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Chapter 13 Financial Evaluation of Projects

LEARNING OBJECTIVES

· 1. To develop skills in evaluating the financial consequences of alternative projects.

· 2. To understand what comprises a cash flow.

· 3. To understand the concept of payback as a tool to evaluate the financial desirability of a project.

· 4. To be able to compute discounted cash flow and to use three tools to evaluate the financial impact of projects (i.e., net present value, internal rate of return, and modified internal rate of return).

REAL WORLD SCENARIO

Eugene Righter is manager of strategy for St. Clement’s–Mercy Medical Center in a midwestern city. The medical center is widely regarded for the excellence of its clinical services, in particular its use of cutting-edge technology. At a recent meeting with the organization’s clinical directors, three new projects were proposed for development within the medical center over the next 5 years. Any of the three projects would enhance the medical center’s image as a progressive healthcare organization, and all of them are consistent with the St. Clement’s mission. As manager of strategy, it was Eugene’s job to assess the financial attractiveness of all new projects; unfortunately, although all three projects could be supported equally from a clinical perspective, the medical center had the financial resources to undertake only one. Eugene realized that because the projects were each designed to operate for a number of years, it was important to consider the financial attractiveness of each over several years. He recalled from his education that there were a number of financial tools that might be useful to assess this long-term financial attractiveness.

LEARNING OBJECTIVE 1: TO DEVELOP SKILLS IN EVALUATING THE FINANCIAL CONSEQUENCES OF ALTERNATIVE PROJECTS

Note: This is the objective for the entire chapter actually, although specific, more focused learning objectives are discussed throughout the chapter.

The concept of the time value of money was introduced in  Chapter 4 , including the tools of compounding and discounting. For a healthcare manager, the most important use of these tools is in evaluating potential organizational projects. This chapter provides examples of how to apply these tools in organizational decision making. Any project must compete for organizational approval and for the capital or funding associated with approval. Capital is limited and must be allocated to meet the many goals and objectives faced by the contemporary healthcare organization. New projects need to be designed to be competitive within this context of organizational priorities and realities.

Every project must compete for capital with existing projects, other new projects, and alternative uses of capital such as capital investment opportunities; e.g., certificates of deposit (CDs), mutual funds, money markets, etc. If an existing project needs to be stopped to furnish the capital needed for a new project, the termination expenses associated with stopping the first project must be added as an expense associated with the new project. However, generally new projects compete against other new projects and alternative capital uses, not existing projects.

In well-managed healthcare organizations, a project never competes only against itself for organizational approval. When organizations consider a new project, it is not enough to know how much a project will cost and how much it can be expected to earn. The manager must also compare a given project with other project alternatives and alternative uses of capital. Well-managed healthcare organizations evaluate projects based upon the implications and alternatives associated with the project and the capital needed to support it.

Most situations requiring managers to evaluate the attractiveness of a potential project or investment opportunity involve understanding and building upon the concept of the time value of money. In general, organizations are required to spend money now, an outflow of cash known as the initial investment or present value (PV). In future years the organization will experience a series of cash flows (cf) as a result of the project; these cash flows may be positive or negative, but in either case, by convention they are generally determined at the end of a defined time period, such as a month or a year. The amount of these cash flows is known as the future value (FV). Cash flows may involve either uneven amounts or equal amounts of money. Cash flows of equal size that occur at equal time intervals are known as annuities or payments (PMT).

Recall from  Chapter 4  in the discussion of compounding and discounting that the rate at which the value of money grows (going forward in time, known as compounding), or declines (going backward in time, known as discounting), is known as the discount rate, cost of capital or opportunity cost (i). The number of time periods (n) involved in the project or investment is the final factor.

The key variables addressed so far are:

· • Present Value: (PV)

· • Cash Flow in Time Period n: (cfn)

· • Future Value in Time Period n: (FVn)

· • Annuity (cash flows of equal size separated by equal time periods): (PMT)

· • Discount Rate, Cost of Capital, Opportunity Cost: (i)

· • Number of Time Periods: (n)

Using the formulas and techniques presented in the discussion of the time value of money it is possible to compute any unknown key variable, given sufficient information regarding other variables. For example, the present value (PV) can be computed, if the future value in time period n (FVn), the number of time periods (n), and an appropriate discount rate (i) are known.

