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Cash Flow Analysis (Not-for-Profit Businesses) The first step in the financial analysis is to estimate the MRI site s net cash flows. This analysis is presented in Exhibit 14.2, which shows the key points of the analysis by line number.

Line 1. Line 1 contains the estimated cost of the MRI system. In general, capital budgeting analyses assume that the first cash flow, normally an outflow, occurs at the end of Year 0. Expenses, or cash outflows, are shown in parentheses.

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Line 2. The related site construction expense, $1,000,000, is also assumed to occur at Year 0.

Line 3. Annual net revenues = Weekly volume . Weeks of operation per year . Net revenue per scan = 40 . 50 . $375 = $750,000 in the first year. The 5 percent inflation rate is applied to all charges and costs that would likely be affected by inflation, so the amount shown on Line 3 increases by 5 percent over time. Although most of the operating revenues and costs would occur more or less evenly over the year, it is difficult to forecast exactly when the flows would occur. Furthermore, there is significant potential for large errors in cash flow estimation. For these reasons, operating cash flows are often assumed to occur at the end of each year. Also, the assumption is that the MRI system could be placed in operation quickly. If this were not EXHIBIT 14.2 Bayside Memorial Hospital: MRI Project Cash Flow Analysis Cash Revenues and Costs 0 12345 System cost 1. ($ 1,500,000) Related expenses 2. (1,000,000) 3. Net revenues $750,000 $787,500 $826,875 $ 868,219 $ 911,629 4. Labor costs 50,000 52,500 55,125 57,881 60,775 5. Maintenance costs 150,000 157,500 165,375 173,644 182,326 6. Supplies 30,000 31,500 33,075 34,729 36,465 7. Incremental overhead 10,000 10,500 11,025 11,576 12,155 8. Depreciation 350,000 350,000 350,000 350,000 350,000 9. Operating income $160,000 $185,500 $ 212,275 $240,389 $ 269,908 10.Taxes 0 0 00 0 11. Net operating income $160,000 $185,500 $ 212,275 $240,389 $ 269,908 12. Depreciation 350,000 350,000 350,000 350,000 350,000 Net salvage value 13. 750,000 Net cashflow 14. ($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 Note: Totals are rounded.

the case, then the first year s operating flows would be reduced. In some situations, it might take several years from the first investment cash flow to the point when the project is operational and begins to generate revenues.

Line 4. Labor costs are forecasted to be $50,000 during the first year, and they are assumed to increase over time at the 5 percent inflation rate.

Line 5. Maintenance fees must be paid to the manufacturer at the end of each year of operation. These fees are assumed to increase at the 5 percent inflation rate.

Line 6. Each scan uses $15 of supplies, so supply costs in the first year total 40 . 50 . $15 = $30,000, and they are expected to increase each year by the inflation rate.

Line 7. If the project is accepted, overhead cash costs will increase by $10,000 in the first year. Note that the $10,000 expenditure is a cash cost that is related directly to the acceptance of the MRI project.

Existing overhead costs that are arbitrarily allocated to the MRI project are not incremental cash flows and thus should not be included in the analysis. Overhead costs are also assumed to increase over time at the inflation rate.

Line 8. Book depreciation in each year is calculated by the straight- line method, assuming a five-year depreciable life. For book purposes, the depreciable basis is equal to the capitalized cost of the project, which includes the cost of the asset and related construction, less the estimated salvage value. Thus, the depreciable basis is ($1,500,000 + $1,000,000) . $750,000 = $1,750,000, and the straight-line depreciation in each year of the project s five-year depreciable life is $1,750,000 5 = $350,000. Note that depreciation is based solely on acquisition costs, so it is unaffected by inflation. Also, note that the Exhibit 14.2 cash flows are presented in a generic format that can be used by both investor-owned and not-for-profit hospitals. Depreciation expense is not a cash flow but an accounting convention that amortizes the cost of a fixed asset over its revenue-producing life. Because Bayside Memorial Hospital is tax exempt, and hence depreciation will not affect taxes, and because depreciation is added back to the cash flows on Line 12, depreciation could be totally omitted from the cash flow analysis.

Line 9. Operating income in each year is calculated as net revenues less all operating expenses.

Line 10. Bayside is a not-for-profit hospital and does not pay taxes; thus, this line contains zeros.

Line 11. Bayside pays no taxes, so the project s net operating income equals its operating income.

Line 12. Because depreciation, a noncash expense, was included on Line 8, it must be added back to the project s net operating income in each year to obtain each year s net cash flow.

Line 13. The project is expected to be terminated after five years, at which time the MRI system would be sold for an estimated $750,000.

This salvage value cash flow is shown as an inflow at the end of Year 5.

Line 14. The project s net cash flows consist of a $2,500,000 investment at Year 0 followed by five years of cash inflows.

The Exhibit 14.2 cash flows do not include interest expense on any debt financing that might be required to fund the project. On average, Bay- side Memorial Hospital will finance new projects in accordance with its target capital structure, which consists of 50 percent debt financing and 50 percent equity (fund) financing. The costs associated with this financing mix, including both interest costs and the opportunity cost of equity capital, are incorporated into the firm s 10 percent corporate cost of capital. Because the cost of debt financing is included in the discount rate that will be applied to the cash flows, recognition of interest expense in the cash flows would be double counting.

Cash Flow Analysis (For-Profit Businesses) The Exhibit 14.2 cash flow analysis can be easily modified to reflect tax implications if the analyzing organization is a for-profit business. To illustrate, assume that the MRI project is being evaluated by Ann Arbor Health Systems, an investor-owned hospital chain. Assume also that all of the project data presented earlier apply to Ann Arbor, except that the MRI falls into the Modified Accelerated Cost Recovery System (MACRS) five-year class for tax depreciation and the firm has a 40 percent tax rate.

Exhibit 14.3 contains Ann Arbor s cash flow analysis. Note the following differences from the not-for-profit analysis performed in Exhibit 14.2:

Line 8. Depreciation expense must be modified to reflect tax depreciation rather than book depreciation. Tax depreciation is calculated using the MACRS as specified in current tax laws. Each year s tax depreciation is found by multiplying the asset s depreciable basis, without reduction by the estimated salvage value, by the appropriate depreciation factor. In this illustration, the depreciable basis is $2,500,000, and the MRI system falls into the MACRS five-year class, so the MACRS factors specified by the tax code are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06, in Years 1 to 6, respectively. Thus, the tax depreciation in Year 1 is 0.20 . $2,500,000 = $500,000, in Year 2 the depreciation is 0.32 . $2,500,000 = $800,000, and so on. (Tax laws are complex and change often. Therefore, this book does not include a complete discussion of MACRS. For more information, see either the IRS publication pertaining to depreciation or any of the many tax guidebooks available at bookstores or online.) Line 10. Taxable firms must reduce the operating income on Line 9 by the amount of taxes. Taxes, which appear on Line 10, are computed by multiplying the Line 9 pretax operating income by the firm s marginal tax rate. For example, the project s taxes for Year 1 are 0.40 . $10,000 = $4,000. The taxes shown for Year 2 are a negative $105,800. In this year, the project is expected to lose $264,500, and hence Ann Arbor s taxable income, assuming that its existing projects are sufficiently profitable, will be reduced by this amount if the project is undertaken.

This reduction in Ann Arbor s overall taxable income would lower the firm s tax bill by T . Reduction in taxable income = 0.40 .

$264,500 = $105,800.

Line 12. The MACRS depreciation amount, because it is a noncash expense, is added back in Line 12.

Line 13. Investor-owned firms will normally incur a tax liability on the sale of a capital asset at the end of the project s life. According to the IRS, the value of the MRI system at the end of Year 5 is the tax book value, which is the depreciation that remains on the tax books.

For the MRI, five years worth of depreciation would be taken, so only one year of depreciation remains. The MACRS factor for Year 6 is 0.06, so by the end of Year 5, Ann Arbor has expensed 0.94 of the MRI s depreciable basis and the remaining tax book value is 0.06 . $2,500,000 = $150,000. Thus, according to the IRS, the value of the MRI system is $150,000. When Ann Arbor sells the system for its estimated salvage value of $750,000, it realizes a profit of $750,000 . $150,000 = $600,000, and it must repay the IRS an amount equal to 0.4 . $600,000 = $240,000. The $240,000 tax bill recognizes that Ann Arbor took too much depreciation on the MRI system, so it represents a recapture of the excess tax benefit taken over the five- year life of the system. The $240,000 in taxes reduces the cash flow received from the sale of the MRI equipment, so the salvage value net of taxes is $750,000 . $240,000 = $510,000.

As can be seen by comparing Line 14 in Exhibits 14.2 and 14.3, all else the same, the taxes paid by investor-owned firms tend to reduce a project s net operating cash flows and net salvage value, reducing the project s financial attractiveness.

EXHIBIT 14.3 Ann Arbor Health Systems: MRI Project Cash Flow Analysis Cash Revenues and Costs 0 12345 System cost 1. ($1,500,000) Related expenses 2. (1,000,000) Net revenues3. $750,000 $787,500 $826,875 $868,219 $ 911,629 Labor costs4. 50,000 52,500 55,125 57,881 60,775 Maintenance costs5. 150,000 157,500 165,375 173,644 182,326 6. Supplies 30,000 31,500 33,075 34,729 36,465 Incremental overhead7. 10,000 10,500 11,025 11,576 12,155 8. Depreciation 500,000 800,000 475,000 300,000 275,000 9. Operating income $ 10,000 ($264,500) $ 87,275 $290,389 $344,908 10. Taxes 4,000 (105,800) 34,910 116,156 137,963 11. Net operating income $ 6,000 ($ 158,700) $ 52,365 $ 174,233 $206,945 12. Depreciation 500,000 800,000 475,000 300,000 275,000 13. Net salvage value 510,000 14. Net cashflow ($2,500,000) $506,000 $641,300 $527,365 $474,233 $991,945 Note: Totals are rounded.

Replacement Analysis Bayside s MRI project was used to illustrate how the cash flows from an expansion project are analyzed. That is, the assumption was made that the hospital did not have an MRI system in operation at the time of the analysis.

All businesses, including Bayside Memorial Hospital, also make replacement decisions, in which a new asset is being considered to replace an existing asset that could, if not replaced, continue in operation. The cash flow analysis for a replacement decision is somewhat more complex than for an expansion decision because the cash flows from the existing asset must be considered.

Again, the key to cash flow estimation is to focus on the incremental cash flows. If the new asset is acquired, the existing asset can be sold, so the current market value of the existing asset is a cash inflow in the analysis. When considering the operating flows, the incremental flows are the cash flows expected from the replacement asset less the flows that the existing asset would produce if not replaced. By applying the incremental cash flow concept, the correct cash flows can be estimated for replacement decisions.

1. Briefly, how is a project cash flow analysis constructed?

2. Is it necessary to include depreciation expense in a cash flow analysis by a not-for-profit provider? Explain your answer.

3. What are the key differences in cash flow analyses performed by investor-owned and not-for-profit businesses?

4. How do expansion and replacement cash flow analyses differ?

Breakeven Analysis Breakeven analysis was introduced in Chapter 5 in conjunction with break- even volume in an accounting profit analysis. Now, the breakeven concept is applied in a project analysis setting. In project analyses, many different types of breakeven can be determined. Rather than discuss all the possible types of breakeven, the focus here is on one type time breakeven.

Payback is defined as the expected number of years required to recover the investment in a project, so payback, or payback period, measures time breakeven. To illustrate, consider the net cash flows for the MRI project contained on Line 14 in Exhibit 14.2. The best way to determine the MRI s payback is to construct the project s cumulative cash flows as shown in Exhibit 14.4. The cumulative cash flow at any point in time is merely the sum of all the cash flows (with proper sign indicating an inflow or outflow) that have occurred up to that point. Thus, in Exhibit 14.4, the cumulative cash flow at Year 0 is .$2,500,000; at Year 1 it is .$2,500,000 + $510,000 = .$1,990,000; at Year 2 it is .$2,500,000 + $510,000 + $535,500 = .$1,990,000 + $535,500 = .$1,454,500; and so on.

SELF-TEST QUESTIONS Payback period The number of years it takes for a business to recover its investment in a project without considering the time value of money.

EXHIBIT 14.4 Year Annual Cash Flows Cumulative Cash Flows Bayside Memorial 0 Hospital: MRI 1 System Annual 2 and Cumulative 3 Cash Flows 4 5 ($2,500,000) ($2,500,000) 510,000 (1,990,000) 535,500 (1,454,500) 562,275 (892,225) 590,389 (301,836) 1,369,908 1,068,072 Industry Practice Discounted Payback The discounted payback is a breakeven measure similar to the conventional payback, except that the cash flows in each year are discounted to Year 0 by the project s cost of capital (but kept at their original positions on the time line) prior to calculating the cumulative cash flows and payback. Thus, the discounted payback solves the conventional payback s problem of not considering the project s cost of capital in the payback calculation. The table below contains the calculation for Bayside s MRI project. Note that each entry in the middle column is the matching annual cash flow discounted at the 10 percent cost of capital for the number of years it occurs in the future. For example, the discounted Year 2 cash flow is $535,500 (1.10)2 = $442,562.

Annual Discounted Cumulative Year Cash Flows Cash Flows Cash Flows 0 ($2,500,000) ($2,500,000) ($2,500,000) 1 510,000 463,636 (2,036,364) 2 535,500 442,562 (1,593,802) 3 562,275 422,446 (1,171,356) 4 590,389 403,244 (768,112) 5 1,369,908 850,605 82,493 Now, with discounted instead of raw cash flows, the payback is 4 + (768,112 850,605) = 4.90 years. Because time value is recognized in the discounted payback, it takes longer than the conventional payback (4.22 years) to recover the initial investment.

What do you think? Is the discounted payback a better measure of time breakeven than the conventional payback? Does it solve all the conventional payback s problems?

As shown in the rightmost column of Exhibit 14.4, the $2,500,000 investment in the MRI project will be recovered at the end of Year 5 if the cash flow forecasts are correct. Furthermore, if the cash flows are assumed to come in evenly during the year, breakeven will occur $301,836 $1,369,908 = 0.22 years into Year 5, so the MRI project s payback is 4.22 years.

Initially, payback was used by managers as the primary financial evaluation tool in project analyses. For example, a business might accept all projects with paybacks of five years or less. However, payback has two serious deficiencies when it is used as a project selection criterion. First, payback ignores all cash flows that occur after the payback period. To illustrate, Bayside might be evaluating a competing project that has the same cash flows as the MRI project in years 0 through 5. However, the alternative project might have a cash inflow of $2 million in Year 6. Both projects would have the same payback, 4.22 years, and hence be ranked the same, even though the alternative project clearly is better from a financial perspective.

Second, payback ignores the opportunity costs associated with the capital employed.

For these reasons, payback generally is no longer used as the primary evaluation tool.

In spite of its shortcomings, payback is useful in capital investment analysis. The shorter the payback, the more quickly the funds invested in a project will become available for other purposes and the more liquid the project. Also, cash flows expected in the distant future are generally regarded as being riskier than near-term cash flows, so shorter payback projects generally are less risky than those with longer paybacks.

Therefore, payback is often used as a rough measure of a project s liquidity and risk.

1. What is payback?

2. What are the benefits of payback?

3. What are its deficiencies when used as the primary evaluation tool?

Return on Investment (Profitability) Analysis Up to this point, the chapter has focused on cash flow estimation and breakeven analysis. Perhaps the most important element in a project s financial analysis is its expected profitability, which generally is expressed by return on investment (ROI) measured either in dollars or in percentage (rate of) return. In the next sections, we discuss one dollar measure and two rate-of-return ROI measures.

Net Present Value Net present value (NPV), which was first discussed in Chapter 9, is a dollar ROI measure that uses discounted cash flow (DCF) techniques, so it is often referred to as a DCF profitability measure. To apply the NPV method:

Find the present (Time 0) value of each net cash flow, including both inflows and outflows, when discounted at the project s cost of capital.

Sum the present values. This sum is defined as the project s net present value.

If the NPV is positive, the project is expected to be profitable, and the higher the NPV, the more profitable the project. If the NPV is zero, the project just breaks even in an economic sense. If the NPV is negative, the project is expected to be unprofitable.

With a project cost of capital of 10 percent, the NPV of Bayside s MRI project is calculated as follows:

01 23 45 ($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 463,636 442,562 422,446 403,244 850,605 $ 82,493 = NPV SELF-TEST QUESTIONS Return on investment (ROI) The estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollars or percentage (rate of) return.

Financial calculators and spreadsheets have NPV functions that easily perform the mathematics if given the cash flows and cost of capital. Here is the spreadsheet solution:

A B C D 1 2 10.0% Project cost of capital 3 $ (2,500,000) Cash flow 0 4 510,000 Cash flow 1 5 535,500 Cash flow 2 6 562,275 Cash flow 3 7 590,389 Cash flow 4 8 1,369,908 Cash flow 5 9 10 $ 82,493 =NPV(A2,A4:A8)+A3 (entered into Cell A10) Note that we have merely entered the net cash flows into the spreadsheet.

In a typical project analysis, the spreadsheet also would be used for the cash flow analysis, with the last row of the analysis containing the net cash flows.

The project s NPV is calculated in Cell A10 using the NPV function. The first entry in the function (A2) is the discount rate (project cost of capital), while the second entry (A4:A8) designates the range of cash inflows from years 1 through 5. Because the NPV function calculates NPV one period before the first cash flow entered in the range, it is necessary to start the range with Year 1 rather than Year 5. Finally, to complete the calculation in Cell A10, A3 (the initial outlay) is added to the NPV function. The end result, $82,493, is displayed in Cell A10.

The rationale behind the NPV method is straightforward. An NPV of zero signifies that the project s cash inflows are just sufficient to (1) return the capital invested in the project and (2) provide the required rate of return on that capital (the opportunity cost of capital). If a project has a positive NPV, it is generating excess cash flows, and these excess cash flows are available to management to reinvest in the business and, for investor-owned firms, to pay bonuses (if a proprietorship or partnership) or dividends. If a project has a negative NPV, its cash inflows are insufficient to compensate the firm for the capital invested or perhaps even insufficient to recover the initial investment, so the project is unprofitable and acceptance would cause the financial condition of the firm to deteriorate. For investor-owned firms, NPV is a direct measure of the contribution of the project to owners wealth, so NPV is considered by many academics and practitioners to be the best measure of project profitability.

The NPV of the MRI project is $82,493, so on a present value basis, the project is expected to generate a cash flow excess of more than $80,000 after all costs, including the opportunity cost of capital, have been considered.

Thus, the project is economically profitable, and its acceptance would have a positive impact on Bayside s financial condition.

Internal Rate of Return Like NPV, internal rate of return (IRR) is a discounted cash flow ROI measure.

However, whereas NPV measures a project s dollar profitability, IRR measures a project s percentage profitability (i.e., its expected rate of return).

Mathematically, IRR is defined as the discount rate that equates the present value of the project s expected cash inflows to the present value of the project s expected cash outflows, so the IRR is simply the discount rate that forces the NPV of the project to equal zero. Financial calculators and spreadsheets have IRR functions that rapidly calculate IRRs. Simply input the project s cash flows, and the computer or calculator computes the IRR.

For Bayside s MRI project, the IRR is that rate that causes the sum of the present values of the cash inflows to equal the $2,500,000 cost of the project:

012345 11.1% 459,046 433,842 410,021 387,509 809,321 ($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 $ 261 = NPV $0 When all of the MRI project s cash flows are discounted at 11.1 percent, the NPV of the project is approximately zero. Thus, the MRI project s IRR is 11.1 percent. Put another way, the project is expected to generate an 11.1 percent rate of return on its $2,500,000 investment. Note that the IRR is like a bond s yield to maturity: It is the rate of return expected on the investment assuming that all the cash flows anticipated actually occur.

Here is the spreadsheet solution:

A B C D 1 2 10.0% Project cost of capital 3 $ (2,500,000) Cash flow 0 4 510,000 Cash flow 1 5 535,500 Cash flow 2 6 562,275 Cash flow 3 7 590,389 Cash flow 4 8 1,369,908 Cash flow 5 9 10 11.1% = IRR (A3: A8) (entered into Cell A10) Note that we have placed the IRR function in Cell A10; the entry in the IRR function (A3:A8) specifies the range of cash flows to be used in the calculation.

The answer, 11.1%, is displayed in Cell A10.

If the IRR exceeds the project cost of capital, a surplus is projected to remain after recovering the invested capital and paying for its use, and this surplus accrues to the firm s stockholders (in Bayside s case, to its stakeholders).

If the IRR is less than the project cost of capital, however, taking on the project imposes an expected financial cost on the firm s stockholders or stakeholders.

The MRI project s 11.1 percent IRR exceeds its 10 percent project cost of capital. Thus, as measured by IRR, the MRI project is profitable and its acceptance would enhance Bayside s financial condition.

Comparison of the NPV and IRR Methods Consider a project with a zero NPV. In this situation, the project s IRR must equal its cost of capital. The project has zero expected profitability, and acceptance would neither enhance nor diminish the firm s financial condition. To have a positive NPV, the project s IRR must be greater than its cost of capital, and a negative NPV signifies a project with an IRR less than its cost of capital.

