Law Week 10 Assignment- Healthcare Finance

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Net Present Value, Accounting Rate of Return, Internal Rate of Return, and Payback to Make Investment Decisions

One decision that managers make that affects the future pertains to evaluating capital investment opportunities. There will be outflows of cash in certain periods and inflows in others. It is not as simple as adding up all the inflows and subtracting the outflows since they occur at different times. For example, if the company invests $10,000 today and will receive $10,500 in 5 years, there is a positive difference of $500. Does this mean the investment should be made? A decision cannot be made based on this information alone because a dollar today is worth more than a dollar received in the future. One method that adjusts for this timing difference is discounted cash flow (DCF) analysis, which is also called net present value (NPV). This approach has four steps. First, identify the amount and timing of each cash flow; next, determine the discount rate; then, calculate the present value of each cash flow; and finally, calculate the NPV of the project (Davis & Davis, 2017). The discount rate is determined by the organization and is based on the risk of the project and the cost of capital. Different projects may have different discount rates. The present value of the investment does not have to be calculated, as it is invested at time zero. The present value of the future cash flows will need to be determined. The easiest method is to use a spreadsheet program such as Microsoft Excel. The investment is subtracted from the present value of the future cash flows. If the answer is positive, the project should be considered. If it is zero or negative, it probably should not be considered. Of course, there is no way to know precisely what the future cash flows will be. NPV is based on an educated estimate of these values. DCF is not the only method used to evaluate investment projects. Other methods include payback, accounting rate of return (ARR), and internal rate of return (IRR). They all can be useful in decision making, but it is important to also understand their drawbacks. The payback period is simply the time it takes for the cash inflows to equal the initial investment. If cash inflows are equal, the payback period is the net initial investment divided by the annual cash flow. It is expressed in years. If the cash flows are not equal, the annual cash flows are added together until they equal the net initial investment. The number of years, including partial years, is then computed. Each organization will have determined the number of years to payback that is acceptable. This is a quick screening tool that can be used prior to using more complicated methods. The limitations of this method are that it ignores the time value of money and the cash flows that occur after the payback period (Davis & Davis, 2017). The accounting rate of return is another method that can be used to evaluate investments. It is also called the return on investment (ROI). The formula is average

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annual income from the project divided by the average annual investment in the project. It is easy to calculate, but it can lead to an incorrect decision, as it ignores the time value of money (Zimmerman, 2020). The internal rate of return (IRR) is another method that can be used when considering an investment. If the project’s IRR exceeds the organization’s cost of capital, the project should be undertaken. The method considers the time value of money; therefore, it is more accurate than those methods that do not consider this aspect. It is difficult and time consuming unless a spreadsheet program is used. If there are multiple changes in the cash flows from inflow to outflows, et cetera, the project could yield more than one IRR (Shim et al., 2012). When analyzing the feasibility of various alternative projects, consider all the quantitative methods given above, but also look at qualitative factors such as location, cultural differences, employee training needs, regulations, etc. In summary, capital budgeting decisions should not be made in a vacuum. Gather the metrics, the qualitative research, and talk to your team. Consider your options carefully and make the best decision you can make after considering all available information. References: Davis, C. E., & Davis, E. (2017). Managerial accounting (3rd ed.). Wiley.

Shim, J. K, Siegel, J. G., & Shim, A. I. (2012). Budgeting basics and beyond (4th ed.).

Wiley.

Zimmerman, J. L. (2020). Accounting for decision making and control (10th ed.).

McGraw-Hill/Irwin.

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