In this chapter, tools for analyzing and comparing the attractiveness of a potential project or investment are described. These tools, the net present value (NPV), the internal rate of return (IRR), and the modified internal rate of return build upon the concept of the time value of money.

So fundamental are these concepts to management decision making that financial and business calculators have keys for each of the important variables to facilitate computation. In addition, spreadsheet programs, such as Excel, have functions to compute the values. Readers are encouraged to utilize such calculators or spreadsheet programs to assist in financial analysis. This chapter also presents how the calculations actually “work,” to provide a better understanding of the nature of the analyses.

LEARNING OBJECTIVE 2: TO UNDERSTAND WHAT COMPRISES A CASH FLOW

Managers of healthcare organizations need to consider many elements when evaluating potential projects. For example, market and competitive factors may influence the effect of the project on market share, the likely impact on the organization’s image, and the organization’s ability to establish and maintain a competitive distinction. Epidemiology too may influence the effect of the project. Health services managers should assess the likely impact of a project on the health status of the community. Managers must also always be sensitive to the impact of new projects on existing personnel and the organization’s ability to attract and retain well-qualified staff. The well-educated and highly trained nature of large portions of the typical health services organization’s staff make these factors especially important.

However, among all relevant factors financial issues are usually weighted most heavily by managers. In particular, managers assess a project’s impact on the organization’s ability to generate cash. This is not surprising, as it is the availability and flow of cash which, in a very real sense “fuel” the organization and its activities. Without an acceptable cash flow, the organization’s survival is in question. For this reason, it is critical to consider cash flow.

As the words suggest, a “cash flow” reflects the actual “movement” of funds in to or out of an organization. Revenues generated by a project are cash inflows. Expenses, such as payroll or supply purchases, are cash outflows. The difference between cash inflows and cash outflows is known as net cash flows. For example, if cash inflows for a new patient care service are $100,000 and the cash outflows associated with the project are $95,000, then the net cash flow for the service is $5,000. Net cash flows for any period of time may be either positive or negative.

Most projects involve a series of events that entail either the outflow or inflow of cash. For example, a multispecialty group practice might decide to purchase a new piece of laboratory equipment with the capability of completing multiple blood analyses electronically and much more rapidly than currently available technology. The purchase price of this equipment is $55,000. It is anticipated that the equipment has a useful life of 5 years; i.e., ongoing technological enhancements will make this equipment essentially obsolete in 5 years, and it will need to be replaced. The original vendor has agreed to pay $5000 to buy back the equipment at the time of replacement. This $5000 is known as the salvage value or salvage price. During its 5 years of operation, it is estimated that the equipment will generate revenue through charges associated with its use.  Table 13-1  displays estimated net revenue for the equipment.

Net cash flow takes into account both cash inflows and cash outflows. Notice that these numbers refer to actual cash flows. As such, some items recognized as an expense by generally accepted accounting principles are not cash flows. The most noteworthy example of this is depreciation. Depreciation expense is an accounting convention that is used to reflect the gradual erosion of an asset’s value because of it use over time. It does not involve any actual flow of cash, however, and thus does not enter into this type of project analysis.

Table 13-1 Estimated Net Cash Flows for Blood Analyzer Project

Table 13-2 Statement of Income—For Profit Nursing Home (000)

Gross Revenue from Operations		$8,300
Expenses:
	Total except Depreciation	$7,300
	Depreciation	100
Total Expenses		($7,400)
Net Income Before Taxes		$ 900
Income Taxes @ 40%		($ 360)
Net Income		$ 540
Cash Flow Statement—For Profit Nursing Home (000)
Service Revenue (net of allowances)		$ 8,300
Total Expenses (except depreciation)		(7,300)
Pre-Tax Cash Flows		$ 1,000
Taxes @ 40%		(360)
Net Cash Flow		$ 640

Consider the case of a private, tax-paying nursing facility. The facility’s income statement and a statement of cash flows are shown as  Table 13-2 . According to accounting convention, net income is calculated including depreciation as an expense. However, depreciation is not a cash expense. It is not included in the statement of cash flows. As a result, net income for the facility is $540,000, whereas the net cash flow for the same period of time is $640,000. The difference between the two, $100,000, is depreciation. The relationship between net income and cash flows is shown in  Equation 13-1 .