Thus, projects that are deemed profitable by the NPV method will also be deemed profitable by the IRR method. In the MRI example, the project would have a positive NPV for all costs of capital less than 11.1 percent. If the cost of capital were greater than 11.1 percent, the project would have a negative NPV. In effect, the NPV and IRR are perfect substitutes for each other in measuring whether or not a project is profitable. Note, however, that when mutually exclusive projects are being analyzed (i.e., two or more projects are being analyzed but only one can be chosen), NPV and IRR rankings can conflict that is, Project A could have the higher NPV, but Project B could have the higher IRR. In such situations, the NPV method is generally considered to be the best measure of profitability.

Modified Internal Rate of Return In general, academics prefer the NPV profitability measure. This preference stems from two factors: (1) NPV measures profitability in dollars, which is a direct measure of the contribution of the project to the value of the business, and (2) both the NPV and the IRR, because they are discounted cash flow techniques, require an assumption about the rate at which project cash flows can be reinvested, and the NPV method has the better assumption.

To further explain the second point, consider the MRI project s Year 2 net cash flow of $535,500. In effect, the discounting process inherent in the NPV and IRR methods automatically assigns a reinvestment rate to this cash flow; that is, both the NPV and IRR methods assume that Bayside has the opportunity to reinvest the $535,500 Year 2 cash flow in other projects, and each method automatically assigns a reinvestment (earnings) rate to this flow for years 3, 4, and 5. The NPV method assumes reinvestment at the project cost of capital, 10 percent, while the IRR method assumes reinvestment at the IRR rate, 11.1 percent.

Which is the better assumption reinvestment at the cost of capital or reinvestment at the IRR rate? In Bayside s MRI project, it does not make much difference. However, in some projects, the difference in NPV and IRR measures is significantly affected by the reinvestment rate assumption. Here s the logic behind favoring the cost of capital as the better assumption: Theoretically, a business will take on all projects that exceed the cost of capital. Thus, at the margin, the returns from capital reinvested within the firm are more likely to be at or close to the cost of capital than at the project s IRR, especially for projects with exceptionally high or low IRRs. Furthermore, a business can obtain outside capital at a cost roughly equal to the cost of capital, so cash flows generated by a project could be replaced by capital having this cost. So, in general, reinvestment at the cost of capital is a better assumption than reinvestment at the IRR rate, and hence NPV is a theoretically better measure of profitability than IRR.

Even though academics strongly favor the NPV method, practicing managers prefer the IRR method because it is more intuitive for most people to analyze investments in terms of percentage (rates of) return than dollars of NPV. Thus, an alternative rate-of-return measure has been developed that eliminates the primary problem with IRR. This method is the modified IRR Modified internal rate of return (MIRR), and it is calculated as follows:

(MIRR) A project ROI Discount all the project s net cash outflows back to Year 0 at the project measure similar cost of capital. to IRR but using the assumption of Compound all the project s net cash inflows forward to the last reinvestment at (terminal) year of the project, at the project cost of capital. This value the cost of capital.

is called the inflow terminal value.

The discount rate that forces the present value of the inflow terminal value to equal the present value of costs is the MIRR.

Applying these steps to Bayside s MRI project produces a MIRR of about 10.7 percent:

012345 ($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 @10.7% $0 $2,500,000 @10% 649,428 680,353 712,750 746,691 $4,159,130 Here is the spreadsheet solution for the MIRR:

A B C D 1 2 10.0% Project cost of capital 3 $ (2,500,000) Cash flow 0 4 510,000 Cash flow 1 5 535,500 Cash flow 2 6 562,275 Cash flow 3 7 590,389 Cash flow 4 8 1,369,908 Cash flow 5 9 10 10.7% = MIRR (A3:A8,A2,A2) SELF-TEST QUESTIONS The MIRR function was placed in Cell A10. The first entry in the function (A3:A8) is the range of cash flows, while the next two entries (A2,A2) are the project cost of capital. (The MIRR function allows the reinvestment rate to differ from the project cost of capital: The first of the two entries is the project cost of capital, and the second is the reinvestment rate. For our purposes, the two rates are the same.) The resulting MIRR, 10.7%, is displayed in Cell A10.

The MIRR method, by compounding the cash inflows forward at 10 percent, forces the reinvestment rate to equal 10 percent, which is the project cost of capital.

Note that the MIRR for the MRI project is less than the project s IRR because the cash inflows are reinvested at only 10 percent rather than at the project s 11.1 percent IRR. In general, the MIRR is less than the IRR when the IRR is greater than the cost of capital, but it is greater than the IRR when the IRR is less than the cost of capital. In effect, the IRR overstates the profitability of profitable projects and understates the profitability of unprofitable projects. By forcing the correct reinvestment rate, the MIRR method provides decision makers with a theoretically better measure of a project s expected rate of return than does the IRR.

In closing our discussion, note that the MIRR has other advantages over the IRR besides the proper reinvestment rate. Primarily, it avoids potential problems when a project has nonnormal cash flows. A project with normal cash flows has one or more outflows followed by one or more inflows, while one with nonnormal cash flows has outflows occurring after one or more inflows have occurred. In the nonnormal situation, it is possible for a project to have two IRRs or even to have no IRR. These unusual results occur because of the mathematics of the IRR calculation. The MIRR overcomes these problems, so it is the only rate-of-return measure that can be applied to some projects.

1. Briefly describe how to calculate net present value (NPV), internal rate of return (IRR), and modified IRR (MIRR).

2. What is the rationale behind each method?

3. Do the three methods lead to the same conclusions regarding project profitability? Explain your answer.

Some Final Thoughts on Breakeven and Profitability Analyses Although we have discussed one breakeven and three profitability measures, there are many other measures commonly used in project financial analyses.

Today, virtually all capital budgeting decisions of financial consequence are analyzed by computer, and hence the mechanics of calculating and listing numerous breakeven and profitability measures are easy. Because each measure contributes slightly different information about the financial consequences of a project, managers should not focus on only one or two financial measures.

A thorough financial analysis of a new project includes numerous financial measures, and capital budgeting decisions are enhanced if all information inherent in all measures is considered in the process.

However, just as it would be foolish to ignore any of the quantitative measures, it would be foolish to base capital budgeting decisions solely on these measures. The uncertainties in the cash flow estimates for many projects are such that the resulting quantitative measures can be viewed only as rough estimates. Furthermore, organizational missions and strategic factors are important elements in capital budgeting decision making. Thus, qualitative factors should play an important role in the decision process. (We discuss one approach, project scoring, in a later section.) Finally, managers should be cautious of potential projects that have high expected profitability. In a highly competitive environment, there would be no highly profitable projects available because the marketplace would have already identified these opportunities and taken advantage of them. Thus, high-profitability projects must have some underlying rationale, such as market dominance or innovation, that justifies the profitability. Even then, under most circumstances, the project s high profitability will be eroded over time by competition.

SELF-TEST 1. Evaluate the following statement: The difficulty in calculating QUESTIONS numerous breakeven and profitability measures restricts the amount of information available in capital budgeting analyses. 2. Should capital budgeting analyses look at only one breakeven or profitability measure? Explain your answer.

3. Why should projects with high expected profitability be viewed with some skepticism?

Capital Budgeting in Not-for-Profit Businesses Although the capital budgeting techniques discussed to this point are appropriate for use by all businesses when assessing the financial impact of a proposed Net present social value (NPSV) The present value of a project s social value. Added to the financial net present value (NPV) to obtain a project s total value.

Industry Practice Accounting Rate of Return The accounting rate of return (ARR) uses accounting information to measure the profitability of an investment. Although there are alternative ways of performing the calculation, the generic formula is as follows:

Accounting rate of return = Average net profit Average investment.

Here, both profit and investment are measured in accounting terms and averaged over the life of the project. For example, a five-year project that cost $100,000 and has a zero salvage value would have an average investment of $100,000 5 = $20,000. If the aggregate profit over the five years were forecast to be $25,000, the average annual net profit would be $5,000. Thus, the project s ARR would be $5,000 $20,000 = 25%.

Proponents of the ARR cite the following advantages: (1) It is simple to use and understand.

(2) It can be readily calculated from accounting data, unlike NPV and IRR. (3) It incorporates the entire stream of income as opposed to looking at only a single year.

What is your opinion of the ARR? Does it have any weaknesses compared to NPV and IRR?

Should healthcare organizations use ARR to make capital budgeting decisions?

project, a not-for-profit business has the additional consideration of meeting its charitable mission. In this section, two models that extend the capital budgeting decision to include the charitable mission are discussed.

Net Present Social Value Model The financial analysis techniques discussed so far have focused exclusively on the cash flow implications of a proposed project. Some healthcare businesses, particularly not-for-profit providers, have the goal of producing social services along with commercial services. For such firms, the proper analysis of proposed projects must, at least in theory, systematically consider the social value of a project along with its pure financial, or cash flow, value.

When social value is considered, the total net present value (TNPV) of a project can be expressed as follows:

TNPV = NPV + NPSV.

Here, NPV represents the conventional NPV of the project s cash flow stream and NPSV is the net present social value of the project. The NPSV term, which represents managers assessment of the social value of a project, clearly differentiates capital budgeting in not-for-profit firms from that in investor-owned firms. In evaluating each project, a project is acceptable if its TNPV is greater than or equal to zero. This means that the sum of the project s financial and social values is at least zero, so when both facets of value are considered, the project has positive, or at least nonnegative, worth. Probably not all projects will have social value, but if a project does, it is considered formally in this decision model.

However, no project should be accepted if its NPSV is negative, even if its TNPV is positive. Furthermore, to ensure the financial viability of the firm, the sum of the conventional NPVs of all projects initiated in a planning period must equal or exceed zero. If this restriction were not imposed, social value could displace financial value over time, and a business cannot continue to provide social value without financial integrity. Note, however, that not-for-profit providers may be able to use contributions and grants to offset some, or even all, of any aggregate negative NPV created by the acceptance of projects with positive social value but negative financial value.

Key Equation: Net Present Social Value Model The net present social value (NPSV) model incorporates both financial and social value into a single model:

TNPV = NPV + NPSV.

Here, TNPV is total net present value, NPV is the net present value of the project s financial worth, and NPSV is the present value of the project s social worth. Although NPSV is difficult to estimate, this model formalizes the concept that not-for-profit providers should consider both social and financial value when making capital budgeting decisions.

NPSV is the sum of the present (Year 0) values of each year s social value. In essence, the suppliers of fund capital to a not-for-profit firm never receive a cash return on their investment. Instead, they receive a return on their investment in the form of social dividends. These dividends take the form of services with social value to the community, such as charity care; medical research and education; and myriad other services that, for one reason or another, do not pay their own way. Services provided to patients at a price equal to or greater than the full cost of production do not create social value. Similarly, if government entities purchase care directly for beneficiaries of a program or support research, the resulting social value is created by the funding organization as opposed to the service provider.

In estimating a project s NPSV, first it is necessary to estimate in dollar terms the social value of the services provided in each year. When a project produces services to individuals who are willing and able to pay for those services, the value of those services is captured by the amount that the individuals actually pay. Thus, the value of the services provided to those who cannot pay, or to those who cannot pay the full amount, can be estimated by the average net price paid by those individuals who are able to pay. Next, a discount rate must be applied to the social value cash flows. In general, providers should require a return on their social value stream that approximates the return available on the equity investment in for-profit firms that offer the same services.

This approach to valuing social services has intuitive appeal, but certain implementation problems merit further discussion:

Price is a fair measure of value only if the payer has the capacity to judge the true value of the service provided. Many observers of the Project scoring An approach to project assessment that considers both financial and nonfinancial factors.

health services industry would argue that information asymmetries between the provider and the purchaser inhibit the ability of the purchaser to judge true value.

The fact that most payments for healthcare services are made by third- party payers may result in price distortions. For example, insurers may be willing to pay more for services than an individual would pay in the absence of insurance, or the market power of some insurers, such as Medicare, may result in a price that is less than individuals would be willing to pay.

A great deal of controversy exists over the true value of treatment in many situations. Suppose that some people are entitled to whatever healthcare is available, regardless of cost, and are not required to personally pay for the care. Even though society as a whole must cover the cost, people may demand a level of care that is of questionable value. For example, should large sums be spent to keep a comatose 92-year-old alive for a few more days? If the true value to society of such an expenditure is zero, assigning a high social value just because that is its cost makes little sense.

Although the NPSV model formalizes the capital budgeting decision process applicable to not-for-profit healthcare firms, few organizations actually attempt to quantify NPSV. However, not-for-profit providers should, at a minimum, subjectively consider the social value inherent in projects under consideration.

Project Scoring Managers of not-for-profit businesses, as well as managers of most investor- owned firms, recognize that nonfinancial factors should be considered in any capital budgeting analysis. The NPSV model examines only one other factor, and it is difficult to implement in practice. Thus, many businesses use a quasi-subjective project scoring approach to capital budgeting decisions that attempts to capture both financial and nonfinancial factors. Exhibit 14.5, which is used by Bayside Memorial Hospital, illustrates one such approach.

Bayside ranks projects on three dimensions: stakeholder, operational, and financial. Within each dimension, multiple factors are examined and assigned scores that range from 2 points for very favorable impact to .1 point for negative impact. The scores within each dimension are added to obtain scores for each of the three dimensions, and then the dimension scores are summed to obtain a total score for the project. The total score gives Bayside s managers a feel for the relative values of projects under consideration when all factors, including financial, are taken into account.

Bayside s managers recognize that the scoring system is completely arbitrary, so a project with a score of 10, for example, is not necessarily twice EXHIBIT 14.5 Relative Score Bayside Criteria 2 1 0 1 Stakeholder Factors Physicians Strongly support Employees Greatly helps morale Visitors Greatly enhances visit Social value High Operational Factors Outcomes Greatly improves Length of stay Documented decrease Technology Breakthrough Productivity Large decrease in FTEs Financial Factors Life cycle Innovation Payback Less than2 years IRR Over 20% Correlation Negative Stakeholder factor score Operational factor score Financial factor score Total score Support Helps morale Enhances visit Moderate Improves Anecdotal decrease Improves current Decrease in FTEs Growth 2 4 years 15 20% Uncorrelated Neutral No effect No effect None No effect No effect Adds to current No change in FTEs Stabilization 4 6 years 10 15% Somewhat positive Opposed Hurts morale Hurts image Negative Hurts outcomes Increases Lowers Adds FTEs Decline Over 6 years Less than 10% Highly positive Memorial Hospital:

Project Scoring Matrix as good as a project that scores 5. Nevertheless, Bayside s project scoring approach forces its managers to address multiple issues when making capital budgeting decisions, and it does provide a relative ranking of projects under consideration. Although Bayside s approach should not be used at other organizations without modification for organizational- and industry-unique circumstances, it does provide insights into how a unique matrix might be developed at any health services business.

SELF-TEST 1. Describe the net present social value (NPSV) model of capital QUESTIONS budgeting.

2. Describe the construction and use of a project scoring matrix.

The Post-audit Capital budgeting is not a static process. If there is a long lag between a project s acceptance and its implementation, any new information concerning either Post-audit The feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations.

SELF-TEST QUESTIONS capital costs or the project s cash flows should be analyzed before the start-up occurs. Furthermore, the performance of each project should be monitored throughout the project s life. The process of formally monitoring project performance over time is called the post-audit. It involves comparing actual results with those projected, explaining why differences occur, and analyzing potential changes to the project s operations, including replacement or termination.

The post-audit has several purposes:

Improve forecasts. When managers systematically compare projections to actual outcomes, there is a tendency for estimates to improve.

Conscious or unconscious biases that occur can be identified and, one hopes, eliminated; new forecasting methods are sought as the need for them becomes apparent; and managers tend to do everything better, including forecasting, if they know that their actions are being monitored.

Develop historical risk data. Post-audits permit managers to develop historical data on new project analyses regarding risk and expected rates of return. These data can then be used to make judgments about the relative risk of future projects as they are evaluated.

Improve operations. Managers run businesses, and they can perform at higher or lower levels of efficiency. When a forecast is made, for example, by the surgery department, the department director and medical staff are, in a sense, putting their reputations on the line. If costs are above predicted levels and volume is below expectations, the managers involved will strive, within ethical bounds, to improve the situation and to bring results into line with forecasts. As one hospital CEO put it: You academics worry only about making good decisions.

In the health services industry, we also have to worry about making decisions good. Reduce losses. Post-audits monitor the performance of projects over time, so the first indication that termination or replacement should be considered often arises when the post-audit indicates that a project is performing poorly.

1. What is a post-audit?

2. Why are post-audits important to the efficiency of a business?

Using Capital Budgeting Techniques in Other Contexts The techniques developed in this chapter can help health services managers make a number of different types of decisions in addition to project selection.

One example is the use of NPV and IRR to evaluate corporate merger opportunities.

Healthcare companies often acquire other companies to increase capacity or expand into other service areas, among other reasons. A key element of any merger analysis is the valuation of the target company. Although the cash flows in such an analysis may be structured differently than in project analysis, the same evaluation tools are applied. We discuss business valuation in more detail in online Chapter 18, Lease Financing and Business Valuation.

Managers also use capital budgeting techniques when deciding whether or not to divest assets or reduce staffing. Like capital budgeting, these actions require an analysis of the impact of the decision on the firm s cash flows. When eliminating personnel, businesses typically spend money up-front in severance payments but then receive benefits in the form of lower labor costs in the future. When assets are sold, the pattern of cash flows is reversed that is, cash inflows occur when the asset is sold, but any future cash inflows associated with the asset are sacrificed. (If future cash flows are negative, the decision, at least from a financial perspective, should be easy.) In both situations, the techniques discussed in this chapter, perhaps with modifications, can be applied to assess the financial consequences of the action.

SELF-TEST 1. Can capital budgeting tools be used in different settings? Explain QUESTION your answer.

Key Concepts This chapter discusses the basics of capital budgeting. The key concepts of this chapter are as follows:

Capital budgeting is the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments.

A capital budgeting financial analysis consists of four steps: (1) estimate the expected cash flows, (2) assess the riskiness of those flows, (3) estimate the appropriate cost-of-capital discount rate, and (4) determine the project s profitability and breakeven characteristics.

The most critical and most difficult step in analyzing a project is estimating the incremental cash flows that the project will generate.

In determining incremental cash flows, opportunity costs (i.e., the cash flows forgone by using an asset) must be considered, but sunk costs (i.e., cash outlays that cannot be recouped) are not included.

(continued) (continued from previous page) Furthermore, any impact of the project on the firm s other projects must be included in the analysis.

Tax laws generally affect investor-owned firms in three ways: (1) Taxes reduce a project s operating cash flows, (2) tax laws prescribe the depreciation expense that can be taken in any year, and (3) taxes affect a project s salvage value cash flow.

Capital projects often require changes in current accounts in addition to the investment in fixed assets. Such changes represent a cash flow that, if material, must be included in the analysis. The net change in current accounts is recovered when the project is terminated.

A project may have some strategic value that is not accounted for in the estimated cash flows. At a minimum, strategic value should be noted and considered qualitatively in the analysis.

The effects of inflation must be considered in project analyses.

The best procedure is to build inflation effects directly into the component cash flow estimates.

Time breakeven, which is measured by the payback period, provides managers with insights concerning a project s liquidity and risk.

Project profitability is assessed by return on investment (ROI) measures. The two most commonly used ROI measures are net present value and internal rate of return.

Net present value (NPV), which is simply the sum of the present values of all the project s net cash flows when discounted at the project s cost of capital, measures a project s expected dollar profitability. An NPV greater than zero indicates that the project is expected to be profitable after all costs, including the opportunity cost of capital, have been considered. Furthermore, the higher the NPV, the more profitable the project.

Internal rate of return (IRR), which is the discount rate that forces a project s NPV to equal zero, measures a project s expected rate of return. If a project s IRR is greater than its cost of capital, the project is expected to be profitable, and the higher the IRR, the more profitable the project.

The NPV and IRR profitability measures provide identical indications of profitability; that is, a project that is judged to be profitable by its NPV will also be judged profitable by its IRR.

However, when mutually exclusive projects are being evaluated, NPV might rank a different project higher than IRR. This difference can occur because the two measures have different reinvestment rate assumptions IRR assumes that cash flows can be reinvested at the project s IRR, while NPV assumes that cash flows can be reinvested at the project s cost of capital.

The modified internal rate of return (MIRR), which forces a project s cash flows to be reinvested at the project s cost of capital, is a better measure of a project s percentage rate of return than the IRR.

The net present social value (NPSV) model formalizes the capital budgeting decision process for not-for-profit firms.

Firms often use project scoring to subjectively incorporate a large number of factors, including financial and nonfinancial, into the capital budgeting decision process.

The post-audit is a key element in capital budgeting. By comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process.

Capital budgeting techniques are used in a wide variety of settings in addition to project evaluation.

The discussion of capital investment decisions continues in Chapter 15, which focuses on risk assessment and incorporation.

Questions 14.1 a. What is capital budgeting? Why are capital budgeting decisions so important to businesses?

b. What is the purpose of placing capital projects into categories such as mandatory replacement or expansion of existing products, services, or markets?

c. Should financial analysis play the dominant role in capital budgeting decisions? Explain your answer.

d. What are the four steps of capital budgeting analysis?

14.2 Briefly define the following cash flow estimation concepts.

a. Incremental cash flow b. Cash flow versus accounting income c. Sunk cost d. Opportunity cost e. Changes in current accounts f. Strategic value g. Inflation effects 14.3 Describe the following project breakeven and profitability measures.

