of the borrowing

Rate-setting and rate-control agencies: Can limit the amount of money available for financing capital projects by reducing the amount of profits that may be retained

External Participants, cont.

Third-party payers: Affect both capital expenditure levels and sources of financing through reimbursement provisions

Planning agencies: Review applications of capital expenditures and pass recommendations to the state authority responsible for final approval or disapproval in states that require certificate-of-need

Internal Participants

Board of trustees: Responsible for the capital expenditure and capital financing program of the healthcare firm

–Main function: clearly establish defined goals and objectives, which is the prerequisite to programming phase of capital expenditure analysis
–Approves preliminary 5-year capital expenditure program, which is linked to strategic financial plan

Planning committee: Defines, analyzes, and proposes programs to help the organization attain its goals and objectives

Internal Participants, cont.

Finance committee: Involved with translating programs into financing requirements; ensures adequate financing to meet program requirements

Chief Executive Officer(CEO): Responsible on a day-to-day basis for implementing approved capital expenditure programs and developing related financing plans; much of the authority is delegated by the board of trustees

Department managers: Make most of the internal requests for capital expenditure approval

Internal Participants, cont.

Medical staff: Mostly employees of the healthcare firm; place demands for capital expenditures due to their influence on firm’s utilization

Controller: Facilitates approval of capital expenditures; assists administrator with allocating budget to competing departments

Treasurer: Responsible for obtaining funds for both short-and long-term programs

Capital Expenditures Classification

Capital expenditure: A commitment of resources that is expected to provide benefits during a reasonably long period, at least 2 or more years
Important classifications are by:

–Period during which the investment occurs
–Types of resources invested
–Dollar amounts of capital expenditures
–Types of benefits received

Period of Investment

Determining the amount of resources committed to a capital project depends heavily on the definition of the period.
Consider this example: the initiation of programs funded by grants

–Capital expenditures and additional operating funds for later periods may be required, if there is a formal or informal commitment to continue the program for a longer period.
–Long-run capital costs of grant-funded projects must be identified.

Types of Resources Invested

Capital assets: Tangible fixed assets
Lease: Many healthcare facilities lease a significant percentage of their fixed assets (e.g., equipment)
Operating costsassociated with beginning and continuing capital project

–Lifecycle costing: Method for estimating the cost of a capital project that reflects total costs, both operating and capital, over the project’s estimated useful life
–Lifecycle costs should be considered for all programs; doing so may affect selection of alternative projects.

Amount of Expenditures

Control over capital expenditures should be conditioned by the total amount involved.
Follows one of three patterns:

–Approval required for all capital expenditures
–Approval required for all capital expenditures above a pre-established limit (e.g., $5,000)
–No approval required for individual capital expenditure projects below a total budgeted amount

Sometimes an absolute dollar limitis placed –an authorized capital budget on any items in question

Types of Benefits

Determine the systems of management control and evaluation to be used (e.g., investment in medical-office building versus investment in alcoholic rehab unit)
In health care, benefits differ from those considered in other industries and may include benefits that are more important than cost reduction or increase in profits
Main categories:

–Operational continuance
–Financial
–Other

Types of Benefits, cont.

Operational continuanceproduces benefits that permit continued operations of the facility along present lines

–Main questions:

Are continued operations in the present form desirable?
Which alternative investment project can achieve continued operations in the most desirable way?

–Example: Requirement to install a sprinkler system in a nursing home; failure to do so may result in discontinuance of operations

Types of Benefits, cont.

Financial, either reduced costs or increased profits to the organization

–If the major benefits are financial, traditional capital budgeting methods may be more appropriate.

Otherinvestments range from projects that activate major new medical areas (e.g., outpatient services) to projects that improve employee working conditions (e.g., employee gymnasiums)

–Benefits may be more difficult to quantify and evaluate

Capital Decision-Making Process

Allocation of limited resources to specific project areas that directly affects the efficiency, effectiveness, and, ultimately, the continued viability of the organization
Main interrelated stages:

–Generation of project information
–Evaluation of projects
–Decisions about which projects to fund
–Project implementation and reporting

Generation of Project Information

Information is gathered that can be analyzed and evaluated later.
Main categories of information needed for capital expenditure proposal evaluation:

–Alternatives available
–Resources available
–Cost data
–Benefit data
–Prior performance
–Risk projection

Project Information Types

Alternatives available: Deficiency in many capital expenditure decisions is failure to consider alternatives (e.g., other manufacturers or financing methods)
Resources available: Often, limited resources must be allocated among numerous investment opportunities; may force department managers to submit only projects in the department’s best interests
Cost data: Lifecycle costs of a project should be presented; limiting cost information to capital costs can be counterproductive

Project Information Types, cont.