Net Income + Depreciation = Net Cash Flow

Equation 13-1

Which Cash Flows Should Be Included in Analyzing Projects?

One fundamental approach to evaluate the attractiveness of a project is to analyze the cash flow’s implications associated with it. Certainly, from a financial perspective, projects that generate larger, positive net cash flows are more attractive than other projects with lower positive, or even negative, net cash flows.

By convention, in assessing project opportunities, not all cash flows are included in the analysis. Only those cash flows directly related to the project should be included. The treatment of several major types of cash flows is described in the following paragraphs.

· 1. Revenues and expenses, other than depreciation, directly related to the project are included in the analysis.

· 2. The impact of the project on areas of the organization apart from the project itself needs to be considered. For example, a hospital opening a freestanding ambulatory surgery center may experience changes in demand for its existing inpatient or hospital-based outpatient surgical services, most likely reduction in demand for these services as a result of implementing the new center, a process known as “cannibalization.” Thus, for the entire organization (in this example, the hospital), some of the revenue realized by the new program is not “new” revenue; rather, it actually represents a shift in revenue brought about by patients using the new center instead of previously existing services. As such, only the “new” or incremental revenue associated with the new venture should be considered in the analysis. In calculating the cash inflows and outflows associated with the project, estimates of the actual incremental impact of the program need to be made. This estimation process, as much an art as a science, requires competence in the forecasting methods as well, as discussed in  Chapter 5 .

· 3. Sunk costs (i.e., a cost that has already been incurred or has been committed), are not included in the cash flow analysis. For example, the hospital may have retained consulting services to analyze the feasibility of the freestanding ambulatory care surgery center before analyzing its feasibility. This cost is a sunk cost; whether or not the hospital decides to proceed with the surgery center, the money has already been spent. Therefore, the expenditure does not represent a relevant cash flow for the analysis.

LEARNING OBJECTIVE 3: TO UNDERSTAND THE CONCEPT OF PAYBACK AS A TOOL TO EVALUATE THE FINANCIAL DESIRABILITY OF A PROJECT

A vital analysis completed by managers is an assessment of the net cash flows of a project, taking into account the timing of these cash flows. The timing of cash flows builds upon the concept of the time value of money. For example, a manager may determine that the project being analyzed is projected to generate a series of negative cash flows, followed by a large positive cash flow. This cash flow pattern is not uncommon for a new product or service that builds market share over a period of several years.  Table 13-3  displays such a cash flow for a planned health screening program.

The initial investment in the project is $10,000, shown as a negative cash flow in time period 0, which represents the present time. Operations in years 1 to 4 each generate a negative cash flow of $3000. Finally, in year 5, a positive cash flow of $25,000 is realized. It is assumed that year 5 is the final year of the project; i.e., no cash flows related to this project, positive or negative, occur after this point.

Table 13-3 Net Cash Flow—Health Screening Program

The question facing a manager is, “As a project, is this a good financial investment?” One way to formulate a response to this question is to assess the project’s cash flows.

It might seem intuitive to sum up the positive cash flows (cash inflows) and negative cash flows (cash outflows) associated with the project and make a decision based on whether the resulting net figure is positive or negative. After all, this approach does recognize the importance of cash flows. However, this approach is not adequate as it totally ignores the time value of money.

Alternatively, a manager might calculate what is known as the payback period. This is the length of time it takes to recoup the project’s initial investment. In this example, the project’s investment is recovered in the fifth year of the project. Based on this knowledge, a decision on whether or not to proceed with the project would be made. Does 5 years represent a reasonable time to recoup an initial investment of $10,000? This is essentially a judgment or value-driven call for the organization.

Although used relatively frequently, calculation of the payback period is also an incomplete approach, incomplete because it does not directly take into account the time value of money. As such, the approach is overly simplistic, and its use is discouraged.