Be sure to include each measure s economic interpretation.

a. Payback b. Net present value (NPV) c. Internal rate of return (IRR) d. Modified internal rate of return (MIRR) 14.4 Critique this statement: NPV is a better measure of project profitability than IRR because NPV leads to better capital investment decisions. 14.5 a. Describe the net present social value (NPSV) model.

b. What is a project scoring matrix?

14.6 What is a post-audit? Why is the post-audit critical to good investment decision making?

14.7 From a purely financial perspective, are there situations in which a business would be better off choosing a project with a shorter payback over one that has a larger NPV?

Problems 14.1 Winston Clinic is evaluating a project that costs $52,125 and has expected net cash inflows of $12,000 per year for eight years. The first inflow occurs one year after the cost outflow, and the project has a cost of capital of 12 percent.

a. What is the project s payback?

b. What is the project s NPV? Its IRR? Its MIRR?

c. Is the project financially acceptable? Explain your answer.

14.2 Better Health, Inc., is evaluating two investment projects, each of which requires an up-front expenditure of $1.5 million. The projects are expected to produce the following net cash inflows:

Year Project A Project B 1 $ 500,000 $2,000,000 2 1,000,000 1,000,000 3 2,000,000 600,000 a. What is each project s IRR?

b. What is each project s NPV if the cost of capital is 10 percent? 5 percent? 15 percent?

14.3 Capitol Healthplans, Inc., is evaluating two different methods for providing home health services to its members. Both methods involve contracting out for services, and the health outcomes and revenues are not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows. Here are the projected flows:

Year Method A Method B 0 ($300,000) ($120,000) 1 (66,000) (96,000) 2 (66,000) (96,000) 3 (66,000) (96,000) 4 (66,000) (96,000) 5 (66,000) (96,000) a. What is each alternative s IRR?

b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why?

14.4 Great Lakes Clinic has been asked to provide exclusive healthcare services for next year s World Exposition. Although flattered by the request, the clinic s managers want to conduct a financial analysis of the project. There will be an up-front cost of $160,000 to get the clinic in operation. Then, a net cash inflow of $1 million is expected from operations in each of the two years of the exposition.

However, the clinic has to pay the organizers of the exposition a fee for the marketing value of the opportunity. This fee, which must be paid at the end of the second year, is $2 million.

a. What are the cash flows associated with the project?

b. What is the project s IRR?

c. Assuming a project cost of capital of 10 percent, what is the project s NPV?

d. What is the project s MIRR?

14.5 Assume that you are the chief financial officer at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments Project X and Project Y. Each project requires a net investment outlay of $10,000, and the cost of capital for each project is 12 percent. The projects expected net cash flows are as follows:

Year Project X Project Y 0 ($10,000) ($10,000) 1 6,500 3,000 2 3,000 3,000 3 3,000 3,000 4 1,000 3,000 a. Calculate each project s payback period, net present value (NPV), and internal rate of return (IRR).

b. Which project (or projects) is financially acceptable? Explain your answer.

14.6 The director of capital budgeting for Big Sky Health Systems, Inc., has estimated the following cash flows in thousands of dollars for a proposed new service:

Year Expected Net Cash Flow 0 ($100) 1 70 2 50 3 20 The project s cost of capital is 10 percent.

a. What is the project s payback period?

b. What is the project s NPV?

c. What is the project s IRR? Its MIRR?

14.7 California Health Center, a for-profit hospital, is evaluating the purchase of new diagnostic equipment. The equipment, which costs $600,000, has an expected life of five years and an estimated pretax salvage value of $200,000 at that time. The equipment is expected to be used 15 times a day for 250 days a year for each year of the project s life. On average, each procedure is expected to generate $80 in collections, which is net of bad debt losses and contractual allowances, in its first year of use. Thus, net revenues for Year 1 are estimated at 15 . 250 . $80 = $300,000.

Labor and maintenance costs are expected to be $100,000 during the first year of operation, while utilities will cost another $10,000 and cash overhead will increase by $5,000 in Year 1. The cost for expendable supplies is expected to average $5 per procedure during the first year. All costs and revenues, except depreciation, are expected to increase at a 5 percent inflation rate after the first year.

The equipment falls into the MACRS five-year class for tax depreciation and is subject to the following depreciation allowances:

Year Allowance 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06 1.00 The hospital s tax rate is 40 percent, and its corporate cost of capital is 10 percent.

a. Estimate the project s net cash flows over its five-year estimated life. (Hint: Use the following format as a guide.) Year 012345 Equipment cost Net revenues Less: Labor/maintenance costs Utilities costs Supplies Incremental overhead Depreciation Operating income Taxes Net operating income Plus: Depreciation Plus: Equipment salvage value Net cash flow b. What are the project s NPV and IRR? (Assume for now that the project has average risk.) 14.8 You have been asked by the president and CEO of Kidd Pharmaceuticals to evaluate the proposed acquisition of a new labeling machine for one of the firm s production lines. The machine s price is $50,000, and it would cost another $10,000 for transportation and installation. The machine falls into the MACRS three-year class, and hence the tax depreciation allowances are 0.33, 0.45, and 0.15 in years 1, 2, and 3, respectively. The machine would be sold after three years because the production line is being closed at that time. The best estimate of the machine s salvage value after three years of use is $20,000. The machine would have no effect on the firm s sales or revenues, but it is expected to save Kidd $20,000 per year in before-tax operating costs. The firm s tax rate is 40 percent and its corporate cost of capital is 10 percent.

a. What is the project s net investment outlay at Year 0?

b. What are the project s operating cash flows in years 1, 2, and 3?

c. What are the terminal cash flows at the end of Year 3?

d. If the project has average risk, is it expected to be profitable?

14.9 The staff of Jefferson Memorial Hospital has estimated the following net cash flows for a satellite food services operation that it may open in its outpatient clinic:

Year Expected Net Cash Flow 0 ($100,000) 1 30,000 2 30,000 3 30,000 4 30,000 5 30,000 5 (salvage value) 20,000 The Year 0 cash flow is the investment cost of the new food service, while the final amount is the terminal cash flow. (The clinic is expected to move to a new building in five years.) All other flows represent net operating cash flows. Jefferson s corporate cost of capital is 10 percent.

a. What is the project s IRR? Its MIRR?

b. Assuming the project has average risk, what is its NPV?

c. Now, assume that the operating cash flows in years 1 through 5 could be as low as $20,000 or as high as $40,000. Furthermore, the salvage value cash flow at the end of Year 5 could be as low as $0 or as high as $30,000. What are the worst-case and best- case IRRs? The worst-case and best-case NPVs?

14.10 BetterCare Insurance Company is considering the development of a case management program for its insured diabetics. BetterCare has estimated that the case management program will cost $200,000 in development and start-up costs. Once the program is operational, BetterCare estimates that the program will reduce utilization, and therefore claims payments, for its diabetic population. Net cash flows, calculated as claims-related savings less program operational costs, are estimated to be as follows:

Years 1 5 ($25,000) per year cash outflow as the program is ramping up Years 6 10 $75,000 per year cash inflow as the program starts generating better outcomes a. Assuming BetterCare s corporate cost of capital is 15%, on purely financial grounds, should BetterCare invest in the program?

b. Now, assume the program is able to generate positive outcomes sooner. If the expected case flows were as follows, would your answer change?

Years 1 2 ($25,000) per year cash outflow as the program is ramping up Years 3 10 $75,000 per year cash inflow as the program starts generating better outcomes 14.11 Assume that you are the chief financial officer at Mercy General Hospital. The CEO has asked you to analyze two proposed capital investments Project X and Project Y. Each project requires a net investment outlay of $75,000, and the cost of capital for each project is 10 percent. The projects expected net cash flows are as follows:

Year Project X Project Y 0 ($75,000) ($75,000) 1 20,000 50,000 2 20,000 15,000 3 20,000 15,000 4 30,000 10,000 a. Calculate each project s net present value (NPV) and internal rate of return (IRR).

b. Which project (or projects) is financially acceptable? If you reach different conclusions regarding the financial acceptability of Project X and Project Y, explain why, given that both projects return total cash flows of $90,000 over the four years.

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Grauman, D. M., G. Neff, and M. M. Johnson. 2011. Capital Planning for Clinical Integration. Healthcare Financial Management (April): 57.66.

Healthcare Financial Management Association (HFMA). 2004. Inside the Real World of Capital Allocation. Healthcare Financial Management (December): 81.86.

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Reiter, K. L., D. G. Smith, J. R. C. Wheeler, and H. L. Rivenson. 2000. Capital Investment Strategies in Health Care Systems. Journal of Health Care Finance (Summer): 31.41.

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PROJECT RISK ANALYSIS 15 Learning Objectives After studying this chapter, readers will be able to Describe the three types of risk relevant to capital budgeting decisions.

Describe the advantages and disadvantages of sensitivity analysis.

Discuss the advantages and disadvantages of scenario analysis.

Explain the advantages and disadvantages of Monte Carlo simulation.

Conduct a project risk assessment.

Incorporate risk into the capital budgeting decision process.

Discuss the concept of capital rationing.

Introduction Chapter 14 covers the basics of capital budgeting, including cash flow estimation, breakeven analysis, and return on investment (ROI) (profitability) measures. This chapter extends the discussion of capital budgeting to include risk analysis, which is composed of three elements: defining the type of risk relevant to the project, measuring the project s risk, and incorporating the risk assessment into the capital budgeting decision process. Although risk analysis is a key element in all financial decisions, the importance of capital investment decisions to a healthcare business s success or failure makes risk analysis vital in such decisions.

The higher the risk associated with an investment, the higher its required rate of return. This principle is just as valid for healthcare businesses that make capital expenditure decisions as it is for individuals who make personal investment decisions. Thus, the ultimate goal in project risk analysis is to ensure that the cost of capital used as the discount rate in a project s ROI analysis properly reflects the riskiness of that project. The corporate cost of capital, which is covered in detail in Chapter 13, reflects the cost of capital to the organization based on its aggregate risk that is, based on the riskiness of the firm s average project.

In project risk analysis, a project s risk is assessed relative to the firm s average project: Does the project under consideration have average risk, below-average Coefficient of variation A statistical measure of an investment s stand-alone risk calculated by dividing the standard deviation of returns by the expected return.

The result is the amount of standalone risk per unit of return.

risk, or above-average risk? The corporate cost of capital is then adjusted to reflect any differential risk, resulting in a project cost of capital. In general, aboveaverage- risk projects are assigned a project cost of capital that is higher than the corporate cost of capital, average-risk projects are evaluated at the corporate cost of capital, and below-average-risk projects are assigned a discount rate that is less than the corporate cost of capital. (Note that when capital budgeting is conducted at the divisional level, the adjustment process is handled in a similar manner, but the starting value is the divisional cost of capital.) Types of Project Risk Three separate and distinct types of financial risk can be defined in a capital budgeting context:

1. Stand-alone risk. Stand-alone risk assumes the project is held in isolation and ignores portfolio effects within the business and among its owners (equity investors).

2. Corporate risk. Corporate risk views the risk of a project within the context of the business s portfolio of projects.

3. Market risk. Market risk views the project from the perspective of a business s owner who holds a well-diversified portfolio of stocks.

The type of risk that is most relevant to a particular capital budgeting decision depends on the business s type of ownership and the number of projects it holds.

Stand-Alone Risk Stand-alone risk is present in a project whenever there is a chance of a return that is less than the expected return. In effect, a project is risky whenever its cash flows are not known with certainty, because uncertain cash flows mean uncertain profitability. Furthermore, the greater the probability of a return far below the expected return, the greater the risk. Stand-alone risk can be measured by the standard deviation, or coefficient of variation, of the project s profitability (ROI), often measured by net present value (NPV), internal rate of return (IRR), or modified internal rate of return (MIRR).

Because standard deviation and coefficient of variation measure the dispersion of a distribution around its expected value, the larger these values, the greater the probability that the project s ROI will be far below that expected.

Conceptually, stand-alone risk is only relevant in one situation: when a not-for-profit business is evaluating its first project. In this situation, the project will be operated in isolation, so no portfolio diversification is present the business does not have a collection of different projects, nor does it have owners who hold diversified portfolios of investments.

Corporate Risk In reality, businesses usually offer many different products or services and thus can be thought of as having a large number (perhaps hundreds) of individual projects. For example, MinuteMan Healthcare, a New England not-for-profit managed care company, offers healthcare services to a large number of diverse employee groups in numerous service areas, and each different group can be considered a separate project. In this situation, the stand-alone risk of a project under consideration by MinuteMan is not relevant because the project will not be held in isolation. The relevant risk of a new project to MinuteMan is its contribution to the business s overall risk (the impact of the project on the variability of the overall profitability of the business). This type of risk, which is relevant when the project is part of a not-for-profit business s portfolio of projects, is called corporate risk.

A project s corporate risk, which is measured by its corporate beta, depends on the context (i.e., the firm s other projects), so a project may have high corporate risk to one business but low corporate risk to another, particularly when the two businesses operate in widely different industries.

Market Risk Market risk is generally viewed as the relevant risk for projects being evaluated by large, investor-owned businesses. In such businesses, the owners hold large, diversified portfolios of securities investments (stocks and bonds of many firms), which can be thought of as large, diversified portfolios of individual projects. Because the goal of owner wealth maximization implies that a project s returns, as well as its risk, should be defined and measured from the owners perspective, the riskiness of an individual project, as seen by a well-diversified owner, is its contribution to the riskiness of a well-diversified stock portfolio.

A project s absolute market risk, as measured by its market beta, is independent of the context; that is, a project s market beta does not depend on the characteristics of the business, assuming the project s cash flows are the same to all firms. However, the market risk of a project, relative to the market risk of the firm s other projects, depends on the aggregate market risk of the business.

SELF-TEST QUESTIONS 1. What are the three types of project risk?

2. How is each type of project risk measured, both in absolute and relative terms?

Relationships Among Stand-Alone, Corporate, and Market Risk After discussing the three different types of project risk, and the situations in which each is relevant, it is tempting to conclude that stand-alone risk is almost never important because not-for-profit businesses should focus on a project s corporate risk and investor-owned firms should focus on a project s market risk. Unfortunately, the situation is not quite that simple.

First, it is almost impossible in practice to quantify a project s corporate or market risk. Fortunately, as is demonstrated in the next section, it is possible to get a rough idea of the relative stand-alone risk of a project. Thus, managers can make statements such as Project A has above-average risk, Project B has below-average risk, or Project C has average risk, all in the stand-alone sense. After a project s stand-alone risk has been assessed, the primary factor in converting stand-alone risk to either corporate or market risk is correlation. If a project s returns are expected to be highly positively correlated with the firm s returns, above-average stand-alone risk translates to above-average corporate risk. Similarly, if the business s returns are expected to be highly correlated with the stock market s returns, above-average corporate risk translates to above-average market risk. The same analogies hold when the project is judged to have average or below-average stand-alone risk.

Most projects will be in a business s primary line of business. Because all projects in the same line of business are generally affected by the same economic factors, such projects returns are usually highly correlated. When this situation exists, a project s stand-alone risk is a good proxy for its corporate risk. Furthermore, most projects returns are also positively correlated with the returns on other assets in the economy most assets have high returns when the economy is strong and low returns when the economy is weak. When this situation holds, a project s stand-alone risk is a good proxy for its market risk.

Thus, for most projects, the stand-alone risk assessment also gives good insights into a project s corporate and market risk. The only exception is when a project s returns are expected to be independent of or negatively correlated with the business s average project. In these situations, considerable judgment is required because the stand-alone risk assessment will overstate the project s corporate risk. Similarly, if a project s returns are expected to be independent of or negatively correlated with the market s returns, the project s stand-alone risk overstates its market risk.

SELF-TEST QUESTIONS 1. What type of project risk generally is the most measurable?

2. How are the types of project risk related?

Risk Analysis Illustration To illustrate project risk analysis, consider Bayside Memorial Hospital s evaluation of a new MRI system that was first presented in Chapter 14. Exhibit 15.1 contains the project s cash flow analysis. If all of the project s component cash flows were known with certainty, its projected profitability would be known with certainty, and hence the project would have no risk. However, in virtually all project analyses, future cash flows and hence profitability are uncertain and in many cases highly uncertain so risk is present.

The starting point for analyzing a project s risk involves estimating the uncertainty inherent in the project s cash flows. Most of the individual cash flows in Exhibit 15.1 are subject to uncertainty. For example, volume was projected at 40 scans per week. However, actual utilization would almost certainly be higher or lower than the 40-scan forecast. In effect, the volume estimate is really an expected value taken from some probability distribution of potential utilization, as are many of the other values listed in Exhibit 15.1.

Graphs of the distributions of the variables could be relatively tight (peaked with small tails), reflecting small standard deviations and low risk, or they could be relatively flat (rounded with large tails), denoting a great deal of uncertainty about the variable in question and hence a high degree of risk.

In other words, high confidence in the forecasted variables typically translates to low risk, while low confidence signifies high risk.

The nature of the component cash flow distributions and their correlations with one another determine the nature of the project s profitability distribution and thus the project s risk. In the following sections, three quantitative techniques for assessing a project s risk are discussed: sensitivity analysis, scenario analysis, and Monte Carlo simulation. (Another risk analysis method, decision tree analysis, is particularly useful when a project is structured with a series of decision points [stages] that allow cancellation prior to full implementation.

For more information on decision tree analysis, see Louis C. Gapenski and George H. Pink, Understanding Healthcare Financial Management, Chapter 12 [Chicago: Health Administration Press, 2015].) Then we discuss a qualitative approach to risk assessment. Remember that our focus here is on the stand-alone risk of the project. After the stand-alone risk is assessed, we will use judgment to translate that assessment into corporate and market risk (if relevant).

SELF-TEST QUESTIONS 1. What condition creates project risk?

2. What makes one project riskier than another?

3. What type of risk is being assessed initially?

EXHIBIT 15.1 Bayside Memorial Hospital: MRI Project Cash Flow Analysis Cash Revenues and Costs 0 12345 System cost 1. ($ 1,500,000) Related expenses 2. (1,000,000) 3. Net revenues $750,000 $787,500 $826,875 $868,219 $ 911,629 4 Labor costs.50,000 52,500 55,125 57,881 60,775 Maintenance costs5.150,000 157,500 165,375 173,644 182,326 6. Supplies 30,000 31,500 33,075 34,729 36,465 7 Incremental overhead.10,000 10,500 11,025 11,576 12,155 8. Depreciation 350,000 350,000 350,000 350,000 350,000 9. Operating income $160,000 $185,500 $ 212,275 $240,389 $ 269,908 10. Taxes 0000 0 11. Net operating income $160,000 $185,500 $ 212,275 $240,389 $ 269,908 12. Depreciation 350,000 350,000 350,000 350,000 350,000 Net salvage value 13. 750,000 Net cashflow 14. ($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 Profitability Measures:

Net present value (NPV) = $82,493 Internal rate of return (IRR) = 11.1% Modified internal rate of return (MIRR) = 10.7% Sensitivity Analysis Historically, sensitivity analysis has been classified as a risk assessment tool.

In reality, it is not very useful in assessing a project s risk. However, it does have significant value in project analysis, so we discuss it in some detail here.

Many of the variables that determine a project s cash flows are subject to some type of probability distribution rather than being known with certainty.

If the realized value of such a variable is different from its expected value, the project s actual profitability will differ from that expected in the project s financial analysis. Sensitivity analysis shows exactly how much a project s profitability net present value (NPV), internal rate of return (IRR), or modified internal rate of return (MIRR) will change in response to a given change in a single input variable, with other input variables held constant.

Sensitivity analysis begins with a base case developed using expected values (in the statistical sense) for all uncertain variables. To illustrate, assume that Bayside s managers believe that all of the MRI project s component cash flows are known with relative certainty except for weekly volume and salvage value. The expected values for these variables (volume = 40, salvage value = $750,000) were used in Exhibit 15.1 to obtain the base case NPV of $82,493. Sensitivity analysis is designed to provide managers the answers to such questions as these: What if volume is more or less than the expected level? What if salvage value is more or less than expected? (Typically, more than two variables would be examined in a sensitivity analysis. We used only two to keep the illustration manageable.) In a sensitivity analysis, each uncertain variable is changed by a fixed percentage above and below its expected value, while all other variables are held constant at their expected values. Thus, all input variables except one are held at their base case values. The resulting NPVs (or IRRs or MIRRs) are recorded and plotted. Exhibit 15.2 contains the NPV sensitivity analysis for the MRI project, assuming that there are only two uncertain variables:

volume and salvage value.

Net Present Value (NPV) Change from Base Case Level Volume Salvage Value 30% ($814,053) ($ 57,215) 20 (515,193) (10,646) 10 216,350 35,923 0 82,493 82,493 10 381,335 129,062 20 680,178 175,631 30 979,020 222,200 Sensitivity analysis A project analysis technique that assesses how changes in a single input variable, such as utilization, affect profitability.

EXHIBIT 15.2 MRI Project Sensitivity Analysis Note that the NPV is a constant $82,493 when there is no change in any of the variables. This situation occurs because a 0 percent change recreates the base case. Managers can examine the Exhibit 15.2 values to get a feel for which input variable has the greatest impact on the MRI project s NPV the larger the NPV change for a given percentage input change, the greater the impact. Such an examination shows that the MRI project s NPV is affected by changes in volume more than by changes in salvage value. This result should be somewhat intuitive because salvage value is a single cash flow in the analysis, whereas volume influences the cash flow in each year that the MRI is in operation.

