MHSA 8630 Health Care Financial Management

Capital Budgeting and Project Risk Assessment

I.

Principles of Capital Budgeting

**

Utilizing basic financial analysis principles such as discounted cash flow

analysis and cost of capital estimation, we now turn our attention to the
process by which organizational financial managers make decisions
regarding capital investments. In this context, capital investments are
regarded as fixed asset(s) having long useful lives that typically require
the organization to expend significant internal financial resources and/or
obtain external capital to finance such purchases.

**

The process by which organizations systematically evaluate alternative

capital investment projects and make decisions as to which should be
funded given limited capital resources is known as capital budgeting.

**

The capital budgeting process is of significant strategic importance to all

types of organizations, both FP and NFP, as appropriate long-term
investments in capital resources ensures, to the extent possible, that the
organization will remain viable in the future. Capital budgeting also
yields a shorter-term benefit in that it allows the organization to effectively
plan for capital expenditures ex ante, so that any required sources of
capital financing (debt, equity) can be obtained at the lowest possible cost
of capital to the organization.

**

Organizational failure to appropriately budget for its strategic capital

needs typically results in either (1) too much capital being deployed, thus
reducing organizational efficiency and cost competitiveness, or (2) too
little capital being deployed, thus resulting is lost strategic opportunities to
the organization and reduced long term growth.

**

Capital Project Classification: for purposes of capital budgeting analysis,

the following types of capital projects are typically included:
**

Discretionary replacement: capital projects intended to replace

existing equipment that is dated, but operational. The intention is
presumably to reduce equipment maintenance costs and/or
improve patient service. (mid-level management decision)

**

Existing product/service line expansion: capital projects intended

to increase service capacity in existing lines of business. (seniorlevel management decision)

**

New product/service line expansion: capital projects intended to

expand/move into new business lines (senior-level management).

**

Steps in the Capital Budgeting Process

(1)

Estimate Cash Flows: includes estimation of initial cash outflow(s)

or cost of financing the project as well as estimation of all
subsequent projected cash inflow(s) associated with the project,
including the terminal cash flow(s) associated with project
termination.
**

For purposes of capital budgeting analysis, only actual

incremental cash flows associated with the project should
be included and not various accounting measures such as
net income, which can present a misleading picture of
project profitability. Also, sunk costs (cash flows that have
already occurred prior to project initiation) should
generally be ignored regardless of association with project.

**

Though it is likely that project-related cash flows will occur

at sporadic intervals throughout the projects life, it is
generally assumed that all project-related flows occur once
per year, usually at the end of the year, for purposes of
analytical simplicity.

**

In terms of length of project life, most organizations will

specify a useful life of between five and ten years for most
capital investments, though some projects associated with
the addition of organizational capacity will likely be
analyzed over longer periods. Of note, for a given
corporate cost of capital, cash flows that occur far into the
future (20 years or greater) contribute little to the overall
capital budgeting analysis.

**

Miscellaneous methodological issues in the estimation of

cash flows include the following:
**

Opportunity cost estimation as it relates to the

project at hand is generally regarded as being
roughly accounted for in the organizations chosen
cost of capital/discount rate if (and only if) the
projects risk is comparable to the risk of the
organizations portfolio of projects as a whole.

**

Opportunity costs associated with other projectrelated resources (e.g. land, building space) should
be included within such analyses as well if the
project at hand makes collateral use of such
resources and imputes a cost as a result.

**

Miscellaneous methodological issues (continued):

**

To the extent that a project may effect other

projects, positively or negatively, such spillover
effects (in terms of incremental cash flows) should
be incorporated into the analysis.

**

In general, most projects will entail administrative

costs, such as shipping/delivery costs, setup and
training costs, maintenance/upkeep costs, etc. Such
costs are explicit and should obviously be
incorporated into the analysis as well.

**

If applicable, the cash flow-related effects of a

project on the organizations net working capital
(current assets less current liabilities) balance
should be included in the analysis as well,
especially if it is expected that a project will
dramatically reduce the NWC of the organization
(i.e. increase inventories, accounts receivables, etc.)

**

Inflation effects on organizational cash flow over

time should also be incorporated into such analyses.
Inflation should be accounted for with respect to
third party reimbursement, cost of goods, labor
costs, supply costs, etc. Depreciation expense
should NOT be adjusted for inflation.