LEARNING OBJECTIVE 4: TO BE ABLE TO COMPUTE DISCOUNTED CASH FLOW AND TO USE THREE TOOLS TO EVALUATE THE FINANCIAL IMPACT OF PROJECTS (I.E., NET PRESENT VALUE, INTERNAL RATE OF RETURN, AND MODIFIED INTERNAL RATE OF RETURN)

Taking into consideration the information on compounding and discounting presented earlier, it should be apparent that “adjustments” must be made to account for the timing of the anticipated cash flows. To assess the financial value of the project, the present value of cash flows associated with the project should be computed. Recall that in computing this present value, cash flows that are more distant in the future are discounted over more time periods. Thus, cash flows received earlier in the project’s life are worth more in current (present) dollars than those received later.

This process of calculating the present value of future cash flows is known as calculating a discounted cash flow. The goal of computing a discounted cash flow is to derive the present value of a project’s cash flows. The present value provides a measure of the project’s value at the current time (time = 0), so managers can compare present values among various projects; i.e., it creates an “apples and apples” framework for financial analysis. The arithmetic sum of the present value of the project’s cash flows is known as the net present value (NPV) of the project.

Determining a net present value requires discounting and involves these steps:

· 1. Select an appropriate discount rate and use it consistently to discount all future cash flows to the current time (i.e., time = 0).

· 2. Calculate the net present value of these discounted cash flows.

· 3. Compare the calculated net present value with a previously stated criterion or compare the net present values of various projects against one another.

In general, the management decision rule is that projects with a positive NPV are attractive, and that projects with larger positive NPVs are more attractive than those with smaller NPVs. Strictly from a financial perspective, projects with a negative NPV are not attractive.

Virtually all projects entail an initial investment, so it is essential that these funds be available at the time they are needed for the project. Regardless of the NPV, if the initial investment required for the project is not available, then the project may not be feasible. It may be possible for the organization to obtain financing (short or long term) to meet the initial investment requirement. The financial impact (in terms of cash flows, ability to take on additional debt, debt service requirement, etc.) would need to be woven into the cash flow analysis as well.

Recall that an important component of discounting is determining the appropriate discount rate. This topic is considered in greater depth later in this chapter. Assume that after careful research, the manager determines that the $10,000 available for investment could be used to purchase a CD for 5 years at an interest rate of 4.5%. Assuming an essentially equivalent level of risk between the CD and a new project opportunity, 4.5% would be an appropriate discount rate to use in calculating net present value. This calculation is depicted on  Table 13-4 , showing the present value of each future cash flow. The NPV of the potential project is –$702, not an attractive outcome from a financial perspective. Based on this analysis, then, investing in the CD would be more attractive financially.

This simple example is useful to illustrate several concepts regarding NPV as a decision tool. For example, although the project is not financially viable under current conditions, what initial investment would make the project attractive?

Table 13-4 Present Value of Future Cash Flows for Health Screening Program

(assume discount rate of 4.5%)
Year	Net Cash Flow	PV of Cash Flow
0	−$10,000	−$10,000
1	−$ 3000	−$ 2871
2	−$ 3000	−$ 2747
3	−$ 3000	−$ 2629
4	−$ 3000	−$ 2516
5	$25,000	$20,061
		NPV = −$  702

If the project’s NPV can be increased to a positive value, then it becomes a viable project; i.e., if the NPV can be increased by over $702. In effect, if any of the cash flows can be modified to result in a positive present value of at least this amount, then the project becomes financially viable. For example, management can determine that if its initial investment (cash outflow in time = 0) can be reduced to less than $9298, the project becomes financially attractive. At an initial investment of exactly $9298, the NPV is equal to 0. If management has defined a philosophy to accept “break even” projects in some circumstances, this project would then be acceptable.

Alternatively, using the cash flows and the discount rate it is possible to compute other changes that would generate a positive NPV. Management can then assess various strategic and tactical options (pricing, marketing, distribution, etc.) to assess whether any such changes are possible. For example, what positive cash flow must be generated in year 5 to result in a positive NPV? This is the same as asking what cash flow, discounted for 5 years at 4.5%, results in a present value of at least $20,763 (the negative discounted net cash flow excluding year 5). By using a hand-held calculator or a spreadsheet program (or working through the mathematics in detail, one cash flow at a time) the answer is $25,874. If the project is able to generate a positive net annual cash flow for year 5 of at least $25,874, then the NPV is greater than or equal to zero.