Often, the results of sensitivity analyses are shown in graphical form.

For example, the Exhibit 15.2 sensitivity analysis is graphed in Exhibit 15.3.

Here, the slopes of the lines show how sensitive the MRI project s NPV is to changes in each of the two uncertain input variables the steeper the slope, the more sensitive NPV is to a change in the variable. Note that the sensitivity lines intersect at the base case values 0 percent change from base case level and $82,493. Also, spreadsheet models are ideally suited for performing sensitivity analyses because such models both automatically recalculate NPV when an input value is changed and facilitate graphing.

EXHIBIT 15.3 Sensitivity Net Present Value Analysis (thousands of dollars) Graphs 800 600 400 200 0 200 400 600 800 30 Volume 20 10 0 10 20 Percentage Change from Base Case Exhibit 15.3 vividly illustrates that the MRI project s NPV is very sensitive to changes in volume but only mildly sensitive to changes in salvage value. If a sensitivity plot has a negative slope, it indicates that increases in the value of that input variable decrease the project s NPV. If two projects were being compared, the one with the steeper sensitivity lines would be regarded as riskier because a relatively small error in estimating a variable for example, volume would produce a large error in the project s projected NPV. If information were available on the sensitivity of NPV to input changes for Bayside s average project, similar judgments regarding the riskiness of the MRI project could be made relative to the firm s average project.

Although sensitivity analysis is classified as a risk assessment tool, it does have severe limitations in this role. For example, suppose that Bayside Memorial Hospital had a contract with an HMO that guaranteed a minimum MRI usage at a fixed reimbursement rate. In that situation, the project would not be very risky, despite the sensitivity analysis showing the NPV to be highly sensitive to changes in volume. In general, a project s stand-alone risk, which is what a sensitivity analysis measures, depends on both the sensitivity of its profitability to changes in key input variables and the ranges of likely values of these variables. Because sensitivity analysis considers only the first factor, it can give misleading results. Furthermore, sensitivity analysis does not consider any interactions among the uncertain input variables; it considers each variable independently of the others.

In spite of the shortcomings of sensitivity analysis as a risk assessment tool, it does provide managers with valuable information. First, it provides profitability breakeven information for the project s uncertain variables. For example, exhibits 15.2 and 15.3 show that a decrease of just a few percent in expected volume makes the project unprofitable, whereas the project remains profitable even if salvage value falls by more than 10 percent. Although somewhat rough, this breakeven information is clearly of value to Bayside s managers.

Second, and perhaps more important, sensitivity analysis identifies those input variables that are most critical to the analysis. By most critical, we mean those variables that have the largest impact on profitability when their realized values differ from their forecasted values. In this example, volume is clearly the most critical input variable of the two being examined, so Bayside s managers should ensure that the volume estimate is the best possible. A small overestimate in volume can make the project seem very attractive financially when evaluated, yet the actual results could easily be disappointing. The concept here is that Bayside s managers have a limited amount of time to spend on analyzing the MRI project, so the resources expended should be as productive as possible.

In addition, sensitivity analysis can be useful after a project has been initiated. For example, assume that Bayside s MRI project was accepted and the first post-audit indicates that the project is not meeting its financial expectations. Bayside s managers must take actions to try to improve the project s financial results. But what actions should they take? Sensitivity analysis identifies the variables that have the greatest impact on profitability. Thus, managers can try to influence those variables that have the greatest potential for improving financial performance, such as volume, rather than those variables that have little impact on profitability.

SELF-TEST QUESTIONS 1. Briefly describe sensitivity analysis.

2. What type of risk does it attempt to measure?

3. Is sensitivity analysis a good risk assessment tool? If not, what is its value in the capital budgeting process?

Scenario Analysis Scenario analysis is a stand-alone risk analysis technique that considers the impact of changes in key variables on NPV, the likely range of the variable values, and the interactions among variables. To conduct a scenario analysis, managers pick a bad set of circumstances (i.e., low volume, low salvage value, and so on), an average or most likely set, and a good set. The resulting input values are then used to create a probability distribution of NPV.

To illustrate scenario analysis, assume that Bayside s managers regard a drop in weekly volume below 30 scans as unlikely and a volume above 50 as also improbable. On the other hand, salvage value could be as low as $500,000 or as high as $1 million. The most likely (and expected) values are 40 scans per week for volume and $750,000 for salvage value. Thus, a volume of 30 and a $500,000 salvage value define the lower bound, or worst-case scenario, while a volume of 50 and a salvage value of $1 million define the upper bound, or best-case scenario.

Bayside can now use the worst, most likely, and best case values for the input variables to obtain the NPV that corresponds to each scenario. Bayside s managers used a spreadsheet model to conduct the analysis, and Exhibit 15.4 summarizes the results. The most likely (base) case results in a positive NPV; the worst case produces a negative NPV; and the best case results in a large, positive NPV. These results can now be used to determine the expected NPV and standard deviation of NPV. For this, an estimate is needed of the probabilities of occurrence of the three scenarios. Suppose that Bayside s managers estimate that there is a 20 percent chance of the worst case occurring, a 60 percent chance of the most likely case, and a 20 percent chance of the best case.

Of course, it is difficult to estimate scenario probabilities with any confidence.

Exhibit 15.4 contains a discrete distribution of returns, so the expected NPV can be found as follows:

Expected NPV = [0.20 . (.$819,844)] + (0.60 . $82,493) + (0.20 . $984,829) = $82,493.

The expected NPV in the scenario analysis is the same as the base case NPV, $82,493. The consistency of results occurs because the values of the uncertain variables used in the scenario analysis 30, 40, and 50 scans for volume and $500,000, $750,000, and $1,000,000 for salvage value when coupled with the scenario probabilities produce the same expected values that were used in the Exhibit 15.1 base case analysis. If inconsistencies exist between the base case NPV and the expected NPV in the scenario analysis, the two analyses have inconsistent input value assumptions.

Using the distribution of NPVs, we can calculate the standard deviation:

= [0.20 ..( $819,844 .

$82,493)2 + 0.60 .($82,493 .

$82,493)2 NPV 2 1/2 + 0.20 .($989,829 .

$82,493) ] = $570,688.

The standard deviation of NPV measures the MRI project s stand-alone risk. Bayside s managers can compare the standard deviation of NPV of this project with the uncertainty inherent in Bayside s aggregate cash flows, or average project. Often, the coefficient of variation (CV) is used to measure the stand-alone risk of a project: CV = .NPV E(NPV) = $570,688 $82,493 = 6.9 for the MRI project. The CV measures the risk per unit of return and is a better measure of comparative risk than the standard deviation is, especially when projects have widely differing NPVs. If Bayside s average project has a CV of 4.0, the MRI project would be judged to be riskier than the firm s average project, so it would be classified as having above-average risk. (We used NPV as the ROI measure in this scenario analysis, but we could have focused on either IRR or MIRR.) Scenario analysis can also be interpreted in a less mathematical way. The worst-case NPV, a loss of about $800,000 for the MRI project, represents EXHIBIT 15.4 Probability of MRI Project Scenario Outcome Volume Salvage Value NPV Scenario Worst case Most likely case Best case 0.20 0.60 0.20 30 40 50 $ 500,000 750,000 1,000,000 ($819,844) 82,493 984,829 Analysis Expected value Standard deviation Coefficient of variation 40 $ 750,000 $ 82,493 $570,688 6.9 an estimate of the worst possible financial consequences of the project. If Bayside can absorb such a loss in value without much impact on its financial condition, the project does not represent a significant financial danger to the hospital. Conversely, if such a loss would mean financial ruin for the hospital, its managers might be unwilling to undertake the project, regardless of its profitability under the most likely and best-case scenarios. Note that the risk of the project is not changing in these two situations. The difference is in the ability of the organization to bear the risk inherent in the project.

While scenario analysis provides useful information about a project s stand-alone risk, it is limited in two ways. First, it only considers a few states of the economy, so it provides information on only a few potential profitability outcomes for the project. In reality, an almost infinite number of possibilities exist. Although the illustrative scenario analysis contained only three scenarios, it could be expanded to include more states of the economy say, five or seven. However, there is a practical limit to how many scenarios can be included in a scenario analysis.

Second, scenario analysis, at least as normally conducted, implies a definite relationship among the uncertain variables; that is, the analysis assumed that the worst value for volume (30 scans per week) would occur at the same time as the worst value for salvage value ($500,000) because the worst-case scenario was defined by combining the worst possible value of each uncertain variable. Although this relationship (all worst values occurring together) may hold in some situations, it may not hold in others. For example, if volume is low, maybe the MRI will have less wear and tear and will be worth more after five years of use. The worst value for volume, then, should be coupled with the best salvage value. Conversely, poor volume may be symptomatic of poor medical effectiveness of the MRI, leading to limited demand for used equipment and a low salvage value. Scenario analysis tends to create extreme profitability values for the worst and best cases because it automatically combines all worst and best input values, even if these values have only a remote chance of occurring together. The extreme profitability problem can be mitigated, but not eliminated, by assigning relatively low probabilities to the best-case and worst-case scenarios or by using more than three scenarios. The next section describes a stand-alone risk assessment method, Monte Carlo simulation, that addresses both the limited number of states and extreme profitability problems.

A word of warning regarding the relationship between profitability and risk analyses is in order here. When conducting a scenario analysis, it is natural to consider both the resulting profitability (NPV in the illustration) and risk. However, it is possible for inconsistencies in the input variable assumptions to cause the expected NPV from the scenario analysis to differ from the base case NPV. A scenario analysis is conducted for the sole purpose of assessing a project s stand-alone risk. A scenario analysis is not conducted to estimate a project s profitability. Thus, once the risk determination has been made (for example, in a later section Bayside judges the MRI project to have above-average risk), the scenario analysis plays no further role in the project evaluation. As you will see, the project risk determination feeds back into the base case analysis to make the final judgment regarding the project s financial worth.

1. Briefly describe scenario analysis.

2. What type of risk does it attempt to measure?

3. What are its strengths and weaknesses?

Monte Carlo Simulation Monte Carlo simulation, so named because it developed from the mathematics of casino gambling, describes uncertainty in terms of continuous probability distributions, which have an infinite number of outcomes rather than just a few discrete values. Monte Carlo simulation provides a more realistic view of a project s risk than does scenario analysis.

Although the use of Monte Carlo simulation in capital investment decisions was first proposed many years ago, it was not used extensively in practice primarily because it required a mainframe computer along with relatively powerful financial planning or statistical software. Now, however, Monte Carlo simulation software can be installed on personal computers as an add-on to spreadsheet software. Because most financial analysis today is done with spreadsheets, Monte Carlo simulation is accessible to virtually all health services organizations, large and small.

The first step in a Monte Carlo simulation is to create a model that calculates the project s net cash flows and profitability measures, as was done for Bayside s MRI project. The relatively certain variables are estimated as single, or point, values in the model, while continuous probability distributions are used to specify the uncertain cash flow variables. After the model has been created, the simulation software automatically executes the following steps:

1. The Monte Carlo program chooses a single random value for each uncertain variable on the basis of its specified probability distribution.

2. The values selected for each uncertain variable, along with the point values for the relatively certain variables, are combined in the model to estimate the net cash flow for each year.

3. Using the net cash flow data, the model calculates the project s profitability for example, as measured by NPV. A single completion SELF-TEST QUESTIONS Monte Carlo simulation A computerized risk analysis technique that uses continuous distributions to represent the uncertain input variables.

of these three steps constitutes one iteration, or run, in the Monte Carlo simulation.

4. The Monte Carlo software repeats the above steps many times (e.g., 5,000). Because each run is based on different input values, each run produces a different NPV.

The result of the simulation is an NPV probability distribution based on a large number of individual scenarios, which encompasses almost all of the likely financial outcomes. Monte Carlo software usually displays the results of the simulation in both tabular and graphical forms and automatically calculates summary statistical data such as expected value and standard deviation.

For an illustration of Monte Carlo simulation, again consider Bayside Memorial Hospital s MRI project. As in the scenario analysis, the illustration has been simplified by specifying the distributions for only two key variables:

(1) weekly volume and (2) salvage value. Weekly volume is not expected to vary by more than 10 scans from its expected value of 40 scans. Because this situation is symmetrical, the normal (bell-shaped) distribution can be used to represent the uncertainty inherent in volume. In a normal distribution, the expected value plus or minus three standard deviations will encompass almost the entire distribution. Thus, a normal distribution with an expected value of 40 scans and a standard deviation of 10 3 = 3.33 scans is a reasonable description of the uncertainty inherent in weekly volume.

A triangular distribution was chosen for salvage value because it specifically fixes the upper and lower bounds, whereas the tails of a normal distribution are, in theory, limitless. The triangular distribution is also used extensively when the input distribution is nonsymmetrical because it can easily accommodate skewness.

Salvage value uncertainty was specified by a triangular distribution with a lower limit of $500,000, a most likely value of $750,000, and an upper limit of $1 million.

The basic MRI model containing these two continuous distributions was used, plus a Monte Carlo add-on to the spreadsheet program, to conduct a simulation with 5,000 iterations. The output is summarized in Exhibit 15.5, and the resulting probability distribution of NPV is plotted in Exhibit 15.6. The mean, or expected, NPV, $82,498, is about the same as the base case NPV and expected NPV indicated in the scenario analysis, $82,493. In theory, all three results should be the same because the expected values for all input variables are the same in the three analyses. However, there is some randomness in the Monte Carlo simulation, which leads to an expected NPV that is slightly different from the others. The more iterations that are run, the more likely the Monte Carlo NPV will be the same as the base case NPV, assuming the assumptions are consistent.

The standard deviation of NPV is lower in the simulation analysis because the NPV distribution in the simulation contains values within the entire range of possible outcomes, while the NPV distribution in the scenario analysis contains only the most likely value and best-case and worst-case extremes.

Expected NPV Minimum NPV Maximum NPV Probability of a positive NPV Standard deviation Skewness $ 82,498 ($ 951,760) $ 970,191 62.8% $256,212 0.002 Probability (%) 20 16 12 8 4 0 NPV (thousands of dollars) 1,000 0 1,000 EXHIBIT 15.5 Simulation Results Summary EXHIBIT 15.6 NPV Probability Distribution In this illustration, one value for volume uncertainty was specified for all five years; that is, the value chosen by the Monte Carlo software for volume in Year 1 for example, 40 scans was used as the volume input for the remaining four years in that iteration of the simulation analysis. As an alternative, the normal distribution for Year 1 can be applied to each year separately, which would allow the volume forecasts to vary from year to year. Then, the Monte Carlo software might choose 35 as the value for Year 1, 43 as the Year 2 input, 32 for Year 3, and so on. This approach, however, probably does not do a good job of describing real-world behavior high usage in the first year presumably means strong acceptance of the MRI system and high usage in the remaining years. Similarly, low usage in the first year probably portends low usage in future years.

The volume and salvage value variables were treated as independent in the simulation that is, the value chosen by the Monte Carlo software from the salvage value distribution was not related to the value chosen from the volume distribution. Thus, in any run, a low volume can be coupled with a high salvage value and vice versa. If Bayside s managers believe that high utilization at the hospital indicates a strong national demand for MRI systems, they can specify a positive correlation between these variables. A positive correlation would tend to increase the riskiness of the project because a low-volume pick in one iteration cannot be offset by a high-salvage-value pick. Conversely, if the salvage value is more a function of the technological advances that occur over the next five years than local utilization, it may be best to specify the variables as independent, as was done.

As in scenario analysis, the project s simulation results must be compared with a similar analysis of the firm s average project. If Bayside s average project were considered to have less stand-alone risk when a Monte Carlo simulation was conducted, the MRI project would be judged to have above- average stand-alone risk.

Monte Carlo simulation has two primary advantages over scenario analysis:

(1) All possible input variable values are considered, and (2) correlations among the uncertain inputs can be incorporated into the analysis. However, there is a downside to these two advantages: Although it is mechanically easy to input the probability distributions for the uncertain variables as well as their correlations into a Monte Carlo simulation, it is much more difficult to determine what those distributions and correlations are. The problem is that the more information a risk analysis technique requires, the harder it is to develop the data with any confidence; hence, managers can be left with an elegant result of questionable value.

SELF-TEST QUESTIONS 1. Briefly, what is Monte Carlo simulation?

2. What type of risk does it attempt to measure?

3. What are its strengths and weaknesses?

Qualitative Risk Assessment In some situations, perhaps in many, it is difficult to conduct a quantitative risk assessment the numbers are just too difficult to predict. In such situations, rather than ignore differential risk, some healthcare businesses use a more subjective approach. For example, one large healthcare clinic uses the following five statements to qualitatively assess project risk:

The project requires additional market share or represents a new service initiative.

The project is outside of the scope of current management expertise.

The project requires difficult-to-recruit technical specialists.

The project will place us in competition with a strong competitor.

The project requires the use of new, unproven technology.

To assess project risk, each statement is assigned zero, one, or two points based on whether the statement does not apply, partially applies, or fully applies. If the total score is 0 to 3 points, the project is judged to have below-average risk; if the score is 4 to 7 points, it is judged to have average risk; a score of 8 to 10 points indicates above- average risk.

Although such a subjective approach initially appears to have little theoretical foundation, a closer examination reveals that each statement in the above list is tied to cash flow uncertainty. Thus, the greater the number of statements given 1 or 2 points, the greater the cash flow uncertainty and hence the greater the stand-alone risk of the project.

Even when a quantitative risk assessment is feasible, a separate qualitative assessment is a good idea. The value of using the qualitative risk assessment approach in conjunction with a quantitative risk assessment is that it forces managers to think about project risk in alternative frameworks. If the quantitative and qualitative assessments do not agree, it is clear that the project s risk assessment requires more consideration.

1. Describe qualitative risk assessment.

2. Why does it work?

3. Assume a quantitative risk assessment has been conducted on a project. Is a qualitative risk assessment necessary?

Incorporating Risk into the Decision Process Thus far, the MRI illustration has demonstrated that it is difficult to quantify a project s riskiness. It may be possible to reach the general conclusion that one project is more or less risky than another or to compare the riskiness of a project with aggregate risk of the firm, but it is difficult to develop a precise measure of For Your Consideration How Many Scenarios in a Scenario Analysis?

In the scenario analysis of Bayside s MRI project, we used three scenarios. However, three is not a magic bullet the more scenarios that are used, the more information that is obtained from the analysis. Furthermore, more scenarios lessen the problem associated with extreme values because the best and worst scenarios can be assigned low probabilities (which are probably realistic) without causing the risk inherent in the project to be understated.

While more scenarios add realism and provide more information for decision makers, a greater number of scenarios increases forecasting difficulty and makes the analysis more time consuming.

Furthermore, the greater the number of scenarios, the more difficulty in interpreting the results. Thus, the entire process is easier if three scenarios are used rather than, say, nine.

What do you think? Are three scenarios sufficient, or should more be used? How many scenarios are too many? Is it better to have an odd number of scenarios than an even number? Is there an optimal number of scenarios?

SELF-TEST QUESTIONS project risk. This lack of precision in measuring project risk adds to the difficulties involved in incorporating differential risk into the capital budgeting decision.

There are two methods for incorporating project risk into the capital budgeting decision process: (1) the certainty equivalent method, in which a project s expected cash flows are adjusted to reflect project risk, and (2) the risk-adjusted discount rate method, in which differential risk is dealt with by changing the cost of capital. Although the risk-adjusted discount rate method is used by most businesses, the certainty equivalent method does have some theoretical advantages.

Furthermore, it raises some interesting issues related to the risk-adjustment process.

The Certainty Equivalent Method The certainty equivalent (CE) method follows directly from the concept of utility theory, which is used by economists to explain how individuals make choices among risky alternatives. Under the CE approach, managers must first evaluate a cash flow s risk and then specify, with certainty, how much money would be required to be indifferent between the riskless (certain) sum and the risky cash flow s expected value. To illustrate, suppose that a rich eccentric offered someone the following two choices:

1. Flip a coin. If it s heads, the person wins $1 million; if it s tails, he gets nothing. The expected value of the gamble is (0.5 . $1,000,000) + (0.5 . $0) = $500,000, but the actual outcome will be either zero or $1 million, so the gamble is quite risky.

2. Do not flip the coin. Simply pocket $400,000 in cash.

If the person is indifferent to the two alternatives, $400,000 is his certainty equivalent value because the riskless $400,000 provides him with the same satisfaction (utility) as the risky $500,000 expected return. In general, investors are risk averse, so the certainty equivalent amount for this gamble will be something less than the $500,000 expected value. But each person would have his own certainty equivalent value the greater the degree of risk aversion, the lower the certainty equivalent amount.

The CE concept can be applied to capital budgeting decisions, at least in theory, in this way:

1. Convert each net cash flow of a project to its certainty equivalent value. Here, the riskiness of each net cash flow is assessed, and a certainty equivalent cash flow is chosen on the basis of that risk. The greater the risk, the greater the difference between the net cash flow s expected value and its lower certainty equivalent value. (If a net cash outflow is being adjusted, the certainty equivalent value is higher than the expected value. The unique risk adjustments required on cash outflows are discussed in a later section.) 2. Once each cash flow is expressed as a certainty equivalent, discount the project s certainty equivalent cash flow stream by the risk-free rate (adjusted for taxes if necessary) to obtain the project s differential risk- adjusted NPV. Here, the term differential risk-adjusted implies that the unique risk of the project, as compared to the overall risk of the business, has been incorporated into the decision process. The risk-free rate is used as the discount rate because certainty equivalent cash flows are analogous to risk-free cash flows.