**

In addition to the use of various objective criteria

(see below) to evaluate the worthiness of a specific
capital investment, organizational managers also
utilize a number of subjective criteria, including the
implied strategic value of a given project to the
organization, to assist in making such evaluations.
In general, the better the strategic fit between a
proposed capital investment and the organizations
strategic plan/mission/vision, the more likely that
such a capital investment should be made.

**

For investor-owned, for-profit organizations, the

effect of corporate taxation on project cash flows
must also be accounted for as part of the analysis, as
such taxes will affect organizational cash flows
during the life of the project as well as at project
termination, when the asset will presumably be sold
for salvage.

(2)

Discount Project Cash Flows: based on the derived estimate for

the corporate cost of capital/discount rate (adjusted if required to
reflect greater/lower project risk), all projected cash flows over the
projects useful life are discounted back to present value.

(3)

Evaluate Project Financial Impact: based on the result obtained

from discounting future cash flows, a formal evaluation of the
projected financial impact of the capital investment on the
organization can be conducted using one of several methods:
**

Net Present Value (NPV) Method -- NPV calculated as:

NPV = [CFi / (1 + r)n] - Initial Investment

>>

The decision rule with respect to using NPV to make

capital budgeting decisions is to only select those capital
investments that have a positive NPV, and reject those
whose NPV is negative.

>>

A positive NPV indicates that the capital project is

expected to provide a return on investment that is greater
than the corporate cost of capital, and thus will presumably
add to the value of the organizational enterprise as a result.
A negative NPV implies the opposite.

>>

The greater the NPV estimate, the greater the financial

return associated with the capital project. Among capital
projects with positive NPV estimates, those with the
highest NPV estimates are preferred, other things being
equal.

**

Project Implied Rate of Return (IRR) also known as

the internal rate of return, it is the rate of return that forces
the projects discounted cash flows to exactly equal the
initial investment (or NPV = 0).

>>

The decision rule with respect to using IRR to make capital

budgeting decisions is to only select those capital
investments where the IRR is greater than the corporate
cost of capital as specified. For all projects where IRR is
greater than the corporate cost of capital, the projected cash
flows are sufficient to provide a return that covers the
organizations cost of capital in addition to providing
returns to the organization and thus increasing its value.

**

>>

Either the NPV or IRR approaches to capital budgeting

analysis may be used in this case, and the results will be the
same regardless of which method used i.e. projects with
positive NPVs will be consistent with projects whose IRR
estimates exceed corporate cost of capital, and vice versa.

**

Breakeven Analysis Methods estimation of either the

period of time required (payback period/discounted
payback period) or the utilization volume required
(breakeven point) for the organization to recoup its initial
capital investment.

>>

Breakeven evaluation of capital investment alternatives

provide the organization with an estimate of the potential
profitability and risk associated with a given project. In
terms of roughly assessing the riskiness of a project,
breakeven methods are preferred to NPV and IRR, and are
often estimated concurrent with either/both measures of
project profitability.

>>

In general, the greater the breakeven utilization volume

required and/or the longer the payback/discounted payback
periods associated with a project, the riskier those projects
tend to be.

Capital Budget Decision Making

**

As mentioned previously, most of the decision-making as it relates

to capital budgeting resides with senior-level management within
the organization, especially as it relates to capital projects that have
significant strategic importance to the organization and/or involve
the commitment of significant organizational resources.

**

For capital projects that have similar useful lives in terms of their
investment time horizons, those projects that are preferred tend to
be those that (a) have significant strategic importance to the
organization, (b) are projected to be reasonably profitable as
measured by a positive NPV or an IRR that exceeds CCC, and
(c) entail a manageable/reasonable level of project risk as
measured by breakeven analysis.

**

Organizations will, from time to time, be faced with the evaluation

of mutually exclusive capital investment alternatives that have
significantly unequal useful lives in terms of investment time
horizon. Different methods must be applied to make such
comparisons fair.

**

**

Methods for Evaluating Projects with Unequal Useful Lives

**

Replacement Chain Analysis assumes that any given

project can be replicated after its termination. For example,
if a project has an estimated useful life of three years, this
method would assume that the same investment could be
made at the termination of the project at the end of year
three, with commensurate cash flows during years four,
five, and six similar to years one, two, and three. The
obvious, and most tenuous, assumption with this method is
that the project can be perfectly replicated. If such an
assumption isnt reasonable, this method shouldnt be used.
Also difficult to use when investment time horizons are
roughly similar (differ by a few years only).