The impact of the discount rate selected can also be illustrated by this example. Suppose the discount rate used were 3% instead of 4.5%. With the new discount rate ( Table 13-5 ), the net present value is $414.

Table 13-5 Present Value of Future Cash Flows for Health Screening Program

(assume discount rate of 3.0%)
Year	Net Cash Flow	PV of Cash Flow
0	−$10,000	−$10,000
1	−$ 3000	−$ 2913
2	−$ 3000	−$ 2828
3	−$ 3000	−$ 2745
4	−$ 3000	−$ 2665
5	$25,000	$21,565
		NPV =  $  414

Annuities: A Particular Series of Cash Flows

Cash flows may occur in a variety of patterns. As in the examples presented earlier, the initial investment is followed by a series of uneven cash flows; i.e., the net annual cash flows differ among years. When this is the case, calculating the discounted present value of these cash flows involves a discounting calculation for each time period.

Table 13-6 Project with Equal Cash Flows—an Annuity

Year	Net Cash Flow
0	−$40,000
1	$ 9500
2	$ 9500
3	$ 9500
4	$ 9500
5	$ 9500

Other projects may generate equal cash flows. For example,  Table 13-6  shows a project that generated net annual cash flows of $9,500 for each of the next 5 years. This pattern of cash flows is known as an annuity. An annuity is a series of equal cash flows occurring over time at equal intervals. In this example, $9500 is received every year; both the amount and the timing of the cash flow are fixed and equal. An annuity is simply a specific pattern of cash flows. The cash flows involved with an annuity can be either net cash inflows or cash outflows. By convention, and for use with business or financial calculators or spreadsheet applications, cash flows associated with annuities are known as payments (PMT).

There are two types of annuities that differ only in the timing of when the payment takes place. If the payment occurs at the end of the time period specified, the annuity is referred to as an ordinary annuity. If the payment takes place at the beginning of the time period specified, the annuity is an annuity due. The majority of annuities are ordinary annuities.

Table 13-7  is an example of an ordinary annuity in which the purchaser will receive a series of $500 payments after each of the next 5 years. This is spoken of as a 5-year ordinary annuity. Notice that the first payment of $500 is received at the end of year 1, the second payment at the end of year 2, and so on for 5 years. A typical question that arises is, How much should an individual be willing to pay now for this annuity?

It should be clear that this question is a version of the present value computations already discussed. As always, the individual needs to determine an appropriate discount rate or cost of capital. Suppose an alternative investment is identified, i.e., a 5-year CD with an interest rate of 6%. As described, this represents the opportunity cost of purchasing the annuity. This problem becomes one of discounting each annual cash flow of $500 at the rate of 6% to determine the present value.

Table 13-7 Pattern of Cash Flows in an Ordinary Annuity—Payment Received at End of Period Indicated

Year	Net cash flow
0	−$2000
1	$ 500
2	$ 500
3	$ 500
4	$ 500
5	$ 500

The calculated present value of $2106 is the purchase price at which the individual should be financially indifferent between the two investments; i.e., there is no financial advantage in purchasing one over the other. Obviously if the annuity  is priced at less than $2106 it becomes a more attractive investment; prices over $2106 are less attractive.

Many standard calculators have a “PMT” key, which enables the user to enter the amount of the annual payment once along with the number of time periods of the annuity, rather than having to enter the same cash flow amount (the payment) for each year of the annuity. This computational function is not only convenient, but it also protects against the risk of entering data incorrectly. Common examples of an annuity are a home mortgage or a car loan, both of which typically involve a series of equal payments (the annuity).

Often, situations arise in which there is an annuity embedded within a series of annual cash flows ( Table 13-8 ). This cash flow has a series of 6 payments of $750 each from years 3 through 8 of the project. Assume a discount rate of 7%, what is the present value of this project (i.e., what is the most that should be invested in this project)?

There are two ways to go about solving this problem. The long way is to calculate the discounted present value of each annual cash flow and determine the NPV. This approach requires that each cash flow be entered individually.