3. A positive differential risk-adjusted NPV indicates that the project is profitable even after adjusting for differential project risk.

The CE method is simple and neat. Furthermore, it can easily handle differential risk among the individual net cash flows. For example, the final year s certainty equivalent cash flow might be adjusted downward an additional amount to account for salvage value risk if that risk is considered to be greater than the risk inherent in the operating cash flows.

Unfortunately, there is no practical way to estimate a risky cash flow s certainty equivalent value. There is no benchmark available to help make the estimate, so each individual would have her own estimate, and these could vary significantly. Also, the risk assessment techniques for example, scenario analysis focus on profitability and hence measure the stand-alone risk of a project in its entirety. This process provides no information about the riskiness of individual cash flows, so there is no basis for adjusting each cash flow for its own unique risk.

The Risk-Adjusted Discount Rate Method In the risk-adjusted discount rate (RADR) method, expected cash flows are used in the valuation process, and the risk adjustment is made to the discount rate (opportunity cost of capital). All average-risk projects are discounted at the firm s corporate cost of capital, which represents the opportunity cost of capital for average-risk projects; above-average-risk projects are assigned a higher cost of capital; and below-average-risk projects are discounted at a lower cost of capital.

One advantage of the RADR method is that the process has a starting benchmark the firm s corporate cost of capital. This discount rate reflects the riskiness of the business in the aggregate, or the riskiness of the business s average project. Another advantage is that project risk assessment techniques identify a project s aggregate risk the combined risk of all of the cash flows and the RADR applies a single adjustment to the cost of capital rather than attempting to adjust individual cash flows. However, the disadvantage is that there typically is no theoretical basis for setting the size of the RADR adjustment, so the amount of adjustment remains a matter of judgment.

The RADR method has one additional disadvantage. It combines the factors that account for time value (the risk-free rate) and the adjustment for risk (the risk premium): Project cost of capital = Differential risk-adjusted Risk-adjusted discount rate (RADR) A discount rate that accounts for the specific riskiness of the investment being analyzed.

discount rate = Risk-free rate + Risk premium. The CE approach, on the other hand, keeps the risk adjustment and time value separate: Time value is accounted for in the discount rate, and risk is accounted for in the cash flows. By lumping together risk and time value, the RADR method compounds the risk premium over time just as interest compounds over time, so does the risk premium. This compounding of the risk premium means that the RADR method automatically assigns more risk to cash flows that occur in the distant future, and the further into the future, the greater the implied risk. Because the CE method assigns risk to each cash flow individually, it does not impose any assumptions regarding the relationship between risk and time.

Key Equation: Risk-Adjusted Discount Rate Theoretical Model The RADR model is one method used to incorporate risk in the capital budgeting decision process. It is based on the following concept:

Project cost of capital = Risk-free rate + Risk premium.

The idea here is that the risk-free rate accounts for the time value of money, while the risk premium accounts for the unique (below-average, average, or above-average) risk of the project. The implementation of the model is discussed in the next section.

The RADR method, with a constant discount rate applied to all cash flows of a project, implies that risk increases with time. This imposes a greater burden on long-term projects, so all else the same, short-term projects will tend to look better financially than long-term projects. For most projects, the assumption of increasing risk over time is probably reasonable because cash flows are more difficult to forecast the further one moves into the future.

However, managers should be aware that the RADR approach automatically penalizes distant cash flows, and an explicit penalty based solely on cash flow timing is probably not warranted unless some specific additional source of risk can be identified.

SELF-TEST QUESTIONS 1. What are the differences between the certainty equivalent (CE) and risk-adjusted discount rate (RADR) methods for risk incorporation?

2. What assumptions about time and risk are inherent in the RADR method?

Making the Final Decision In most project risk analyses, it is impossible to assess the project s corporate or market risk quantitatively, so managers are left with only an assessment of the project s stand-alone risk. Because Bayside Memorial Hospital is not-for-profit, corporate risk is the most relevant risk in capital budgeting decisions. What is the MRI project s corporate risk? The MRI project, like most projects being evaluated by Bayside, is in the same line of business the provision of patient services as the firm s other projects. Under these circumstances, it is likely that the returns on the MRI project would be highly correlated with Bayside s aggregate returns (overall profitability). Thus, Bayside s managers concluded that the stand-alone risk assessment is a good proxy for the project s corporate risk, and the MRI project was categorized as having above-average risk.

The business s corporate cost of capital provides the basis for estimating a project s differential risk-adjusted discount rate average-risk projects are discounted at the corporate cost of capital, above-average-risk projects are discounted at a higher cost of capital, and below-average-risk projects are discounted at a rate less than the corporate cost of capital. Unfortunately, there is no good way of specifying exactly how much higher or lower these discount rates should be. Given the present state of the art, risk adjustments are necessarily judgmental and somewhat arbitrary.

Bayside s standard procedure is to add 4 percentage points to its 10 percent corporate cost of capital when evaluating above-average-risk projects, and to subtract 2 percentage points when evaluating below-average-risk projects.

Thus, to estimate the above-average-risk MRI project s differential risk- adjusted NPV, the project s expected (base case) cash flows shown in Exhibit 15.1 are discounted at 10% + 4% = 14%. This rate is called the project cost of capital, as opposed to the corporate cost of capital, because it reflects the risk characteristics of a specific project rather than the aggregate risk characteristics of the business (or average project). The resultant NPV is .$200,017, so the project becomes unprofitable when the analysis is adjusted to reflect its high risk. Bayside s managers may still decide to go ahead with the MRI project for other reasons, but at least they know that its expected profitability is not sufficient to make up for its risk.

Key Equation: Risk-Adjusted Discount Rate Implementation Model The RADR model is implemented as follows:

Project cost of capital = Corporate cost of capital + Risk adjustment.

(continued) SELF-TEST QUESTIONS (continued from previous page) Here, the corporate cost of capital is used as the base rate (starting point) and a risk adjustment is applied if the project has nonaverage risk. For above-average-risk projects, the risk premium is added to the base rate, while the risk premium is subtracted for those projects judged to have below-average risk. To illustrate, assume a project having above-average risk is being evaluated. The corporate cost of capital is 10 percent, and the standard adjustment amount is 3 percentage points. With these assumptions, the project cost of capital is 13 percent:

Project cost of capital = Corporate cost of capital + Risk adjustment = 10% + 3% = 13%.

1. How do most firms incorporate differential risk into the capital budgeting decision process?

2. Is the risk adjustment objective or subjective?

3. What is a project cost of capital?

For Your Consideration Objective Versus Subjective Risk Although it seems that healthcare managers have the tools available to measure the riskiness of proposed projects, there is an elephant in the room that is too often ignored: the difference between objective risk and subjective risk.

Objective risk is the risk that can be measured in a quantitative way, such as the standard deviation or coefficient of variation of a project s NPV.

Subjective risk is the risk that the objective risk assessment is wrong. In other words, the cash flow estimates do not truly represent the financial worthiness of the project.

In general, subjective risk is greatest when the investment being evaluated is using new, unproven technology or is in an unfamiliar line of business. In these situations, there may be some chance that a black swan event could occur that drastically alters the project s financial landscape.

(A black swan event is an occurrence that deviates beyond what is normally expected and hence (continued) Adjusting Cash Outflows for Risk Although most projects are evaluated on the basis of profitability, some projects are evaluated solely on the basis of costs. Such evaluations are done when it is impossible to allocate revenues to a particular project, or when two competing projects will produce the same revenue stream. For example, suppose that Greenbriar Oncology Associates must choose one of two ways for disposing of its medical wastes. There is no question about the need for the project, and the medical practice s revenue stream is unaffected by which method is chosen. In this case, the decision will be based on the present value of expected future costs the method with the lower present value of costs will be chosen.

Exhibit 15.7 contains the forecasted annual costs associated with each method.

The in-house system would require a large expenditure at Year 0 to upgrade the (continued from previous page) practice s current disposal system, but the would be extremely difficult to predict during the yearly operating costs would be relatively planning process.) For example, a promising new low. Conversely, if Greenbriar contracts for technology for robotic surgery of a specific cancer disposal services with an outside vendor, it type is made obsolete by the unforeseen develop- will have to pay only $25,000 up front to ment of a biologic drug, or an unforeseen takeover of one health insurer by another drastically initiate the contract. However, the annual reduces the volume of certain surgeries.

contract fee would be $200,000 a year.

What do you think? Is subjective risk some- If both methods were judged to have thing that healthcare managers should worry average risk, Greenbriar s corporate cost of about? Can anything be done to adjust for subjeccapital, 10 percent, would be applied to the tive risk when it is present?

cash flows to obtain the present value (PV) of costs for each method. Because the PVs of costs for the two waste disposal systems ($784,309 for the in-house system and $783,157 for the contract method) are roughly equal at the 10 percent discount rate, on the basis of financial considerations alone, Greenbriar s managers are indifferent as to which method should be chosen.

However, Greenbriar s managers actually believe that the contract method is much riskier than the in-house method. The cost of modifying the current system is known almost to the dollar, and operating costs can be predicted fairly well. Furthermore, with the in-house system, operating costs are under the control of Greenbriar s management. Conversely, if Greenbriar relies on the contractor for waste disposal, the practice is more or less stuck with continuing the contract because it will not have the in-house capability.

Because the contractor was only willing to guarantee the price for one year, the bid may have been lowballed and large price increases will occur in future years. The two methods have about the same PV of costs when both are considered to have average risk, so which method should be chosen if the contract method is judged to have above-average (higher) risk? Clearly, if the EXHIBIT 15.7 Year In-House System Outside Contract Greenbriar 0 1 2 3 4 5 Present value of costs ata discount rate of:

10% 14% 6% ($500,000) (75,000) (75,000) (75,000) (75,000) (75,000) ($784,309) ($ 25,000) (200,000) (200,000) (200,000) (200,000) (200,000) ($783,157) ($ 711,616) ($867,473) Oncology Associates:

Waste Disposal Analysis costs are the same under a common discount rate, the lower-risk in-house project should be chosen.

Now, try to incorporate this intuitive differential risk conclusion into the quantitative analysis. Conventional wisdom is to increase the corporate cost of capital for above-average-risk projects, so the contract cash flows would be discounted using a project cost of capital of 14 percent, which is the rate that Greenbriar applies to above-average-risk projects. But at a 14 percent discount rate, the contract method has a PV of costs of only $711,616, which is about $70,000 lower than for the in-house method. If the discount rate were increased to 20 percent on the contract method, it would appear to be $161,000 less costly than the in-house method. Thus, the riskier the contract method is judged to be, the better it looks.

Something is obviously wrong here. To penalize a cash outflow for higher- than-average risk, that outflow must have a higher present value, not a lower one.

Therefore, a cash outflow that has above-average risk must be evaluated with a lower-than-average cost of capital. Recognizing this, Greenbriar s managers applied a 10% . 4% = 6% discount rate to the above-average-risk contract method s cash flows. This produces a PV of costs for the contract method of $867,473, which is about $83,000 more than the PV of costs for the average-risk in-house method.

The appropriate risk adjustment for cash outflows is also applicable to other situations. For example, the City of Detroit offered Ann Arbor Health Systems the opportunity to use a city-owned building in one of the city s blighted areas for a walk-in clinic. The city offered to pay to refurbish the building, and all profits made by the clinic would accrue to Ann Arbor. However, after ten years, Ann Arbor would have to buy the building from the city at the then-current market value. The market value estimate that Ann Arbor used in its analysis was $2 million, but the realized cost could be much greater, or much less, depending on the economic condition of the neighborhood at that time. The project s other cash flows were of average risk, but this single outflow had higher risk, so Ann Arbor lowered the discount rate that it applied to this one cash flow. This action created a higher present value on a cost (outflow) and hence lowered the project s NPV.

The bottom line here is that the risk adjustment for cash outflows is the opposite of the adjustment for cash inflows. When cash outflows are being evaluated, higher risk leads to a lower discount rate.

SELF-TEST QUESTIONS 1. Why are some projects evaluated on the basis of present value of costs?

2. Is there any difference between the risk adjustments applied to cash inflows and cash outflows? Explain your answer.

3. Can differential risk adjustments be made to single cash flows, or must the same adjustment be made to all of a project s cash flows?

Divisional Costs of Capital In theory, project costs of capital should reflect both a project s differential risk and its differential debt capacity. The logic here is that if a project s optimal financing mix is significantly different from the business in the aggregate, the weights used in estimating the corporate cost of capital do not reflect the weights appropriate to the project.

Because of the difficulties encountered in estimating a project s debt capacity (its optimal capital structure), such adjustments are rarely made in practice.

Even though it is not common to make capital structure adjustments for individual projects, firms often make both capital structure and risk adjustments when developing divisional costs of capital. To illustrate, a for-profit healthcare system might have one division that invests primarily in real estate for medical uses and another division that runs an HMO. Clearly, each division has its own unique business risk and optimal capital structure. The low-risk, high-debt-capacity real estate division could have a cost of capital of 10 percent, while the high-risk, low-debt-capacity HMO division could have a cost of capital of 14 percent.

The health system itself, which consists of 50 percent real estate assets and 50 percent HMO assets, would have a corporate cost of capital of 12 percent.

If all capital budgeting decisions within the system were made on the basis of the overall system s 12 percent cost of capital, the process would be biased in favor of the higher-risk HMO division. The cost of capital would be too low for the HMO division and too high for the real estate division. Over time, this cost-of-capital bias would result in too many HMO projects being accepted and too few real estate projects, which would skew the business line mix toward HMO assets and increase the overall risk of the system. The solution to the cost-of-capital bias problem is to use divisional costs of capital, rather than the overall corporate cost of capital, in the capital budgeting decision process.

Unlike individual project costs of capital, divisional costs of capital often can be estimated with some confidence because it is usually possible to identify publicly traded firms that are predominantly in the same line of business as For Your Consideration Uncertainty in Initial Cash Outflows In many capital budgeting situations, the initial cost of the project, especially when occurring only at Time 0, is assumed to be known with certainty. The idea here is that in most cases bids have already been received from contractors and vendors, so the initial cost can be predicted with relative precision. However, in some circumstances, there can be substantial uncertainty in initial costs. For example, there can be a great deal of uncertainty in the cost of a building that will not be constructed for several years. Or there can be uncertainty in the cost of a major construction project that will take several years to complete.

When there is uncertainty in initial cost, how should that risk be incorporated into the analysis?

If the entire cost, or even the major portion, occurs at Time 0, the discount rate is not applied to the cash flow, so the risk-adjusted discount rate method will not get the job done.

What do you think? Can the certainty equivalent method be used? Assume that Time 0 costs on a project could be $100,000 or $150,000 with equal probability, so the expected initial cost is $125,000. What is your estimate of the certainty equivalent cash flow? (Hint: Remember that risk adjustments to cash outflows are the opposite of those applied to inflows.) the subsidiary. For example, the cost of capital for the HMO division could be estimated by looking at the debt and equity costs and capital structures of the major for-profit HMOs such as Humana and UnitedHealth Group. With such market data at hand, it is relatively easy to develop divisional costs of capital. As a final check, the weighted average of the divisional costs of capital should equal the firm s corporate cost of capital.

SELF-TEST QUESTIONS 1. In theory, should project cost-of-capital estimates include capital structure effects?

2. Should all divisions of a firm use the firm s corporate cost of capital as the benchmark rate in making capital budgeting decisions?

3. How might a business go about estimating its divisional costs of capital?

An Overview of the Capital Budgeting Decision Process Our discussion of capital budgeting thus far has focused on how managers evaluate individual projects. For capital planning purposes, health services managers also need to forecast the total number of projects that will be undertaken and the dollar amount of capital needed to fund the projects. The list of projects to be undertaken, along with the cost of each project and the total cost, is called the capital budget.

While every healthcare provider estimates its capital budget in its own unique way, some procedures are common to all firms. The procedures fol lowed by Seattle Health System are used to illustrate the process:

1. The chief financial officer (CFO) estimates the system s corporate cost of capital. As discussed in Chapter 13, this estimate depends on market conditions, the business risk of the system s assets in the aggregate, and the system s optimal capital structure.

2. The CFO then scales the corporate cost of capital up or down to reflect the unique risk and capital structure features of each division. To illustrate, assume that the system has three divisions. For simplicity, the divisions are identified as LRD, ARD, and HRD, which stand for low- risk, average-risk, and high-risk divisions.

3. Managers in each of the divisions evaluate the risk of the proposed projects within their divisions, categorizing each project as having low risk (LRP), average risk (ARP), or high risk (HRP). These project risk classifications are based on the riskiness of each project relative to the other projects in the division, not to the system in the aggregate.

4. Each project is then assigned a project cost of capital that is based on the divisional cost of capital and the project s relative riskiness within that division. As discussed previously, this project cost of capital is then used to discount the project s expected net cash flows. From a financial standpoint, all projects with positive NPVs are acceptable, while those with negative NPVs should be rejected. Subjective factors are also considered, and these factors may result in an optimal capital budget that differs from the one established solely on the basis of financial considerations.

Exhibit 15.8 summarizes Seattle Health System s overall capital budgeting process. It uses the same adjustment amounts as does Bayside: 4 percentage points for high risk and 2 percentage points for low risk. Thus, the corporate cost of capital is adjusted upward to 14 percent in the high-risk division and downward to 8 percent in the low-risk division. The same adjustment 4 percentage points upward for high-risk projects and 2 percentage points downward for low-risk projects is applied to differential risk projects within each division. The end result is a range of project costs of capital within the system that runs from 18 percent for high-risk projects in the high-risk division to 6 percent for low-risk projects in the low-risk division.

This process creates a capital budget that incorporates each project s debt capacity (at least at the divisional level) and risk. However, managers also must consider other possible risk factors that may not have been included in High-risk project 18% HRD cost Average-risk project of capital = 14% 14% Low-risk project 12% High-risk project 14% Corporate cost ARD cost of capital = 10% of capital = 10% Average-risk project 10% Low-risk project 8% High-risk project 12% LRD cost of capital = 8% Average-risk project 8% Low-risk project 6% EXHIBIT 15.8 Seattle Health System: Project Cost of Capital Chart SELF-TEST QUESTIONS Capital rationing The situation that occurs when a business has more attractive investment opportunities than it has capital to invest.

the quantitative analysis. For example, could a project under consideration significantly increase the system s liability exposure? Conversely, does the project have any strategic or social value or other attributes that could affect its profitability?

Such additional factors must be considered, at least subjectively, before a final decision can be made. Typically, if the project involves new products or services and is large (in capital requirements) relative to the size of the firm s average project, the additional subjective factors will be important to the final decision; one large mistake can bankrupt a firm, and bet the company decisions are not made lightly. On the other hand, the decision on a small replacement project would be made mostly on the basis of numerical analysis.

Ultimately, capital budgeting decisions require an analysis of a mix of objective and subjective factors such as risk, debt capacity, profitability, medical staff needs, and social value. The process is not precise, and often there is a temptation to ignore one or more important factors because they are so nebulous and difficult to measure. Despite the imprecision and subjectivity, a project s risk, as well as its other attributes, should be assessed and incorporated into the capital budgeting decision process.

1. Describe a typical capital budgeting decision process.

2. Are decisions made solely on the basis of quantitative factors?

Explain your answer.

Capital Rationing Standard capital budgeting procedures assume that for-profit businesses can raise virtually unlimited amounts of capital to meet capital budgeting needs.

Presumably, as long as the business is investing the funds in profitable (positive NPV) projects, it should be able to raise the debt and equity needed to fund all worthwhile projects. Additionally, standard capital budgeting procedures assume that a business will raise the capital needed to finance its optimal capital budget roughly in accordance with its target capital structure.

This picture of a firm s capital financing/capital investment process is probably appropriate for most investor-owned firms. However, not-for-profit businesses do not have unlimited access to capital. Their equity capital is limited to retentions, contributions, and grants, and their debt capital is limited to the amount supported by the equity capital base. Thus, not-for-profit businesses, and even investor-owned firms on occasion, face periods in which the capital needed for investment in new projects exceeds the amount of capital available. This situation is called capital rationing.

If capital rationing exists, and the business has more acceptable projects than capital, then, from a financial perspective, the firm should accept that set of capital projects that maximizes aggregate NPV and still meets the capital constraint. This approach could be called getting the most bang for the buck because it picks those projects that have the most positive impact on the firm s financial condition.

An ROI measure not yet discussed, the profitability index (PI), is useful under capital rationing. The PI is defined as the present value (PV) of cash inflows divided by the PV of cash outflows. Thus, for Bayside s MRI project discussed earlier in the chapter, PI = $2,582,493 $2,500,000 = 1.03. The PI measures a project s dollars of profitability per dollar of investment, all on a present value basis. In other words, it measures the bang for the buck. The MRI project promises three cents of profit for every dollar invested, which indicates it is not very profitable. (The PI of 1.03 is before adjusting for risk. After adjusting for risk, the project s PI is less than 1.00, indicating that the project is unprofitable.) Under capital rationing, the optimal capital budget is determined first by listing all profitable projects in descending order of PI. Then, projects are selected from the top of the list downward until the available capital is used up.

