Assignment 11: Final Strategic Development

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Strategic Analysis for Healthcare

Chapter 26

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Financial Fit Assessment and Projection

In strategy selection, the financial investment required to support implementation is a significant criterion, as is the amount of time needed to recoup the investment and profit potential.

The QSPM model might show one proposal to be superior to the others in a strategic sense; however, the organization might not have the financial resources to successfully implement and maintain that strategy.

To address concerns of this nature, the strategist must apply a financial screen to the proposed strategies.

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Financial Fit Assessment and Projection

In a survey of 1,139 executives by McKinsey & Company, 75 percent said companies that get the best results use a balanced mix of financial and strategic targets; only 11 percent disagreed.

The point behind these findings is that a strategic fit is not enough. One needs both a strategic fit and a financial fit.

A complete financial analysis, using factors such as depreciation, tax effect, and so on, is beyond the scope of this book. However, this chapter introduces several important financial analysis measures, including net present value, internal rate of return, profitability index, payback period, and probability of success.

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Net Present Value

The net present value (NPV) of a future stream of income recognizes that the future income is worth less in today’s dollars than a simple arithmetic sum of the same dollars would indicate.

The basic idea behind this concept is that a dollar in hand today is worth more than the promise of a dollar five years from now.

The promise five years from now will be eaten away by inflation, which lessens the dollar’s purchasing power.

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Net Present Value

The next slide demonstrates a calculation for net present value using Microsoft Excel.

To begin, set up a chart showing the annual cost of capital or discount rate, followed by each yearly income.

You can then use Excel’s “=NPV” function to calculate the net present value.

Use the discount rate as “rate,” and highlight the cells with the initial cost and yearly incomes to finish the equation.

In the example shown in the exhibit, the total return less the up-front investment is $4,000,000; however, the net present value is only $1,188,443 due to the time value of money.

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Net Present Value

Excel syntax: NPV(rate,value1,value2, ...)

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Internal Rate of Return

The internal rate of return (IRR) determines the percent return on an investment considering an initial start-up expenditure followed by an annual income stream.

The measure enables a strategist to compare one strategy to another to determine which has the highest percent return.

Some companies use the discount rate for comparison with the IRR.

However, most companies have a discreet decision criteria threshold such as, “Any project investment must have an IRR of 10 percent or greater, or we will not pursue it.”

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Internal Rate of Return

The next slide shows a Microsoft Excel calculation of internal rate of return.

Using the same chart you used for calculating the NPV, select Excel’s “=IRR” function and then highlight the cell with the initial cost plus the cells with the yearly incomes to finish the equation.

Excel allows a space in the syntax for “guess,” but we recommend that you leave this field blank, in which case Excel will automatically assume 10 percent.

In the example shown in the exhibit, the total income less the up-front investment is $4,000,000, and the internal rate of return is 16 percent.

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Internal Rate of Return

Excel syntax: IRR(value1,value2, ..., Guess)

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Profitability Index

The profitability index (PI) is similar to the internal rate of return, but it is calculated differently and gives a slightly different percent return.

The PI provides information on your strategic investment opportunity, as well as a decision rule by which you can accept or reject an investment.

The PI tells you what your return will be for every dollar invested in a strategic initiative (e.g., for every $1 invested you will return $1.29).

The PI also suggests that a project with a PI score of less than 1 should be rejected as an insufficient return, whereas a project with a PI score of 1 or greater should be considered for investment.

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Profitability Index

Formula: (NPV + startup costs) / start-up costs

($1,188,443 + $10,000,000) / $10,000,000

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Payback Period

The payback period (PP) answers the question, “If I make the required investment in this strategy, how long will it take to recoup my investment?”

This period can be expressed in the number of months or number of years.

In the previous example, the payback period is approximately 30 months to recoup the initial $10,000,000 invested (excluding the time value of money).

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Probability of Success

Potential strategies will each have different likelihoods of success, and a strategy’s profit potential should be discounted by the probability of achieving it.

You can estimate the probability of success based on research and intuition, and then multiply the probability by the NPV.

This calculation enables you to compare across potential strategies that have different NPVs and different probabilities of success, to level the comparison playing field.

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Putting It All Together

Lining up the various calculations in a single display, as shown on the next slide, allows you and your viewer to quickly see the values and thus more easily compare competing strategies to find the best financial fit with your organization.

Keep in mind that a strategy with a good financial fit might not be a good strategic fit; likewise, a strategy with a great strategic fit might not make the most financial sense.

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Putting It All Together

	NPV	IRR	PI	PP	Prob	Prob*NPV	Choice
Strategy A	$28.1M	15.1%	1.2	7.1yrs	91%	$26.133M	1st
Strategy B	$30.7M	16.3%	1.3	7.5yrs	85%	$24.867M	2nd

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Data Description

10% Annual discount rate

$(10,000,000) Initial cost of investment one year from

today

$3,000,000 Return (less costs) from first year

$4,200,000 Return (less costs) from second year

$6,800,000 Return (less costs) from third year

$4,000,000 Total return

$1,188,443 NPV

Data Description

10% Annual discount rate

$(10,000,000) Initial cost of investment one year from

today

$3,000,000 Return (less costs) from first year

$4,200,000 Return (less costs) from second year

$6,800,000 Return (less costs) from third year

$4,000,000 Total return

16% IRR

Data Description

10% Annual discount rate

$(10,000,000) Initial cost of investment one year

from today

$3,000,000 Return (less costs) from first year

$4,200,000 Return (less costs) from second year

$6,800,000 Return (less costs) from third year

$4,000,000 Total return

$1,188,443 NPV

1.12 PI