**

Equivalent Annual Annuity (EAA) based on the

estimated NPV for each project, involves the estimation of
the implied annuity amount (PMT) for each project that
would yield the same estimated NPV. That project which is
associated with the higher EAA is the one that would be
preferred using this method because a higher EAA implies
a higher cash flow/higher NPV associated with a project of
whatever investment time horizon, assuming that such
investments could be easily replicated over time.

Capital Budget Decision Making Within NFP Organizations

**

Most of what has been discussed up to this point will apply

to both investor-owned and charitable organizations as it
relates to capital budget decision making.

**

NFP organizations differ substantively from FP entities due

largely to their charitable missions and the operational and
strategic constraints these missions impose.

**

One such constraint is particularly applicable in the capital

budgeting process, involving some degree of consideration
for the social value of a capital project in addition to
considering its financial/strategic value to the organization.

**

The Net Present Social Value Model was developed for the
purpose of evaluating capital investment alternatives in a
not-for-profit organizational setting, whereby both the net
present social value (NPSV) of a project is formally
considered along with the financial net present value
(NPV). (TNPV = NPV + NPSV)

**

**

In this model, it is assumed that the NFP entity will choose

to invest its limited resources in those capital projects that
provide the highest total net present value (TNPV). It is
further assumed that such entities will also not invest in any
capital projects where net present social value (NPSV) is
negative, regardless of the financial net present value
associated with such projects. Lastly, it is assumed that the
financial NPV associated with all of the NFPs capital
projects will be greater than or equal to zero, to ensure
long-run organizational viability.

**

The estimation of NPSV is somewhat conceptual, and

involves an attempt to assign a dollar value (cash flow
equivalent) to the social (un-priced) benefits associated
with a given capital project. Most often, such monetary
benefits are estimated based on an estimate of average
consumer willingness to pay for such benefits.

**

The discounting of future social benefits associated with a

capital project using the NPSV method requires the
specification of a social discount rate, or cost of capital,
much as in the investor-owned case. The social rate of
return or discount rate is even more conceptually
challenging to estimate than its investor-owned counterpart.
The most typical approach to estimating this rate of return
is to equate it to the returns that could be obtained by
investing those resources in an equivalent for-profit entity.

Evaluation of Capital Budgeting Financial Performance

**

Organizations that are committed to effective and efficient

capital budgeting processes will also have an interest in
evaluating the performance of their chosen capital
investment projects post hoc. Such retrospective forms of
evaluation are referred to as post audits.

**

Such audits involve the comparison of actual project results

(in terms of cash flows) with initial project projections,
explaining why differences exist between the two if
present, and analyzing potential changes to the projects
operations, including replacement and/or termination.

**

The primary purposes of the post capital budgeting audit

are to improve future forecasts, develop historical risk and
return data, improve organizational operations, and reduce
organizational losses associated with capital projects.

II.

Project Risk Measurement and Incorporation

**

Up to this point, it has been acknowledged that the most critical, and least
certain, part of the capital budgeting process involves the estimation of
future project cash flows for the purpose of estimating the profitability
associated with a capital project.

**

The presence of uncertainty, sometimes substantial, in the estimation of

future project cash flows introduces a degree of financial risk into the
capital budgeting process. The estimation and incorporation of project
risk into the capital budgeting process is necessary to account for those
proposed projects that have higher risk compared to other projects, as the
typical cost of capital estimate used to discount project cash flows only
applies to projects of average risk.

**

Measures of Project Risk

**

Stand-alone risk project-associated risk assuming the project is

held in isolation of any other projects, measured as the standard
deviation of the returns associated with the project.

**

Corporate risk project-associated risk assuming the project is

part of the business portfolio of projects, measured by the firms
corporate beta.

**

Market risk project-associated risk assuming the project is part of

a stockholders portfolio of projects/stocks, measured by the
market beta associated with the firms stock.

**

Among these three measures of project risk, it was argued

previously that corporate risk and market risk were more
appropriate measures because all businesses invest in multiple
projects and/or stocks, such that the risk associated with a single
project is best evaluated in light of a much larger, more well
diversified portfolio of projects/stocks.

**

Be that as it may, attempts to estimate project risk vis--vis a firms

corporate and/or market risk measures is fraught with
methodological as well as theoretical difficulties. As the vast
majority of projects that a firm may invest in are typically
significantly positively correlated with the returns of the business
as a whole/the returns of the companys stock (r = 0.3-0.6), it is
usually the case that estimates of a projects stand-alone risk,
which is much simpler to estimate, can be used to approximate
either/both the corporate risk and/or market risk associated with a
given project.