Of course, in healthcare businesses, priority may be assigned to some low or even negative PI projects, which is fine as long as these projects are offset by the selection of profitable projects that prevent the low-profitability priority projects from eroding the business s financial condition.

1. What is capital rationing?

2. From a financial perspective, how are projects chosen when capital rationing exists?

3. What is the profitability index, and why is it useful under capital rationing?

Profitability index (PI) A project return on investment (ROI) measure defined as the present value of cash inflows divided by the present value of outflows.

It measures the number of dollars of inflow per dollar of outflow (on a present value basis), or the bang for the buck. SELF-TEST QUESTIONS Key Concepts This chapter, which continues the discussion of capital budgeting started in Chapter 14, focuses on risk assessment and incorporation. The key concepts of this chapter are as follows:

Three separate and distinct types of project risk can be identified and defined: (1) stand-alone risk, (2) corporate risk, and (3) market risk.

A project s stand-alone risk is the relevant risk if the project is the sole project of a not-for-profit firm. It is a function of the project s profit uncertainty and is generally measured by the standard (continued) (continued from previous page) deviation of NPV. Stand-alone risk is often used as a proxy for corporate and market risk because (1) corporate and market risk are often impossible to measure and (2) the three types of risk are usually highly correlated.

Corporate risk reflects the contribution of a project to the overall riskiness of the business. Corporate risk ignores stockholder diversification, so it is the relevant risk for most not-for-profit businesses.

Market risk reflects the contribution of a project to the overall riskiness of owners well-diversified portfolios. In theory, market risk is the relevant risk for investor-owned firms, but many people argue that corporate risk is also relevant to owners, and it is certainly relevant to a firm s other stakeholders.

Three quantitative techniques are commonly used to assess a project s stand-alone risk: (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation.

Sensitivity analysis shows how much a project s profitability for example, as measured by NPV changes in response to a given change in an input variable such as volume, with other things held constant.

Scenario analysis defines a project s best, most likely, and worst cases and then uses these data to measure its stand-alone risk.

Whereas scenario analysis focuses on only a few possible outcomes, Monte Carlo simulation uses continuous distributions to reflect the uncertainty inherent in a project s component cash flows. The result is a probability distribution of NPV, or IRR, that provides a great deal of information about the project s riskiness.

In many situations, it is impractical to conduct a quantitative project risk assessment. In such situations, many healthcare businesses use a qualitative approach to risk assessment.

There are two methods for incorporating project risk into the capital budgeting decision process: (1) the certainty equivalent (CE) method, in which a project s expected cash flows are adjusted to reflect project risk, and (2) the risk-adjusted discount rate (RADR) method, in which differential risk is dealt with by changing the cost of capital.

Projects are generally classified as above-average, average, or below-average risk on the basis of their stand-alone risk assessment.

Above-average-risk projects are evaluated at a project cost of capital that is greater than the firm s corporate cost of capital. Average-risk projects are evaluated at the firm s corporate cost of capital, while below-average-risk projects are evaluated at a rate less than the corporate cost of capital.

If a large organization has several divisions that operate in different business lines, it is best to estimate and use divisional costs of capital as the starting point in a project analysis.

When evaluating risky cash outflows, the risk adjustment process is reversed that is, lower rates are used to discount more risky cash flows.

Capital rationing occurs when a business does not have access to sufficient capital to fund all profitable projects, so the best financial outcome results from accepting the set of projects that has the highest aggregate NPV. In such situations, the profitability index (PI) is a useful profitability (ROI) measure.

Ultimately, capital budgeting decisions require an analysis of a mix of objective and subjective factors such as risk, debt capacity, profitability, medical staff needs, and service to the community.

The process is not precise, but good managers do their best to ensure that none of the relevant factors is ignored.

This chapter concludes our discussion of capital investment decisions.

The next chapter examines the revenue cycle and current accounts management.

Questions 15.1 a. Why is risk analysis so important to the capital budgeting process?

b. Describe the three types of project risk. Under what situation is each of the types most relevant to the capital budgeting decision?

c. Which type of risk is easiest to measure in practice?

d. Are the three types of project risk usually highly correlated?

Explain your answer.

e. Why is the correlation among project risk measures important?

15.2 a. Briefly describe sensitivity analysis.

b. What are its strengths and weaknesses?

15.3 a. Briefly describe scenario analysis.

b. What are its strengths and weaknesses?

15.4 a. Briefly describe Monte Carlo simulation.

b. What are its strengths and weaknesses?

15.5 a. How is project risk incorporated into a capital budgeting analysis?

b. Suppose that two mutually exclusive projects are being evaluated on the basis of cash costs. How would risk adjustments be applied in this situation?

15.6 What is the difference between the corporate cost of capital and a project cost of capital?

15.7 What is meant by the term capital rationing? From a purely financial standpoint, what is the optimal capital budget under capital rationing?

15.8 Santa Roberta Clinic has estimated its corporate cost of capital to be 11 percent. What are reasonable values for the project costs of capital for low-risk, average-risk, and high-risk projects?

15.9 Under what conditions should a business estimate divisional costs of capital?

15.10 Describe the qualitative approach to risk assessment. Why does this approach, which does not rely on numerical data, work?

Problems 15.1 The managers of Merton Medical Clinic are analyzing a proposed project. The project s most likely NPV is $120,000, but as evidenced by the following NPV distribution, there is considerable risk involved:

Probability NPV 0.05 ($700,000) 0.20 (250,000) 0.50 120,000 0.20 200,000 0.05 300,000 a. What: are the project s expected NPV and standard deviation of NPV?

b. Should the base case analysis use the most likely NPV or the expected NPV? Explain your answer.

15.2 Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and probabilities (Prob.):

Year Prob. = 0.2 Prob. = 0.6 Prob. = 0.2 0 ($100,000) ($100,000) ($100,000) 1 20,000 30,000 40,000 2 20,000 30,000 40,000 3 20,000 30,000 40,000 4 20,000 30,000 40,000 5 30,000 40,000 50,000 The Year 5 values include salvage value. Heywood s corporate cost of capital is 10 percent.

a. What is the project s expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.) b. What are the project s most likely, worst-case, and best-case NPVs?

c. What is the project s expected NPV on the basis of the scenario analysis?

d. What is the project s standard deviation of NPV?

e. Assume that Heywood s managers judge the project to have lower-than-average risk. Furthermore, the company s policy is to adjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive?

15.3 Consider the project contained in Problem 14.7 in Chapter 14.

a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value.

b. Conduct a scenario analysis. Suppose that the hospital s staff concluded that the three most uncertain variables were number of procedures per day, average collection amount, and the equipment s salvage value. Furthermore, the following data were developed:

Number of Average Equipment Scenario Probability Procedures Collection Salvage Value Worst 0.25 10 $ 60 $100,000 Most likely 0.50 15 80 200,000 Best 0.25 20 100 300,000 c. Finally, assume that California Health Center s average project has a coefficient of variation of NPV in the range of 1.0 2.0.

(Hint: The coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?

d. What type of risk was measured and accounted for in parts b and c? Should this be of concern to the hospital s managers?

15.4 The managers of United Medtronics are evaluating the following four projects for the coming budget period. The firm s corporate cost of capital is 14 percent.

Project Cost IRR A $15,000 17% B 15,000 11 C 12,000 15 D 20,000 13 a. What is the firm s optimal capital budget?

b. Now, suppose Medtronics s managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm s optimal capital budget when differential risk is considered? (Hint: The firm s managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.) 15.5 Allied Managed Care Company is evaluating two different computer systems for handling provider claims. There are no incremental revenues attached to the projects, so the decision will be made on the basis of the present value of costs. Allied s corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:

Year System X System Y 0 ($500) ($1,000) 1 (500) (300) 2 (500) (300) 3 (500) (300) a. Assume initially that both systems have average risk. Which one should be chosen?

b. Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its corporate cost of capital up or down by 2 percentage points. Which system should be chosen?

15.6 University Health System has three divisions: Real Estate, with an 8 percent cost of capital; Health Services, with a 10 percent cost of capital; and Managed Care, with a 12 percent cost of capital. The system s risk adjustment procedures call for adding 3 percentage points to adjust for high risk and subtracting 2 percentage points for low risk. Construct a diagram such as the one in Exhibit 15.8 that illustrates the range of project costs of capital for the system.

15.7 Refer to the table developed in Problem 15.6 for University Health System. Assume the Managed Care Division is evaluating a project with the net cash flows and probabilities shown in the table below.

Assume the Managed Care Division has judged the project to have lower-than-average risk. Is the project financially attractive?

Year Prob. = 0.3 Prob. = 0.4 Prob. = 0.3 0 ($100,000) ($100,000) ($100,000) 1 20,000 30,000 40,000 2 20,000 30,000 40,000 3 20,000 30,000 40,000 4 20,000 30,000 40,000 15.8 Pediatric Partners is evaluating a project with the following net cash flows and probabilities:

Year Prob. = 0.25 Prob. = 0.5 Prob. = 0.25 0 ($75,000) ($75,000) ($75,000) 1 15,000 20,000 30,000 2 15,000 20,000 30,000 3 15,000 20,000 30,000 4 15,000 20,000 30,000 5 20,000 30,000 40,000 The Year 5 values include salvage value. Pediatric Partners corporate cost of capital is 12 percent.

a. What is the project s expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.) b. What are the project s most likely, worst-case, and best-case NPVs?

c. What is the project s expected NPV on the basis of the scenario analysis?

d. What is the project s standard deviation of NPV?

e. Assume that Pediatric Partners managers judge the project to have higher-than-average risk. Furthermore, the practice s policy is to adjust the corporate cost of capital up or down by 2 percentage points to account for differential risk. Is the project financially attractive?

Resources Casolari, C., and S. Womack. 2010. Prioritizing Capital Projects When Cash Is Scarce. Healthcare Financial Management (March): 114 16.

Holmes, R. L., R. E. Schroeder, and L. F. Harrington. 2000. Objective Risk Adjustment Improves Calculated ROI for Capital Projects. Healthcare Financial Management (December): 49 52.

. 1999. Using Microcomputers to Improve Capital Decision Making. Journal of Health Care Finance (Spring): 52 59.

Vianueva, D. 2011. Healthcare Capital Projects: How to Avoid Common Problems. Healthcare Financial Management (April): 86 90.

Williams, D. R., and P. H. Hammes. 2007a. Real Option Logic for Healthcare Entrepreneurial Growth and Survival. Healthcare Financial Management (May): 76 79.

. 2007b. Real Options Reasoning in Healthcare: An Integrative Approach and Synopsis. Journal of Healthcare Management (May/June): 170 87.

VII OTHER TOPICS Up to this point, our discussion of financial management has primarily focused on long-term, or strategic, management decisions. In Part VII, we move first to more immediate, short-term decision making. Then, in the final chapter, we focus on financial condition analysis, which will act as a capstone to many of the topics covered throughout the book.

The first chapter in Part VII focuses on managing short-term accounts such as cash, receivables, short-term debt, and payables. In addition to discussing individual accounts, Chapter 16 covers the revenue cycle, which ties together health services operations, billing, and collections. An understanding of these topics is critical to sound financial management at all health services organizations. In Chapter 17, we discuss how to assess the financial condition of a business. If managers are to plan for the future, they must know the current financial status of the business.

In addition to the chapters in the text, two chapters are available online.

Online Chapter 18 covers two broad topics: (1) the nature of lease financing and how leases are evaluated and (2) the valuation of entire businesses, as opposed to individual projects. Finally, online Chapter 19 focuses on how for-profit businesses return capital to owners. These two chapters are available from the Health Administration Press book companion website at ache.org/ books/HCFinance6.

REVENUE CYCLE AND CURRENT ACCOUNTS 16 MANAGEMENT Learning Objectives After studying this chapter, readers will be able to Discuss in general terms how businesses manage cash and marketable securities.

Describe the construction and use of cash budgets.

Explain the key elements of the revenue cycle and the issues involved in its management.

Explain the basics of receivables management and why it is so important to the revenue cycle.

Describe the basic framework for supply chain management.

Explain the alternatives available for short-term financing, including the use of security to obtain loans.

Introduction In our discussion of financial management leading up to this chapter, the general focus has been on long-term, strategic decisions.

This chapter covers another important element of healthcare finance the management of current accounts, which include short-term (current) assets and their financing.

Unlike long-term financial management, the management of current accounts is highly dependent on the specific type of provider organization (i.e., hospital versus medical practice versus nursing home).

Thus, our treatment of this topic is somewhat basic and generic in nature.

The chapter begins with an overview of current accounts management, followed by a brief discussion of the management of Industry Practice Working Capital Traditionally, a business s current assets were known as working capital. The term originated in the 1700s in the United States when Yankee peddlers were the main source of goods for many farmers in remote areas of the Northeast. These merchants loaded up their wagons with goods and set off on a regular route to peddle their wares. According to the economic definitions of capital (assets) versus labor, the peddler s horse and wagon constituted the business s fixed capital (fixed assets), while the merchandise was called working capital because it was what was sold, or turned over, to produce a profit. Over the years, usage of the term has evolved so that today the term gross working capital is defined as current assets while the term net working capital is defined as current assets minus current liabilities.

each current asset account plus revenue cycle management, which ties together health services operations, billing, and collections. The chapter closes with a discussion of the various types of short-term financing used by healthcare providers.

An Overview of Current Accounts Management Current accounts management involves all current assets and most current liabilities. The primary goal of current accounts management is to support the operations of the business at the lowest possible cost. Clearly, a business must have the level of current assets necessary to meet its operational requirements.

However, it is imprudent to hold too high a level because of the costs of carrying those assets.

To illustrate the requirement for short-term financing and to review the current asset and current liability accounts, consider the situation facing Sun Coast Clinics, a for-profit operator of four walk-in clinics in South Florida.

Exhibit 16.1 contains the firm s December 2015 and April 2016 balance sheets. The provision of ambulatory care services in this part of Florida is a seasonal business. The peak season for Sun Coast is December through April, when the population of the area soars because of winter tourism and the arrival of the snow birds (i.e., retired individuals who typically live in the north during the summer and fall months but move to residences in Florida for the winter).

EXHIBIT 16.1 Sun Coast Clinics, Inc.:

End-of-Month Balance Sheets (in thousands) Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets December 2015 $ 30 155 15 $200 500 $700 April 2016 $ 20 210 10 $240 500 $740 Accounts payable Accruals Notes payable Total current liabilities Long-term debt Common equity Total liabilities and equity $ 30 15 105 $150 150 400 $700 $ 40 25 125 $190 140 410 $740 In December of each year, Sun Coast has just finished its slow season and is preparing for its busy season. Thus, the clinic s accounts receivable are relatively low, but its cash and inventories are relatively high. (In this example, the cash account also contains cash equivalents, which are highly liquid securities with maturities of three months or less.) By the end of April, Sun Coast has completed its busy season, so its accounts receivable are relatively high, but its cash and inventories are relatively low in preparation for the slow summer season. On the current liabilities side, Sun Coast s accounts payable and accruals are relatively high at the end of April, just after the busy season.

Consider what happens to Sun Coast s total current assets and total current liabilities over the December to April period. Current assets increase from $200,000 to $240,000, so the clinic must increase its capital by $40,000 an increase on the assets side of the balance sheet must be financed by an increase on the liabilities and equity side. However, the higher volume of purchases and labor expenditures associated with increased services causes accounts payable and accruals to increase spontaneously by $20,000, from $30,000 + $15,000 = $45,000 in December to $40,000 + $25,000 = $65,000 in April. The net result is an additional $40,000 . $20,000 = $20,000 current asset financing requirement in April, which Sun Coast obtained from the bank as a short-term loan (notes payable). Therefore, at the end of April, Sun Coast showed notes payable of $125,000, up from $105,000 in December.

These fluctuations for Sun Coast result from seasonal factors. Similar fluctuations in current asset requirements, and hence in financing needs, can occur because of business cycles; typically, current asset requirements and financing needs contract during recessions and expand during boom times.

SELF-TEST 1. What is the goal of current accounts management? QUESTIONS 2. Describe how seasonal volume fluctuations influence both current asset levels and financing requirements.

Cash Management Businesses need cash, which includes both actual cash on hand and cash held in commercial checking accounts, to pay for labor and materials, to buy fixed assets, to pay taxes, to service debt, and so on. However, cash is a nonearning asset it provides no return. Thus, similar to the overall goal of current accounts management, the goal of cash management is to minimize the amount of cash the business must hold to conduct its normal activities while having sufficient cash on hand to support operations. Maintaining sufficient cash ensures that a business is liquid, which means that it can meet its cash obligations as they come due. Conversely, a business that is illiquid cannot easily generate the cash needed to meet its obligations, and its operations suffer.

Float The difference between the balance shown on a business s (or individual s) checkbook and the balance shown on the bank s books.

A key element in a business s cash management process is the cash budget, which we discuss in the next major section. In essence, the cash budget tells managers how effective they are in applying the cash management techniques discussed in the following subsections.

Managing Float A well-run business has more money in its checking account than the balance shown on its checkbook. Net float, or just float, is the difference between the balance shown on the bank s records and the balance on the business s checkbook. Alternatively, float can be thought of as the sum of the business s two component floats: disbursement and collections.

To illustrate net float and its components, assume that Gainesville Clinic writes, on average, checks in the amount of $5,000 each day. As the checks are written, the amounts are deducted from the checkbook balance. It takes six days for these checks to be mailed, delivered, deposited, and cleared and for the amounts to be deducted from the clinic s bank account. This will cause the clinic s own checkbook to show a balance that is 6 . $5,000 = $30,000 less than the balance on the bank s records. Considering only disbursements, the clinic s actual balance at the bank is $30,000 greater than the amount shown on its checkbook, so it has a positive $30,000 disbursement float.

Now assume the clinic receives checks in the amount of $5,000 daily, but it loses four days while they are being deposited and cleared. This difference will result in 4 . $5,000 = $20,000 of collections float. Because of the delay in depositing and clearing checks, the clinic s balance at the bank is $20,000 less than that on its checkbook, which represents a negative collections float of $20,000.

The clinic s net float, which is the sum of the positive $30,000 disbursement float and negative $20,000 collections float, is $10,000. On average, the clinic s balance at the bank is $10,000 larger than the balance on its checkbook. Some businesses are so good at managing float that they carry a negative checkbook balance but have a positive balance at the bank. For example, one medical equipment manufacturer stated that its bank s records show an average cash balance of about $200,000, while its own checkbook balance is minus $200,000 it has $400,000 of net float.

A firm s net float is a function of its ability to speed up collections on checks received and to slow down collections on checks written. Efficient businesses go to great lengths to speed up the processing of incoming checks, thus putting the funds to work faster, and they try to delay their own payments as long as possible (without engaging in unethical or illegal practices).

Note, however, that recent changes in check-clearing procedures have made it more difficult for businesses to create substantial floats. In 2004 a new law, the Check Clearing for the 21st Century Act, gave banks greater flexibility in using electronic check clearing, which reduces disbursement float.

Still, well-run businesses recognize the value inherent in float and, as we explain in the following sections, continue to do whatever is possible to maximize it.

Acceleration of Receipts Managers have searched for ways to collect receivables faster since the day that credit transactions began. Although cash collection is the responsibility of a firm s managers, the speed with which checks are cleared is dependent on the banking system. Several techniques are now used to speed collections and to get funds where they are needed, but the three most popular are lockbox services, concentration banking, and electronic claims processing. Following are some points to note about lockbox services and concentration banking. The discussion of electronic claims processing occurs later in this chapter.

Lockboxes are one of the oldest cash management tools, and virtually all banks that offer cash management services offer lockbox services. In a lockbox system, incoming checks are sent to post office boxes rather than to corporate headquarters.

For example, Health SouthWest, a regional HMO headquartered in Oklahoma City, has its Texas members send their payments to a box in Dallas, its New Mexico members send their checks to Albuquerque, and so on, rather than have all checks sent to Oklahoma City. A local bank collects the contents of each post office box (which is called the lockbox ) and deposits the checks into the company s local account. The bank then provides the HMO with daily records of the receipts collected, usually via an electronic data transmission system in a format that permits online updating of the firm s receivables accounts.

A lockbox system reduces the time required for a business to receive incoming checks, deposit them, and get them cleared through the banking system, so the funds are available for use more quickly. This time reduction occurs because mail time and check collection time are both reduced if the lockbox is located in the geographic area where the customer is located.

Lockbox services can often increase the availability of funds by one to four days over the regular system for firms with customers over a large geographic area.

For Your Consideration Credit Cards the Ultimate Float for Individuals Businesses, especially those with large amounts of checks written and received, can take advantage of the float inherent in checking accounts.

But for most individuals, the volume of checking activity makes float management impractical.

However, there is a good source of float available to individuals: credit cards.

Here s how they work. When you charge a purchase on a credit card (but not a debit card), you are given a grace period to pay it off. So as long as you pay the full amount within the grace period, you are not charged interest. In essence, you buy now and pay later without any interest charges. Because you receive the food or merchandise or service now and pay for it, say, 40 days later, the bank that issues the credit card is extending you an interest-free loan. Smart people use credit cards for the convenience and for the value of the float. However, credit cards are only a good deal when you have the financial means to pay them off in full by the payment date.

What do you think about credit cards? In what situations are they a benefit to the individual?

How can credit cards be abused? Do you own a credit card? Do you use it wisely?