A second, somewhat shorter, way to solve this problem is to utilize the fact that there is an annuity embedded in the cash flow stream. In effect, the cash flow stream is divided into multiple parts, those included in the annuity and those separate from it. The steps to solve this problem using the embedded annuity are described below and illustrated in  Table 13-9 .

Table 13-8 Pattern of Cash Flows with an Embedded Annuity (Years 3–8)

Year	Net cash flow
0
1	$ 1000
2	$  500
3	$  750
4	$  750
5	$  750
6	$  750
7	$  750
8	$  750
9	$  500
10	$  100

Table 13-9 Calculation of Net Present Value including Cash Flow Stream with an Embedded Annuity (Discount rate 5 7%)

· 1. Calculate the present value of the discounted cash flow for those periods not included in the annuity; i.e., years 1, 2, 9, and 10. Calculated present values are:

Year 1:	$934.58
Year 2:	$436.72
Year 9:	$271.97
Year 10:	$ 50.83

· 2. Calculate the present value of the embedded annuity. For this computation, the payment is $750, the interest rate is 7%, and the number of periods is six, the length of the annuity. This calculation yields a present value for the annuity of $3574.89. However, the annuity cash flows have been discounted only to the end of time period 2, the point at which the embedded annuity begins, not time period 0. Therefore, this calculated value must be discounted for an additional two periods to arrive at a present value at time 0. The calculated value of the embedded annuity portion of the cash flow stream at time = 0 is $3122.45.

· 3. Total the calculated present values to arrive at the NPV for the project. This amount equals $4816.55 for this example. The organization should be willing to invest no more than $4816.55 in this project.

Obviously, either approach to solving the problem should arrive at the same NPV. Viewing the project as an annuity simplifies the calculation somewhat. If the annuity is embedded in the middle of a cash flow stream, care must be taken to ensure that the cash flow of the annuity is fully discounted to the present time.

Internal Rate of Return

The NPV measures the present value of discounted cash flows for a project, assuming a particular discount rate. This is useful input for organizational decision making. On the other hand, the manager might be interested to know what rate of financial return is, in fact, generated by the project. This rate is known as the internal rate of return (IRR).

Table 13-10  displays the anticipated cash flows for a large respite care program planned by a nursing facility. Management of the facility has determined that an appropriate discount rate for this project is 6%. The NPV of the project is $5103, as calculated in the following. Because the NPV is positive, the organization decides to pursue the project.

Management may also be interested in calculating the actual rate of return (i.e., the IRR) for this project; that is the same as determining what discount rate generates an NPV of zero. Using a financial calculator with an IRR key to accomplish this computation, the IRR is 9.9%. As a check, the NPV is computed using a discount rate of 9.9%. As shown in  Table 13-11 , the NPV using these data is ($3), a value essentially equivalent to zero. This indicates that the calculated IRR is correct.

Table 13-10 Internal Rate of Return

Year	Net cash flow	PV (discounted at 6%)
0 (initial investment)	($40,000)	($40,000)
1	$ 5000	$ 4717
2	$10,000	$ 8900
3	$10,000	$ 8396
4	$15,000	$11,881
5	$15,000	$11,209
Net Present Value		$ 5103

Managers, particularly in industries other than health care, speak of something known as the “hurdle rate,” which refers to the minimum rate of return required for a project to be accepted or pursued by the organization. Hurdle rates may be established formally by boards, committees, or management teams, or they may be informal expectations of an organization. Suppose the formally established hurdle rate of the nursing facility is 10%. This means that it is willing to pursue only projects with an IRR greater than 10% (i.e., 10% is the financial return hurdle that must be “cleared” by the project).

Table 13-11 Estimated Cash Flows and NPV for Respite Care Program at Discount Rate = 9.9%

Year	Net cash flow	PV (discounted at 9.9%)
0 (initial investment)	−$40,000	−$40,000
1	$ 5000	$ 4550
2	$10,000	$ 8280
3	$10,000	$ 7534
4	$15,000	$10,283
5	$15,000	$ 9356
	NPV =	$    −3

Based on the information presented, independent from other nonfinancial considerations, the proposed respite care program would not be pursued, because the IRR is less than the approved hurdle rate. If the IRR exceeds the hurdle rate, then the project exceeds the required minimum return, and all other things being equal it is financially acceptable to the organization. As stated, there are always nonfinancial factors, such as community need and impact on health status, that must be considered before making a final decision on health services projects.