Benefit data: Quantitative (financial) and qualitative (unquantifiable benefits)
Prior performance: Comparison of prior actual results with forecast results gives a decision maker some idea of the reliability of forecasting
Risk projection: “What if” questions (e.g., How would costs and benefits change if volume changed?); programs with extremely high proportions of fixed or sunk costs are much more sensitive to changes in volume and thus more risky

Project Evaluation

Based most importantly on solvencyand cost
Solvency: The ability to show positive rate of return in the long run; operation of an insolvent program eventually can threaten the solvency of the entire organization
Cost: The organization needs to select the projects that contribute most to the attainment of its objectives, given resource constraints; this is called cost–benefit analysis

–Cost-effectiveness analysis: projects that are eventually selected should cost the least to provide a given service

Decisions About Which Projects to Fund

Decision makers possess lists of possible projects that may be funded.
Each project should represent the lowest cost of providing the desired service or output.
Various benefit data on each project should be described.

Decision-Making Example

Consider this example: How many projects, if any, out of these three will be funded?
Projects: hemodialysis unit, burn care unit, commercial lab
Relevant decision criteria:

–Solvency
–Incremental management time required
–Public image
–Medical staff approval

Decision makers must weight the criteria according to their preferences, because there is no dominant project.

Decision Making Example, cont.

Project Implementation and Reporting

Expenditure control systems should be focused on whether the projected benefits are actually being realized as forecast (in addition to analysis and evaluation prior to selection).
Benefits of establishing capital expenditure review program:

–Highlights differences between planned versus actual performance that may permit corrective action
–May result in more accurate estimates
–Forecasts by individuals with a continuous record of biased forecasts can be adjusted to reflect that bias

Justification of Capital Expenditures

Initiated by a department or responsibility-center manager through the completion of a capital expenditure approval form
Approval provides a detailed summary of:

–Amount and type of expenditure
–Attainment of key decision criteria
–Detailed financial analysis

Small capital expenditures (e.g., under $2,000) are usually not subjected to detailed analysis and do not require justification.

Justification of Capital Expenditures, cont.

Replacement items are specially recognized:

–For example, expenditure less than $20,000 may not be subject to review
–This higher limit is due to replacement items being essential to continuance of existing operations
–Not evaluated as closely as expenditures for new pieces of equipment

Justification of Capital Expenditures, cont.

Overall criteria of selection process includes:

–Need (management goals, hospital goals)
–Economic feasibility
–Acceptability (physicians, employees, community)

Nonfinancial criteria also important, to avoid subjectivity and avoid illegitimate inferences
Key aspect of the capital expenditure approval process is the financial or economic feasibility of the project, measured by summary statistic:

–Discounted cash-flow method (DCF)
–Nondiscounted cash-flow method

Discounted Cash-Flow Methods

DCF methods are based on the time-value concept of money
Calculation of specific DCF measures is important but not critical; most important phase in capital expenditure review process is the generation of quality project information
Main methods and their areas of application:

–Net present value: capital financing alternative
–Profitability index: capital expenditures with financial benefits
–Equivalent annual cost: capital expenditures with nonfinancial benefits

Net Present Value (NPV)

Discounted cash inflows less discounted cash outflows and initial investment outlay.
The NPV presents the return on investment expressed in dollar terms.
Only incrementalcash flows should be considered (i.e., the additionalcash inflows and outflows that accrue as a result of taking on the capital project).
Not included: sunk and financing costs (financing costs are represented by the discount rate)

Net Present Value, cont.

When comparing two alternative financing packages, the one with the highest NPV should be selected.
Consider this example: Asset can be financed with 4-year annual $1,000 lease payment, or can be purchased for $2,800.
In this case, select the project with the lowest NPV cost.
Assume the discount rate is 10% (can reflect both borrowing or investment cost).
Present value (PV) cost of lease = $3,169, compared to the PV cost of purchase = $2,800
The purchase alternative is the lowest costalternative method of financing.

Cost Reimbursement

Means that facility would be entitled to reimbursement for depreciation if an asset was purchased, or the facility would be entitled to the rent payment if an asset was leased
Effects are declining for many providers, except for designated critical access hospitals and other groups under Medicare
Example: PV of reimbursed cash inflow under straight-line depreciation with 20% of capital expenses reimbursed by third-party cost payers

Present Value of Reimbursement Example

If asset was purchased: Organization would pay $2,800 immediately

–For each of the next 4 years, it would be reimbursed for the noncash expense item of depreciation in the amount of $700 per year ($2,800 ÷4)
–However,because only 20% of patients are capital cost payers (covered by third-party payers who reimburse the facility for capital costs), only $140 per year would be received (0.20 ×$700)

If asset was leased: Organization would be reimbursed for lease payment of $1,000 per year

–However, because only 20% of patients are capital cost payers, only $200 (0.20 ×$1,000) would be paid

Present Value of Reimbursement

NPV of Financing Alternatives

NPV of Financing Alternatives Example

Best method of financing is purchase

–Annual expenses will be $700 in depreciation, compared with $1,000 per year with the leasing plan
–Lower NPV

Caution: Relative ratings regarding NPV could change quickly, given higher percentages of capital cost reimbursement.

–If 80% of capital costs reimbursed, leasing’s NPV (–$634) is better (i.e., less negative) than purchasing’s NPV (–$1,025)

Profitability Index

Compares rates of return of competing projects
Useful when the benefits of the projects are mostly financial (e.g., capital project that saves costs)
When funding is limited, projects with the highest rate of return per dollar of capital investment are best candidates for selection.