Lockbox A post office box used by a business to receive checks at locations other than the corporate headquarters.

Automated Clearing House (ACH) An electronic communication network for transmitting data from one financial institution to another.

Zero-balance account (ZBA) A bank account having a zero balance established by a business to handle disbursements of a particular type. Funds are transferred to ZBAs from a master account as needed to cover the checks written.

Lockbox systems, although efficient in speeding up collections, result in the firm s cash being spread around among many banks. The primary purpose of concentration banking is to mobilize funds from decentralized receiving locations, whether they are lockboxes or decentralized company locations, into one or more central cash pools. In a typical concentration system, the firm s collection banks record deposits received each day. Based on disbursement needs, the funds are then transferred from these collection points to a concentration bank. Concentration accounts allow firms to take maximum advantage of economies of scale in cash management and investment. Health SouthWest uses an Oklahoma City bank as its concentration bank. The HMO cash manager uses this pool for short-term investing or reallocation among its other banks.

Electronic systems make concentration banking easy. The Automated Clearing House (ACH) is a communication network that sends data from one financial institution to another. Instead of using paper checks, the ACH creates electronic files that place all transactions for a particular bank on a single file and then send it to that bank. Some banks send and receive their data on tapes, while most link to the ACH electronically. In addition to the ACH, the Fedwire is used to move large sums between banks. Between the two systems, trillions of dollars are efficiently moved among banks on a daily basis.

Disbursement Control Accelerated collections represent one side of using float, and controlling funds outflows is the flip side of the coin. Efficient cash management can only result if both inflows and outflows are effectively managed.

No single action controls disbursements more effectively than payables centralization. This permits the firm s managers to evaluate the payments coming due for the entire business and to meet those needs in an organized and controlled manner. Centralized disbursement also permits more efficient monitoring of payables and float balances. However, centralized disbursement does have a downside centralized offices may have difficulty in making all payments promptly, which can create ill will with suppliers and potentially lead to the loss of prompt-payment discounts.

Zero-balance accounts (ZBAs) are special disbursement accounts that have a zero-dollar balance on which checks are written. Typically, a firm establishes several ZBAs in the concentration bank and funds them from a master account. As checks are presented to a ZBA for payment, funds are automatically transferred from the master account, which is an interest-earning account. If the master account goes negative, it is replenished by borrowing from the bank against a line of credit or by selling some securities from the firm s marketable securities portfolio. ZBAs simplify the control of disbursements and cash balances and hence reduce the amount of idle (i.e., non-interest-bearing) cash.

Whereas ZBAs are typically established at concentration banks, controlled disbursement accounts can be set up at any bank. In fact, controlled disbursement accounts were initially used only in relatively remote banks, so this technique was originally called remote disbursement. The basic technique is simple: Controlled disbursement accounts are not funded until the day s checks are presented against the account. The key to controlled disbursement is the ability of the bank that has the account to report the total amount of checks received for clearance each morning. This early notification gives a firm s managers sufficient time to wire funds to the controlled disbursement account to cover the checks presented for payment.

Matching the Costs and Benefits of Cash Management Although a number of techniques have been discussed to reduce cash balance requirements, implementing these procedures is not a costless operation. How far should a firm go in making its cash operations more efficient? As a general rule, the firm should incur these expenses only so long as the marginal returns exceed the marginal costs.

The value of careful cash management depends on the opportunity costs of funds invested in cash, which in turn depends on the current level of interest rates. For example, in the early 1980s, with interest rates at relatively high levels, businesses were devoting a great deal of care to cash management.

Today, with interest rates much lower, the value of cash management is reduced.

Clearly, larger businesses, with larger cash balances, can better afford to hire the personnel necessary to maintain tight control over their cash positions.

Because cash management is an element of business operations in which economies of scale are present, banks place considerable emphasis on developing and marketing these services. Thus, banks can generally provide cash management services to smaller companies at lower costs than companies can achieve by operating in-house cash management systems.

SELF-TEST 1. What is float? QUESTIONS 2. How do firms use float to increase cash management efficiency?

3. What are some methods businesses can use to accelerate receipts?

4. What are some methods businesses can use to control disbursements?

5. How should cash management actions be evaluated?

The Cash Budget In Chapter 8, in our discussion of financial planning and budgeting, we focused on the operating budget, which provides managers with numerous insights Cash budget A schedule that lists a business s expected cash inflows, outflows, and net cash flows for some future period.

into the efficiency of an organization s operations. However, the operating budget is based on accrual accounting principles and does not provide managers with much information about a business s cash position. This situation is corrected by the cash budget.

To create a cash budget, managers begin by forecasting volume, revenue, and collections data. Then they forecast fixed-asset acquisition and inventory requirements, along with the times when payments for assets and inventory must be made. Finally, this information is combined with cash outlay projections for operating and financial expenses such as wages and benefits, interest payments, tax payments, and so on. All this collection and payment information is then combined to show the organization s projected cash inflows and outflows over some specified period. Generally, the cash budget consists of individual monthly cash budgets forecasted for one year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budget is used for liquidity planning purposes, and the daily or weekly budget is used for actual cash control.

Creating a cash budget does not require the application of a complex set of accounting rules. Rather, all the entries in a cash budget represent the actual movement of cash into or out of the organization. To illustrate, Exhibit 16.2 contains a monthly cash budget that covers six months of 2016 for Madison Homecare, a small, for-profit home health care company. Madison s cash budget, which is broken down into three sections, is typical, although there is a great deal of variation in formats used by different organizations. Also, for ease of illustration, the cash budget has been constrained to relatively few lines.

The first section of Madison s cash budget contains the collections worksheet, which translates the billing for services provided into cash revenues.

Because of its location in a summer resort area, Madison s patient volume, and hence billings, peak in July. However, like most health services organizations, Madison rarely collects when services are provided. What is relevant from a cash budget perspective is not when services are provided or when billings occur but when cash is collected. Based on previous experience, Madison s managers know that most collections occur 30 to 60 days after billing. In fact, Madison s managers have created a collections worksheet that allows them to forecast, with some precision, the timing of collections. This worksheet was used to convert the billings shown on Line 1 of Exhibit 16.2 into the collection amounts shown on lines 2 and 3.

To illustrate the relationship between billings and collections, consider the $100,000 of billed charges forecasted for May. Of this amount, $19,600 is expected to be collected in May (within 30 days), $70,000 is expected to be collected in June (30 60 days after billing), and $10,000 is expected to be collected in July (60 90 days after billing). Thus, of the $100,000 in May billings, $19,600 + $70,000 + $10,000 = $99,600 is expected to be collected, so a small amount ($400) is forecasted to be a bad debt loss.

EXHIBIT 16.2 Madison Homecare: May Through October Cash Budget March April May June July August September October Collections Worksheet:

1. Billed charges $50,000 $50,000 $100,000 $150,000 $200,000 $100,000 $100,000 $ 50,000 2. Collections:

a. Within 30 days 19,600 29,400 39,200 19,600 19,600 9,800 b. 30 60 days 35,000 70,000 105,000 140,000 70,000 70,000 c. 60 90 days 5,000 5,000 10,000 15,000 20,000 10,000 3. Total collections $ 59,600 $104,400 $154,200 $174,600 $109,600 $ 89,800 Supplies Worksheet:

4. Amount of supplies ordered $ 10,000 $ 15,000 $ 20,000 $ 10,000 $ 10,000 $ 5,000 5. Payments made for supplies $ 10,000 $ 15,000 $ 20,000 $ 10,000 $ 10,000 $ 5,000 Net Cash Gain (Loss):

6. Total collections (from Line 3) $ 59,600 $104,400 $ 154,200 $174,600 $109,600 $ 89,800 7. Total purchases (from Line 5) $ 10,000 $ 15,000 $ 20,000 $ 10,000 $ 10,000 $ 5,000 8. Wages and salaries 60,000 70,000 80,000 60,000 60,000 60,000 9. Rent 2,500 2,500 2,500 2,500 2,500 2,500 10. Other expenses 1,000 1,500 2,000 1,000 1,000 500 11. Taxes 20,000 20,000 12. Payment for capital assets 50,000 13. Total payments $ 73,500 $109,000 $ 104,500 $123,500 $ 93,500 $ 68,000 14. Net cash gain (loss) ($ 13,900) ($ 4,600) $ 49,700 $ 51,100 $ 16,100 $ 21,800 Surplus/Deficit Summary:

15. Cash at beginning with no borrowing $ 15,000 $ 1,100 ($ 3,500) $ 46,200 $ 97,300 $ 113,400 16. Cash at end with no borrowing $ 1,100 ($ 3,500) $ 46,200 $ 97,300 $ 113,400 $135,200 17. Target cash balance 10,000 10,000 10,000 10,000 10,000 10,000 18. Cumulative surplus (deficit) ($ 8,900) ($ 13,500) $ 36,200 $ 87,300 $103,400 $125,200 The next section of Madison s cash budget is the supplies worksheet, which accounts for the amount of supplies purchased and the timing differences between when supplies are ordered and when the resulting bills are paid. Madison s patient volume forecasts, which are used to predict the billing amounts shown on Line 1, are also used to forecast the supplies (primarily medical) needed to support patient services. These supplies are ordered and received one month prior to expected usage, as shown on Line 4. However, Madison s suppliers do not demand immediate payment. Madison has, on average, 30 days to pay for supplies after they are received, so the actual payment occurs one month after purchase, as shown on Line 5.

The next section combines data from the collections and supplies worksheets with other projected cash outflows to show the net cash gain (loss) for each month. Cash from collections is shown on Line 6. Lines 7 through 12 list cash payments that are expected to be made during each month, including payments for supplies. Then all payments are summed, with the total shown on Line 13. The difference between expected cash receipts and cash payments, Line 6 minus Line 13, is the net cash gain or loss during the month, which is shown on Line 14. For May, there is a forecasted net cash outflow of $13,900, with the parentheses indicating a negative cash flow.

Although Line 14 contains the meat of the cash budget, lines 15 through 18 (the surplus/deficit summary) extend the basic budget data to show Madison s monthly forecasted cumulative cash position. Line 15 shows the forecasted cash on hand at the beginning of each month, assuming that no borrowing takes place. Madison is expected to enter the budget period, the beginning of May, with $15,000 of cash on hand. For each succeeding month, Line 15 is merely the value shown on Line 16 for the previous month.

The values on Line 16, which are obtained by adding lines 14 and 15, show the cash on hand at the end of each month, assuming no borrowing takes place. For May, Madison expects a cash loss of $13,900 on top of a starting balance of $15,000, for an ending cash balance of $1,100, in the absence of any borrowing. This amount is the cash at the beginning with no borrowing amount for June shown on Line 15.

To continue, Madison s target cash balance (i.e., the amount that it wants on hand at the beginning of each month), which is shown on Line 17, is $10,000. The target cash balance is subtracted from the forecasted ending cash with no borrowing amount to determine the firm s monthly deficit (shown in parentheses) or surplus (shown without parentheses). Because Madison expects to have ending cash in May, as shown on Line 16, of only $1,100, it will have to obtain $1,100 . $10,000 = .$8,900 to bring the cash account up to the target balance of $10,000. If this amount is borrowed, as opposed to obtained from other sources such as liquidating marketable securities, the total loan outstanding will be $8,900 at the end of May. (The assumption here is that Madison will not have any loans outstanding on May 1.) The cumulative cash surplus or deficit is shown on Line 18; a positive value indicates a cash surplus, while a negative value indicates a deficit.

The surplus cash or deficit shown on Line 18 is a cumulative amount. Thus, Madison is projected to require $8,900 in May; it has a cash shortfall during June of $4,600, as reported on Line 14, so its total deficit projected for the end of June is $8,900 + $4,600 = $13,500, as shown on Line 18.

The same procedures are followed in subsequent months. Patient volume and billings are projected to peak in July, accompanied by increased payments for supplies, wages, and other items. However, collections are projected to increase by a greater amount than costs, and Madison expects a $49,700 net cash inflow during July. This amount is sufficient to pay off the cumulative loan (if one is used) of $13,500 and have a $36,200 cash surplus on hand at the end of the month.

Patient volume, and the resulting operating costs, is expected to fall sharply in August, but collections will be the highest of any month because they will reflect the high June and July billings. As a result, Madison would normally be forecasting a healthy $101,100 net cash gain during the month.

However, the company expects to make a cash payment of $50,000 to purchase a new computer system during August, so the forecasted net cash gain is reduced to $51,100. This net gain adds to the surplus, so August is projected to end with $87,300 in surplus cash. If all goes according to the forecast, later cash surpluses will enable Madison to end this budget period with a surplus of $125,200.

The cash budget is used by Madison s managers for liquidity planning purposes. For example, the Exhibit 16.2 cash budget indicates that Madison will need to obtain $13,500 in total to get through May and June. Thus, if the firm does not have any marketable securities to convert to cash, it will have to arrange a loan, typically a line of credit, to cover this period. Furthermore, the budget indicates a $125,200 cash surplus at the end of October. Madison s managers will have to consider how these funds can best be used. Perhaps the money should be returned to owners as dividends or bonuses, or perhaps it should be used for fixed-asset acquisitions or be temporarily invested in marketable securities for later use within the business. This decision will be made on the basis of Madison s overall financial plan.

This brief illustration shows the mechanics and managerial value of the cash budget. However, before concluding the discussion, several additional points need to be made. First, if cash inflows and outflows are not uniform during the month, a monthly cash budget could seriously understate a business s peak financing requirements. The data in Exhibit 16.2 show the situation expected on the last day of each month, but on any given day during the month it could be quite different. For example, if all payments had to be made on the fifth of each month, but collections came in uniformly throughout the month, Madison would need to borrow cash to cover within-month shortages.

SELF-TEST QUESTIONS Marketable securities Securities that are held in lieu of cash. Typically safe, short-term securities such as Treasury bills. Called cash equivalents or short-term investments when listed on the balance sheet.

Looking at August, the $123,500 of cash payments would occur before the full amount of the $174,600 in collections has been made. In this situation, some amount of cash would be needed to cover shortfalls in August, even though the end-of-month cash flow after all collections had been made is positive.

Because Madison s cash flows do occur unevenly during each month, it also prepares weekly cash budgets to forecast within-month shortages.

Also, because the cash budget represents a forecast, all the values in Exhibit 16.2 are expected values. If actual patient volume, collection times, supplies purchases, wage rates, and so on differ from forecasted levels, the projected cash deficits and surpluses will be incorrect. Thus, there is a reasonable chance that Madison may end up needing to obtain a larger amount of funds than is indicated on Line 18. Because of the uncertainty of the forecasts, spreadsheets are particularly well suited for constructing and analyzing cash budgets. For example, Madison s managers could change any assumption say, projected monthly volume or the time third-party payers take to pay and the cash budget would automatically and instantly be recalculated. This would show Madison s managers exactly how the firm s cash position changes under alternative operating assumptions. Typically, such an analysis is used to determine the size of the credit line needed to cover temporary cash shortages. In Madison s case, such an analysis indicated that a $20,000 credit line is sufficient.

1. Why do organizations need a cash budget?

2. Does the cash budget require an extensive knowledge of accounting principles?

3. In your view, what is the most important line of the cash budget?

Marketable Securities Management Many businesses hold temporary portfolios of short-term securities called marketable securities. On the balance sheet, short-term securities with maturities of three months or less are lumped in with cash and often labeled cash and cash equivalents. Short-term securities with maturities between three months and one year are reported separately as short-term investments. Although cash and marketable securities management are discussed in separate sections, in practice they cannot be separated from one another because management of one implies management of the other.

There are two primary reasons for holding market securities: (1) They serve as an interest-earning substitute for cash balances, and (2) they are used to hold funds that are being accumulated to meet a specific large, near-term obligation, such as a tax payment or capital expenditure.

In general, the key characteristic sought in marketable securities investments is safety (preservation of principal). Most health services managers are willing to give up some return to ensure that funds are available, in the amounts expected, when needed. Large businesses, with large amounts of surplus cash, often directly own securities such as Treasury bills (short-term debt issued by the federal government).

Conversely, smaller businesses are more likely to invest with a bank or with a money market mutual fund because a small firm s volume of investment simply does not warrant its hiring specialists to manage a marketable securities portfolio. Small businesses often use a mutual fund and write checks on the fund to bolster the cash account as the need arises. Interest rates on mutual funds are somewhat lower than rates on direct investments of equivalent risk because of management fees. However, for smaller companies, net returns may well be higher on mutual funds because no in-house management expense is required.

The bottom line here is that, regardless of size, businesses marketable securities portfolios consist almost exclusively of safe, liquid investments that can be sold at any time at a predictable price.

SELF-TEST QUESTIONS 1. Why do firms hold marketable securities?

2. How are these holdings reported on the balance sheet?

3. What are some securities that are commonly held as marketable securities?

4. Why are these the securities of choice?

Revenue Cycle Management One of the hottest topics in healthcare finance today is revenue cycle management.

Its importance stems from the fact that most healthcare providers do not get paid the entire bill at the same time services are rendered. Thus, providers incur cash costs for facilities, supplies, and labor but do not receive immediate payment to cover those costs. In fact, hospitals and medical practices have to wait an average of 50 days to collect from third-party payers.

The revenue cycle can be thought of as the set of recurring business Revenue cycle The set of activities and related information processing necessary to bill for and collect recurring activities the revenues due for services provided. More pragmatically, the revenue cycle and related at provider organizations should ensure that patients are properly categorized information by payment obligation, that correct and timely billing takes place, and that processing required to provide the correct payment is promptly received.

patient services Revenue cycle activities typically are broken down into four phases based and collect for on when they occur: (1) those that occur before the service is provided, (2) those services.

those that occur simultaneously with the service, (3) those that occur afterward, and (4) those that are continuous. Here are some examples of revenue cycle activities listed by phase.

Before-Service Activities Preservice insurance verification. The insurance status of the patient is identified immediately after the outpatient visit (or inpatient stay) is scheduled to ensure that the patient actually has the insurance indicated when the appointment was made.

Precertification (if necessary). If the insurance verification indicates that the payer requires precertification, it should be done immediately.

Without precertification for services that require it, the provider runs the risk of having the claim (bill) denied even though the services were provided.

Preservice patient financial counseling. The patient should be counseled regarding the payer s and patient s payment responsibilities.

It is not fair to present a large bill to an unsuspecting patient after the service is rendered.

At-Service Activities Time-of-service insurance verification. The patient s insurance status should be reverified with both the patient and the payer at time of service to ensure that no changes have occurred since the initial verification.

Service documentation/claims production. The services provided should be documented in a way that facilitates correct claims submission. The documentation process should ensure that (1) the services provided are coded in accordance with the payer s claim system, (2) the code reflects the highest legitimate reimbursement amount, and (3) the claim is formatted in accordance with payer guidelines and contains all required information.

After-Service Activities Claims submission. The claim should be submitted to the payer as quickly as possible after the service is rendered. However, speed should not take precedence over accuracy because incomplete and inaccurate billing accounts for a large proportion of late payments.

Third-party follow-up. If payment is not received within 30 days, a reminder should be sent.

Denials management. Claims denial by third-party payers is one of the major impediments to timely reimbursement. Typically, most denials are caused by improper precertification and incomplete or erroneous claims submission. Prompt claims resubmission is essential to good revenue cycle management.

Payment receipt and posting. When the reimbursement is received, it must be properly deposited and credited. This activity ends the revenue cycle.

Continuous Activities Monitoring. Once revenue cycle activities are identified and timing goals are set for each activity, the provider should implement a system of metrics (key indicators) to ensure that these goals are being met.

Review and improvement. The key indicators monitoring the revenue cycle must be continually reviewed and any deficiencies corrected.

The revenue cycle requires constant attention because the external factors that influence the cycle are constantly changing.

Also, problems that occur at any point in the cycle tend to have ripple effects that is, a problem that occurs early in the cycle can create additional problems at later points in the cycle. For example, failure to obtain required precertification can lead to claim denial, which at best means delayed payment and at worst means no payment at all.

The ability of healthcare providers to convert services rendered into cash is critical to their financial performance. Problems in the revenue cycle lead to lost and late payments, both of which degrade provider revenues and financial condition. You can think of the provider as furnishing to the payer an interest-free loan that covers the costs of the services rendered. The faster the loan is repaid, the better for the lender (provider).

Monitoring Revenue Cycle Performance The ultimate goal of revenue cycle management is to convert services provided into the correct amount of cash reimbursement as quickly as possible. Thus, a provider s patient accounts receivable plays a key role For Your Consideration Revenue Cycle Management in Medical Practices Like in hospitals, revenue cycle management is an important contributor to medical practice profitability. Yet, many physicians struggle with the idea that they are businessmen and businesswomen as well as clinicians.

One of the problems frequently encountered in medical practices is the lack of physician engagement in revenue cycle management. To create the most efficient revenue cycle process, it is essential that all physicians, especially the lead physician, be fully committed to the effort.

Without a high level of executive sponsorship, small problems can quickly turn into large ones.

When physicians are fully engaged in revenue cycle management, it becomes clear that the process is of utmost importance to the overall success of the practice and that the entire team needs to be on board. This is particularly true when new processes or technologies are being introduced.

What do you think about the need for physician involvement in revenue cycle management?

Can t the office manager and billing and collections staff handle the task? What can be done to encourage physicians to be more supportive of the organization s business practices?

in assessing performance. The total amount of accounts receivable outstanding at any given time is determined by two factors: (1) the volume of services provided and (2) the average length of time between services and collections.