Modified Internal Rate of Return

Taking a closer look at IRR, it should be apparent that what is being done in calculating the IRR is that each future cash flow is, in effect, being compounded at the IRR percentage. In the respite care example this amounts to compounding at a rate of 9.9%. That is, an assumption is being made that funds could be invested and generate a return of 9.9%. Although the mechanics of the calculation may be clear, this IRR rate may or may not be an appropriate (or available) interest rate. The question is really one of whether money could actually be invested at this rate; i.e., it may be higher than or lower than the actual financial rate of return that could be obtained. To reflect this discrepancy, the IRR is frequently modified or adjusted to take into account any disparity between the IRR and the rate of financial return actually available in the financial market. This new measure can be referred to as the modified IRR.

Determining the modified IRR involves what is known as the terminal value. The terminal value is the value (taken at the final or terminal year of the project) of all cash flows compounded to this terminal year at an appropriate cost of capital. The specific steps to complete to determine the modified IRR are:

· 1. Determine an appropriate cost of capital or discount rate.

· 2. Compound all net cash inflows forward to the terminal year using this cost of capital. This compounded value is known as the terminal value. Compute the sum of the terminal values in the terminal year.

· 3. Use the cost of capital to discount all cash outflows back to year 0 of the project. Frequently, there may be only one cash outflow, the initial investment. Because this outflow takes place in year 0, no discounting is required.

· 4. The modified IRR is the discount rate that equates the present value of the terminal value to the present value of cash outflows.

Table 13-12  displays the discounted and compounded cash flow values for the respite care project. For this example, management has determined that 7% is an appropriate cost of capital (step 1). That is, 7% is the rate of return actually available for this project.)

Table 13-12 Modified Internal Rate of Return for Respite Care Program (000)

	Terminal value
0	1	2	3	4	5	@ 7%
−$40
	$5		$ 6554
		$10		$12,250
	$10		$11,449
	$15		$16,050
	$15	$15,000
	Net Terminal Value	$61,303

Table 13-13 Timeline for Mammography Center

0	1	2	3
−$25,000	$7000	$10,000	$20,000

The terminal value of each cash flow is computed by compounding each cash flow by the cost of capital 7%. For example, the terminal value of the $5000 cash flow projected for year 1 is the future value of this amount compounded for 4 years at 7%, or $6554. The sum of terminal values for the project is $61,303. The only cash outflow in this example is the initial investment of $40,000 which takes place at time 0, so it need not be discounted.

The modified IRR is the discount rate which equates the present value of the terminal value to the present value of the cash outflows. In this example, the adjusted IRR is the discount rate that “equates” $61,303 with $40,000. Taken another way, it is the compounding factor that grows an investment of $40,000 to a value of $61,303 in 5 years. The adjusted IRR is 8.91%.

To illustrate another example, suppose a group of hospitals and several physicians are considering developing a state-of-the-art mammography center. To participate, hospital A needs to contribute $25,000 now. Its anticipated net cash flows over the next 3 years are $7000, $10,000, and $20,000, respectively. The board of trustees of hospital A has identified 14% as the organization’s hurdle rate for this type of project. The chief financial officer has identified an opportunity cost of 7%. Based only on financial factors, should hospital A participate in the project?

Table 13-13  displays the timeline for this project. Using a PV or initial investment of $25,000, and the net cash flows anticipated, an IRR of 18.6% is computed. Using 7% as the discount rate or cost of capital yields an adjusted IRR of 15.7%.

Both the IRR and the modified IRR exceed the hurdle rate of 14%, so hospital A should pursue the mammogram project.

CONCLUSION

This chapter presents three tools to assist in analyzing projects: the net present value, the internal rate of return, and the modified rate of return. In actual practice, the internal rate of return is the most frequently used tool. Discussions regarding hurdle rates are not uncommon in finance and executive management meetings. Although in some respects the modified IRR is a more accurate assessment of the return of a project, it is infrequently encountered in management suites or boardrooms. NPV falls somewhere in between in terms of frequency of use. Capable healthcare managers should be equally competent in the use of all three tools, and in fact, it may be useful to compare the outcomes of the three approaches in arriving at a final determination regarding a potential project.