Profitability Index Example

Consider this example: investment in laundry service shared with a group of hospitals
Investment cost: $100,000
Savings in operating costs: $20,000 per year for 10-year project
Discount rate: 10%

Profitability Index, cont.

Profitability indices greater than 0 imply that the project is earning at a rate greater than the discount rate.
With no funding constraints, all projects with profitability indices greater than 0 should be funded.
In most situations, funding constraints do exist, and only a portion of those projects with positive profitability indices are actually accepted.

Profitability Index Example and Cost Reimbursement

Need to adjust initial NPV of $22,900 to reflect the effects of cost reimbursement
The firm can receive 50% of the annual depreciation of $10,000 ($100,000/10), or $5,000 per year, as a reimbursement cash flow.

–PV of this stream, $30,725, is added to the initial NPV of $22,900.

Savings of $20,000 per year reduce reimbursable costs by $10,000 annually.

–PV of the loss is $61,450, subtracted from initial NPV.

Cost reimbursement thus reduces increased costs associated with new programs, but it also reduces the cost savings associated with new programs.

Equivalent Annual Cost

The expected average cost, considering both capital and operating cost, over the life of the project
Primarily important when selecting capital projects for which alternatives exist

Equivalent Annual Cost Example

Example: investment in sprinkler system to maintain license for extended care facility
Two alternatives:

–System A: $5,000 investment and annual maintenance of $500 for 10 years
–System B: $10,000 investment and annual maintenance of $200 for 20 years

Discount rate: 10%

Equivalent Annual Cost Example, cont.

$5,000 sprinkler system would produce the lowest equivalent annual cost (EAC) of $1,314 per year, compared with a $1,375 EAC for the $10,000 system.
Note: EAC method allows comparison of projects with different lives, assuming that technology will not change.
Subjective weight should be given to projects of shorter duration in situations of estimated rapid technologic change.

EAC and Accounting Costs

Not identical: EAC versus accounting cost

–Annual reported accounting cost for each alternative is annual depreciation expenses plus the maintenance cost.
–In our sprinkler example:

EAC and Accounting Costs, cont.

Not incorporating the time-value concept of money can produce misleading results, as it does in the previous example.
Second alternative is not the lowest cost alternative when the cost of capital is included.
Savings of $5,000 in investment cost between the two systems can be used either to generate additional investment income or to reduce outstanding indebtedness.

EAC and Cost Reimbursement

In the sprinkler example, consider the effects of cost reimbursement (assume 50% cost will be reimbursed):
EAC of the $5,000 sprinkler system:

–PV of reimbursed operating costs = $500 x 6.145 x 0.50

= $1,536.25

–PV of reimbursed depreciation = $5000/10 x 6.145 x 0.50

= $1,536.25

–EAC with cost-based reimbursement =

$1,314 –(1,526.25+1,536.25)/6.145 = $814

EAC and Cost Reimbursement, cont.

In the sprinkler example, consider the effects of cost reimbursement (assume 50% cost will be reimbursed):
EAC of the $10,000 sprinkler system:

–PV of reimbursed operating costs = $200 x 8.514 x 0.50

= $851.40

–PV of reimbursed depreciation = $10,000/20 x 8.514 x 0.50

= $2,128.50

–EAC with cost-based reimbursement =

$1,375 –(851.40 + 2,128.50)/8.514 = $1,025

EAC and Cost Reimbursement, cont.

In this example, the effect of cost reimbursement did not change the decision.

–The lower-cost sprinkler system is still the best alternative.

Discount Rate

In health care, discount rate is important but not critical, as decision making is not solely based on financial considerations.
Change in relative ranking of projects is much more likely to result from an accurate forecast of cash flows than from an alternative discount rates.
However, the choice of discount rate may affect desirability of alternative projects, so it is important to consider.
Primary methods for defining a discount rate (or cost of capital) for use in DCF analysis:

–Cost of specific financing source
–Yield achievable on other investments
–Weighted cost of capital

Discount Rate Selection

Cost of specific financing source: sometimes used as the discount rate (e.g., firm borrows money at 8%)
Yield rate: often, this is equal to the investment yield possible in the firm’s security portfolio (e.g., firm earns 10% on security investments)

Discount Rate Selection, cont.

Weighted average cost of capital (WACC)is the most widely used method for defining the discount rate:

Represents the cost of capital to the firm, recognizing that capital consists of both debt and equity
The major challenge with this method is defining cost of equity for NFP firms.

–A solution is to use the cost of equity for a similar IO firm.

Valuation

Common occurrence today is that healthcare entities are buying or acquiring related healthcare businesses (e.g., other hospitals, nursing homes, physician practices)
Main question: What is the valueof the business acquired?
Valuation is a subset of capital expenditure analysis

–Acquired business: capital expenditure that needs to be evaluated
–Nonfinancial criteria should be considered, and the contribution that the acquired business will make toward the acquiring firm’s mission must be addressed.