**

Estimation of Project Stand-Alone Risk

**

The three most common methods utilized to estimate a projects

stand-alone risk are sensitivity analysis, scenario analysis, and
Monte Carlo simulation techniques. In this course, we will only
discuss/examine the first two methods in any detail.

**

Sensitivity analysis methodological technique sometimes also

referred to as what if type of analysis, this technique shows how
specific changes in one or more project input variables (utilization,
charges, costs) affect the projects profitability as measured by
NPV, IRR, or payback.

**

>>

Typically, such analyses are conducted on several input

variables that are presumed to be most critical to the final
financial outcome of the project. Each variable is varied by
+/- 30% typically, holding all other variables constant, to
elucidate the relationship between the input variable and
the financial outcome of interest (NPV, IRR).

>>

Input variables that have more of an impact on the financial

outcome of interest are said to contribute the MOST to the
overall stand alone risk of the project. Graphically, such
relationships are identified as having steeper slopes when
graphed against the projects NPV

>>

The primary disadvantages to using sensitivity analysis for

this purpose are: (1) such analyses do not consider the
amount by which the input variable(s) could actually
change; (2) such analyses do not allow for the
consideration of any input variable interactions; (3) such
analyses provide no direct quantitative measure of standalone project risk.

Scenario analysis methodological technique that allows for the

examination of several possible project profitability outcomes typically by identifying a best case scenario, a worst case scenario,
and a most likely case scenario and estimating the projects
expected profitability as well as its stand-alone risk.
>>

A projects expected profitability under a variety of

possible scenarios is simply estimated by multiplying the
probability of each scenario by the financial outcome
associated with each scenario, much as was the process for
estimating the expected return associated with an
investment under conditions of uncertainty,

**

**

>>

A projects stand-alone risk is similarly estimated as before,

by calculating the standard deviation associated with the
expected financial outcome in the analysis.

>>

An alternative measure of stand-alone risk which adjusts

for the overall size of the project (and thus allows for more
applicable comparisons to other projects) is known as the
projects coefficient of variation (CV), which is simply the
projects standard deviation divided by the expected
financial outcome (NPV). In general, projects that have
large CV values have more stand-alone risk than those
projects that have smaller CV values.

Project Risk Incorporation into Capital Budgeting Decision Process

**

As mentioned previously, it is necessary to incorporate measures of

financial risk into the capital budgeting process for those projects
that are associated with higher levels of risk compared with the
firms average project.

**

As has been the case time and again in the financial analysis of risk
and return, the assumption of higher levels of financial risk require
greater financial returns to compensate investors for assuming
greater than average levels of risk. So, for projects that are more
risky, as well as less risky, than the businesss average project,
adjustments to the standard required rate of return
(corporate/divisional cost of capital) is necessary.

**

The most commonly utilized method for the purpose of risk

incorporation into capital budgeting is the risk-adjusted discount
rate method. In a nutshell, those projects that are riskier than the
firms average project should utilize a higher discount rate/cost of
capital to discount project cash flows. Those projects that are less
risky than the firms average project should utilize a lower discount
rate/cost of capital to discount project cash flows.

Capital Budgeting Applications for Non-Revenue Producing Projects

**

From time to time, organizations will make capital budgeting

decisions related to projects that do not produce any new sources
of revenue but are necessary for normal organizational operations.
(e.g. linen disposal service)

**

In the case of non-revenue producing projects, the goal of the

capital budgeting decision process is to identify those projects that
have the LOWEST net present cost to the organization.

**

As a typical example, an organization is faced with a build versus

buy choice related to a needed service, such as linen services for a
hospital. It is often the case that such alternatives will differ
substantially in the magnitude and timing of the costs to the
organization over a defined period.

**

If both projects are assumed to be of similar risk to the

organization, the costs associated with each are discounted at the
appropriate corporate/divisional cost of capital, and the alternative
with the lowest net present cost is typically preferred.

**

If one of the projects is deemed to be more risky than the other, for
whatever reason, such projects should utilize a different
corporate/divisional cost of capital to estimate NPC. Unlike NPV
methods, however, higher risk, non-revenue producing projects
should be discounted using a LOWER/SMALLER
corporate/divisional cost of capital than projects that are less risky.