Determining the Discount Rate, and a Brief Look at Risk

From the material presented in this chapter it should be apparent that the determination of an appropriate discount rate (alternatively known as the cost of capital, or opportunity cost) is an important element of financial evaluation of projects. Choosing a rate that is either unrealistically high or low may result in poor management decisions; e.g., missed opportunities or poor returns on projects.

Determining the discount rate is not a precise science; rather, it is an excellent example of a manager’s use of reasoned judgment. As described, probably the most appropriate approach is to use the rate of return of an alternative investment. This is the opportunity cost.

In earlier examples, interest rates on bank passbook accounts and CDs were used. A bank account interest rate is an example of a relatively risk-free investment (assuming the amount of the account is less than the limit of federal deposit insurance). In the context of finance, risk refers to the probability that actual future returns will be less than expected returns. For a bank savings account, in most cases, the depositor is guaranteed the stated interest rate; i.e., the risk is low. Various investment offerings of the federal government are also examples of virtually risk-free investments; e.g., treasury bills, notes, and bonds. In fact, government treasury bonds (t-bonds), long-term investment vehicles requiring investments of over $1000, are often considered the benchmark for risk-free investments. Other investments are more risky, although all investments have some level of risk, however minimal.

Different types of risk exist; some are associated with business uncertainty (e.g., the level of variation between actual and forecast utilization levels of a new project), and some are associated with changes in the broader economy (e.g., the effect of inflation). Many theoretical approaches have been developed to attempt to estimate levels of risk. For a more thorough discussion of elements associated with risk and approaches to estimate it, the reader is encouraged to review any of the general finance texts cited in the list of suggested readings. For the purposes of this book, readers need to be aware that risk is a factor in all projects, levels of risk may vary among projects, and it is incumbent on the manager to take the relevant risk into account when evaluating projects.

EXERCISES

· 13-1 A representative of a reputable financial services company has approached you as manager of a four-person group of anesthesiologists with an opportunity to purchase a 10-year annuity due for each member of the group. The annuity due would pay $40,000 each year beginning 5 years from now (i.e., at time = 5). What is the most you would be willing to pay now, per each physician, for this investment? Assume an appropriate discount rate of 7%.

· 13-2 The hospital’s marketing and finance departments have just provided you, as chief financial officer, with pro forma income statements for your proposed sonogram center. These statements appear in the following.

Pro forma Income Statement

(000)

Time	t + 1	t + 2	t + 3	t + 4
Service Revenues (net)	$425	$500	$580	$700
Expenses	$400	$450	$525	$600
Depreciation Expense	$ 35	$ 35	$ 35	$ 35
Net Income	($ 10)	$ 15	$ 20	$ 65

What is the project’s IRR? Assume an initial investment of $175,000 and an appropriate discount rate of 6%. The hospital is operated as a not-for-profit facility.

· 13-3 The chief operating officer (COO) of a small, not-for-profit community hospital has to make a recommendation to the board of trustees on choosing among three project options for an unrestricted gift of $250,000 that has just been received. The board has established a time horizon of 5 years on this project. The options are described in the following.

· a. Purchase a 5-year treasury note at an interest rate (annual) of 7%.

· b. Purchase the practice of a young physician (the hospital’s third highest admitter). Estimates of projected cash flows for the practice (post-purchase), are:

Probability of Cash Flow

Time	60%	20%	20%
t + 1	$ 40,000	$20,000	$ 60,000
t + 2	$ 60,000	$30,000	$ 80,000
t + 3	$  75,000	$40,000	$100,000
t + 4	$100,000	$50,000	$125,000
t + 5	$100,000	$50,000	$125,000

· c. Purchase an upgraded analyzer for the laboratory. Based on forecasts of laboratory utilization, the net cash flows for this project are:

Time	Net Cash Flow
t + 1	$75,000
t + 2	$75,000
t + 3	$50,000
t + 4	$50,000
t + 5	$50,000

· Which investment should the COO recommend and why?

· 13-4 What are some of the factors that can influence the riskiness of projects (investments) in healthcare organizations?