For example, suppose Home Infusion, Inc., a home health care business, begins operations on January 1 and on the first day starts to provide services to patients billed at $1,000 each day. For simplicity, assume that all patients have the same insurance, that it takes Home Infusion two days to submit patients bills, and that it takes the insurer another 18 days to make the payments.

Thus, it takes 20 days from delivery of service to receipt of payment.

At the end of the first day, Home Infusion s accounts receivable will be $1,000; they will rise to $2,000 by the end of the second day; and by January 20, they will have risen to $20,000. On January 21, another $1,000 will be added to receivables, but, assuming that the insurer pays the full amount for services provided 20 days earlier, payments for services provided on January 1 will reduce receivables by $1,000, so total accounts receivable will remain constant at $20,000. If either patient volume or the collection period changes, the amount in accounts receivable will change.

Monitoring Overall Revenue Cycle Performance If a service is provided for cash, the payment is received at that time, but if the service is provided on credit, the payment is not actually received until the account is collected. If the account is never collected, the payment is never received. Thus, healthcare managers must closely monitor receivables to ensure that they are being collected in a timely manner and to uncover any deterioration in the quality of receivables. Early detection can help managers take corrective action before the situation has a significant negative impact on the organization s financial condition. (Receivables quality is defined as the likelihood that the receivables will be collected in a timely manner and without losses.) The common approach to monitoring revenue cycle performance, both in the aggregate and by specific activity, is by using metrics. Generically, a metric is a single quantitative indicator usually a ratio that can be used to measure the performance of some process. The primary purpose of metrics is to monitor performance and aid in the identification of corrective action plans if performance is subpar. In this section, we discuss two metrics that monitor overall revenue cycle performance: average collection period and aging schedule.

Average Collection Period Suppose Home Infusion provides an average of ten home health visits a day at an average net charge of $100 per visit, for $1,000 in average daily billings (ADB). Assuming 250 workdays a year, the company s annual billings total $1,000 . 250 = $250,000. Furthermore, assume that all services are paid by two third-party payers: One pays for half of the billings 15 days after the service is provided, and the second pays for the other half of billings in 25 days. Home Infusion s average collection period (ACP), also called days in patient accounts receivable, is 20 days.

ACP = (0.5 . 15 days) + (0.5 . 25 days) = 20 days.

Assuming a constant uniform rate of services provided, and hence billings, the accounts receivable balance will at any point in time be equal to ADB . ACP. Home Infusion s receivables balance would be $20,000:

Receivables balance = ADB . ACP = $1,000 . 20 = $20,000.

What is the cost implication of carrying $20,000 in receivables? The $20,000 on the left side of the balance sheet must be financed by a like amount on the right side. Home Infusion uses a bank loan, which has an interest rate of 8 percent, to finance its receivables. Thus, over a year, the firm must pay the bank 0.08 . $20,000 = $1,600 in interest to carry its receivables balance. The cost associated with carrying other current assets can be thought of in a similar way.

Key Equations: Average Collection Period and Receivables Balance The average collection period (ACP) is a weighted average of the time it takes an organization to collect its receivables. Assume Payer A takes 20 days to pay and contributes 40 percent of a provider s receivables, while Payer B takes 50 days and contributes 60 percent. The ACP is 38 days:

ACP = (0.4 . 20 days) + (0.6 . 50 days) = 8 + 30 = 38 days.

With the ACP known, the receivables balance is calculated as follows:

Receivables balance = ADB . ACP, where ADB is average daily billings. For example, if a provider has $5,000 in average daily billings and an ACP of 38 days, its receivables balance is $190,000:

Receivables balance = ADB . ACP = $5,000 . 38 = $190,000.

Average collection period (ACP) The average length of time it takes a business to collect its receivables.

Also called days sales outstanding (DSO) and days in patient accounts receivable.

The ACP, which is a measure of the average length of time it takes patients (or third-party payers) to pay their bills, often is compared to the industry average ACP. For example, if the home health industry average ACP Aging schedule A table that expresses a business s accounts receivable by how long each account has been outstanding.

is 22 days, versus Home Infusion s 20-day ACP, its collections department is doing a better-than-average job. Note, however, that even though Home Infusion s payers are, on average, paying faster than the 22-day industry average, its two payers are paying in 15 days and 25 days. Thus, the firm s collections department should take a hard look to see if the ACP of the 25-day payer can be reduced to the industry average or even to the 15 days of the other payer.

Why is it so important to minimize a business s ACP? To illustrate, assume that Home Infusion s ACP was 25 days, and its receivables balance was $25,000. Assuming an 8 percent cost of financing (carrying) its receivables, the annual carrying cost to Home Infusion is 0.08 . $25,000 = $2,000.

But at its actual ACP of 20 days, its carrying costs are only 0.08 . $20,000 = $1,600. Thus, by reducing its ACP by five days, Home Infusion reduced its receivables carrying costs by $400 annually. No big deal, you say. True, but now consider a 500-bed hospital with $100 million in receivables and a 60-day ACP, which implies average daily billings (ADB) of $100 million 60 = $1.67 million. A reduction of ACP by five days would reduce the receivables balance to $1.67 million . 55 = $91.85 million, or by about $8 million. Assuming the same 8 percent cost of carrying receivables, the savings amounts to a substantial 0.08 . $8 million = $0.64 million = $640,000.

In addition, the hospital would receive a one-time cash flow of $8 million as the receivables balance is reduced. It should be apparent that immediate cash flow as well as large savings can be obtained by reducing a business s ACP and hence its receivables balance.

Aging Schedules An aging schedule breaks down a firm s receivables by age of account. To illustrate, Exhibit 16.3 contains the December 31, 2015, aging schedules of two home health companies: Home Infusion and Home Care. Both firms offer the same services and show the same total receivables balance. However, Home Infusion s aging schedule indicates that it is collecting its receivables faster than Home Care is. Only 50 percent of Home Infusion s receivables are more than ten days old, while Home Care shows 55 percent of its receivables falling into the more-than-ten-days-old categories. More important, Home Care has receivables that are more than 30 days old and even some that are more than 40 days old. Based on an industry average ACP of 22 days, Home Care s managers should be concerned about the efficiency of the firm s collections effort and about the ability of the late payers to make the payments due.

Aging schedules cannot be constructed from the type of summary data that is reported in a firm s financial statements; they must be developed from the firm s accounts receivable ledger. However, well-run businesses have computerized accounts receivable records. Thus, it is easy to determine the age of each invoice, sort electronically by age categories, and generate an aging schedule.

EXHIBIT 16.3 Home Infusion Home Care Aging Age of Value of Percentage of Value of Percentage of Schedules Account (Days) Account Total Value Account Total Value for Two Firms 0 10 11 20 21 30 31 40 Over 40 $10,000 7,500 2,500 0 0 50% 38 12 0 0 $ 9,000 5,000 3,000 2,000 1,000 45% 25 15 10 5 Total $20,000 100% $20,000 100% Monitoring Specific Revenue Cycle Activities Of course, overall revenue cycle performance is a function of how well the specific revenue cycle activities are performed. Here are five metrics, of many, that are commonly used to measure the performance of specific revenue cycle activities:

1. Cost to collect. This metric is used to measure the overall cost- effectiveness of an organization s revenue cycle management. It is defined as Total revenue cycle costs Total amount collected. The idea here is that it makes no sense to spend $1.50 to collect $1.

2. Point-of-service collection rate. This metric is defined as Point-ofservice collections Total patient collections. Its purpose is to measure the percentage of the monies owed by patients that is collected when the service is rendered. Clearly, the more money that is collected at the time of service, the better. Collection when the patient is at the facility saves the cost of billing and ensures that the payment is made.

3. Initial denial rate. This metric, which is a broad measure of billing efficiency, is defined as Number of initial claims denied Number of claims submitted. Here, the higher the metric value, the greater the cost of collecting payments due from insurers. Claims denials increase revenue cycle costs in three ways. First, denials require additional work, and hence cost, at the billing organization. Second, denials delay the receipt of payment, which increases the cost of carrying the receivables balance. Third, if the denial is permanent, the claim is never paid and the cost of service is borne by the provider.

4. Registration quality score. This metric measures the effectiveness of the patient registration process. It is defined as Number of correct patient demographic and insurance data elements input at registration Total number of data elements. A high score indicates good up-front patient data collection and prevents downstream revenue cycle defects.

5. Charge lag days. This metric measures the time it takes from the day a service is provided to the day a bill is sent to the payer (patient or insurer). It is defined as Total days between service and billing Number of bills. Note this definition gives the average lag days over some time period. The metric could also be calculated by payer (patient, Medicaid, or others). Clearly, on average, the faster that bills are generated and sent, the quicker the collection.

Before we end our discussion of specific metrics, it is useful to consider this question: What makes a good metric? First and foremost, metrics are supposed to measure process performance. So good metric design starts with defining what the fundamental purpose is for the process being assessed. Only after having defined the process purpose can a discussion begin about measuring performance. In the case of the revenue cycle, the fundamental purpose can be defined as identifying the correct amount owed to the organization for services rendered and converting that amount into cash.

Second, recognize that metrics are used to provide the organizational focus to ensure that resources are aimed at the correct activities. To further this concept, selected metrics, coupled with associated goals, are used to define incentive pay plans to motivate staff to achieve the desired results. With these goals in mind, here are several characteristics of good metrics:

Metrics must directly measure the degree of success of the process purpose.

Metrics must be measurable and quantitative.

Metrics must be objective and precise.

Metrics must be measurable over time.

Metrics should be easily defined and understood by all affected managers and staff.

While the performance monitoring objective of metrics is apparent to most individuals, the human component evades many. Metrics play a major role not only in motivating staff to work better but also in communicating organizational goals and objectives. In high-performing organizations, managers and staff have a sense of purpose related to their daily activities, and metrics play a fundamental role in communicating how this purpose is achieved.

Unique Problems Faced by Healthcare Providers Although the general principles of receivables management discussed up to this point are applicable to all businesses, healthcare providers face some unique problems. The most obvious problem is the billing complexity created by the third-party payer system. For example, rather than having to deal with a single billing system that applies to all customers, providers have to deal with the rules and regulations of many different governmental and private insurers that use different payment methodologies. Thus, providers have to maintain large staffs of specialists who report to a patient accounts manager.

For an illustration of the problem, consider Exhibit 16.4, which contains the receivables mix for the hospital industry. There are multiple payers in many of the categories listed in the exhibit, so the actual number of different payers can easily run into the hundreds.

Exhibit 16.5 provides information on how long it takes hospitals to collect receivables. Because of the large number of payers and the complexities involved in billing and follow-up actions, hospitals clearly have a great deal of difficulty collecting bills in a timely manner. On average, it takes about 50 days to collect a receivable. However, this number has decreased in recent years as hospital managers have become increasingly aware of the costs associated with carrying receivables and as automated systems have made the collections process more efficient. Despite the positive trend, about 33 percent of receivables still were more than 60 days old. In addition, about 5.4 percent of patient bills were never paid at all, of which about 3.2 percent were charged off as bad debt losses and 2.2 percent went to charity care.

EXHIBIT 16.4 Payer Percentage of Total Accounts Receivable Hospital Medicare Managed care Self-pay 29.9% 25.5 17.1 Industry s Receivables Mix Medicaid 12.4 Commercial insurers 10.5 Other 4.6 100.0% Source: Data from Aspen Publishers, Hospital Accounts Receivable Analysis (HARA), third quarter, 2012. HARA reports are updated quarterly.

Age of Account (Days) 0 30 31 60 61 90 91 120 Over 120 Percentage of Total Accounts Receivable (Days) EXHIBIT 16.5 Hospital Industry s Aggregate Aging Schedule Percent Source: Data from Aspen Publishers, Hospital Accounts Receivable Analysis (HARA), third quarter, 2012. HARA reports are updated quarterly.

SELF-TEST QUESTIONS Supply chain management The management of the procurement, storage, and utilization of supplies. Also called materials management.

To help providers collect from managed care plans in a timely fashion, many states have enacted laws that mandate prompt payment. For example, New York requires that all undisputed claims by providers be paid by plans within 45 days of receipt. If prompt payment is not made, fines are assessed.

1. What is the revenue cycle?

2. What four phases make up the cycle?

3. Why is proper management of the revenue cycle critical to the financial performance of healthcare providers?

4. Explain how a firm s receivables balance is built up over time and why there are costs associated with carrying receivables.

5. Briefly discuss two metrics used to monitor overall revenue cycle performance.

6. What are some of the unique problems healthcare providers face in managing receivables?

Supply Chain Management Supply chain management involves the requisitioning of, ordering of, receipt of, and payment for supplies. Historically, supply chain management was called inventory management. Inventories are an essential part of virtually all business operations. As is the case with accounts receivable, inventory levels depend heavily on volume. However, whereas receivables build up after services have been provided, inventories must be acquired ahead of time. This is a critical difference, and the necessity of forecasting patient volume before establishing target inventory levels makes inventory management a difficult task. Also, because errors in inventory levels can lead either to catastrophic consequences for patients or to excessive carrying costs, supply chain management in health services organizations is as important as it is difficult.

Proper supply chain management requires close coordination among the marketing, purchasing, patient services, and finance departments. The marketing department is generally the first to spot changes in demand. These changes must be worked into the company s purchasing and operating schedules, and the financial manager must arrange any financing that will be needed to support inventory buildups. Improper communication among departments, poor volume forecasts, or both can lead to disaster.

The key to cost-effective supply chain management is information technology.

Without information systems that support supply chain management, the control system will become bogged down with slow-moving hard-copy data.

To illustrate, most healthcare businesses now employ computerized inventory control systems. The computer starts with an inventory count in memory. As withdrawals are made, they are recorded in the computer, and the inventory balance is revised. When the order point is reached, the computer automatically places an order, and when the order is received, the recorded balance is increased.

A good supply chain management system must be dynamic. A large provider may stock thousands of different items of inventory. The usage of these various items can rise or fall separately from rising or falling aggregate utilization of services. As the usage rate for an individual item begins to rise or fall, the supply chain manager must adjust its balance to avoid running short or ending up with obsolete items. If the change in the usage rate appears to be permanent, the base inventory level should be recomputed, the safety stock should be reconsidered, and the computer model used in the control process should be reprogrammed.

Today, many health services providers are using the just-in-time (JIT) approach to supply chain management. JIT is a management strategy aimed at minimizing costs by having inventory items arrive on-site shortly before they are needed. This simple concept reduces the costs associated with carrying large inventories at any given point in time. To illustrate the use of just-intime systems among providers, consider Bayside Memorial Hospital, which consumes large quantities of medical supplies each year. A few years ago, the hospital maintained a 25,000-square-foot warehouse to hold its medical supplies.

However, as cost pressures mounted, the hospital closed its warehouse and sold the inventory to a major hospital supplier. Now the supplier is a full-time partner of Bayside in ordering and delivering the products of some 400 hospital supply companies.

Bayside s supply chain streamlining process began with daily deliveries to the hospital s loading dock but soon expanded to a JIT system called stockless inventory. Now the supplier fills orders in exact, sometimes small, quantities and delivers them directly to departments inside the hospital, including the operating rooms and nursing floors. Bayside s managers estimate that the stockless system has saved the hospital about $1.5 million a year since it was instituted, including $350,000 from staff reductions and $1,150,000 from inventory and facilities reductions. Additionally, the hospital has converted space that was previously used as storerooms to patient care and other cash- generating uses. The distributors that offer stockless inventory systems typically add 3 to 5 percent service fees, but large hospitals with high materials costs can realize savings on total inventory costs even when such fees are considered.

However, the stockless inventory concept has its own set of problems.

The major concern is that a stock-out, which occurs when a needed inventory item is not available, will cause a serious problem. In addition, some hospital managers are concerned that such systems create too much dependence on a Just-in-time (JIT) approach A supply chain management technique that requires suppliers to deliver inventory items in relatively small quantities as they are needed, which reduces the amount of inventory stock held. There are several variations of JIT systems.

For Your Consideration The GS1 System of Standards Founded in 1977, GS1 is an international not-forprofit organization dedicated to the improvement of supply chain efficiency. GS1 s primary activity is the development of the GS1 System, a series of standards composed of four key elements: bar codes, which are used to automatically identify items; eCom, which creates standardized business inventory messaging data; Global Data Synchronization, which allows multiple businesses to have consistent inventory data; and EPCglobal, which establishes a system that uses radio frequency chips to track items across the entire supply chain.

In the US healthcare sector, many companies from manufacturers to distributors to end users such as hospitals are actively supporting the adoption of GS1 standards. The goals of the companies involved include enhanced patient safety, improved supply chain management, enhanced drug control, and better connectivity to electronic health records.

What do you think of the GS1 standards concept? How can bar codes and radio frequency chips enhance patient safety? Do you think that the adoption of GS1 standards will increase or decrease supply chain costs?

single supplier, and eventually the cost savings will disappear as prices increase because of the sole-supplier relationship.

As stockless inventory systems become more prevalent in hospitals, more and more hospitals are relying on outside contractors who assume both inventory management and supplier roles. In effect, hospitals are beginning to outsource supply chain management. For example, some hospitals are experimenting with an inventory management program known as point-of-service (POS) distribution, which is one generation ahead of stockless systems.

Under point-of-service programs, the supplier delivers supplies, intravenous solutions, medical forms, and so on to the supply rooms, as is done in stockless systems.

However, in POS programs, the supplier owns the products in the supply rooms until they are used by the hospital, at which time the hospital pays for the items.

In addition to reducing inventories, outside supply chain managers are often better at ferreting out waste than are their in- house counterparts. For example, an inventory management company recently found that one hospital was spending $600 for products used in open heart surgery, while another was spending only $420.

Because there was no meaningful difference in the procedure or outcomes, the higher-cost hospital was able to change the medical devices used in the surgery and pocket the difference.

In an even more advanced form of supply chain management, some hospitals are just beginning to negotiate with suppliers to furnish materials on the basis of how much medical care is delivered, rather than the type and number of products used. In such agreements, providers pay suppliers a set fee for each unit of patient service provided for example, $125 for each case-mix-adjusted patient day. Under this type of system, a hospital ties its supplies expenditures to its revenues, which, at least for now, are for the most part tied to the number of units of patient service. The end of the evolution of inventory management techniques for healthcare providers is expected to be some form of capitated payment, whereby providers will pay suppliers a previously agreed-upon fee, regardless of actual future patient volume and regardless of the amount of materials actually consumed.

1. Why is good supply chain management important to a firm s success?

2. Describe some recent trends in supply chain management by healthcare providers.

Current Liability Management At this point in the chapter, we conclude our discussion of current assets management and turn our attention to current liabilities management. We begin with two nondebt accounts accruals and trade credit after which we cover short-term debt financing.

Accruals Firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance sheet will typically show some accrued wages. Similarly, the firm s own estimated income taxes (if applicable); the Social Security and income taxes withheld from employee payrolls; and any required sales, workers compensation, and unemployment taxes are generally paid on a weekly, monthly, or quarterly basis. Thus, as discussed in Chapter 4, the balance sheet accruals account typically includes both taxes and wages.

Accruals increase automatically, or spontaneously, as a firm s operations expand. Furthermore, this type of short-term debt is free in the sense that no explicit interest is paid on funds raised through accruals. However, a firm cannot ordinarily control the amount of accruals on its balance sheet because the timing of wage payments is set by economic forces and industry custom, and tax payment dates are established by law. Because accruals represent free financing, businesses should use all of the accrual financing they can obtain, but managers have little control over the levels of such accounts.

Accounts Payable (Trade Credit) Firms often make purchases from other firms on credit. Such debt is recorded on the balance sheet as an account payable. Accounts payable, or trade credit, is the largest single category of short-term debt for many businesses. Because very small companies typically do not qualify for financing from other sources, they rely especially heavily on trade credit.

Trade credit is another spontaneous source of financing in the sense that it arises from ordinary business transactions. For example, suppose that a SELF-TEST QUESTIONS Credit policy Generically, a business s rules and regulations regarding granting credit and collecting from buyers that take credit.

For healthcare providers, the business s policy regarding self- pay and indigent patients.

hospital purchases an average of $2,000 a day of supplies on terms of net 30 days meaning that it must pay for goods 30 days after the invoice date. On average, the hospital will owe 30 . $2,000 = $60,000 to its suppliers, assuming that the hospital s managers act rationally and do not pay before the credit is due. If the hospital s volume, and consequently its purchases, were to double, its accounts payable would also double to $120,000. Simply by growing, the hospital would have spontaneously generated an additional $60,000 of financing.

Similarly, if the terms under which it bought supplies were extended from 30 to 40 days, the hospital s accounts payable would expand from $60,000 to $80,000. A supplier lengthening the credit period and expanding volume and purchases generates additional financing for a business.

Firms that sell on credit have a credit policy that includes certain terms of credit. For example, Midwestern Medical Supply Company sells on terms of 2/10, net 30 meaning that a 2 percent discount is given if payment is made within ten days of the invoice date, with the full invoice amount being due and payable within 30 days if the discount is not taken. Suppose that Chicago Health System buys an average of $12 million of medical and surgical supplies from Midwestern each year, less a 2 percent discount, for net purchases of $11,760,000 360 = $32,666.67 per day. For the sake of simplicity, suppose that Midwestern is Chicago Health System s only supplier. If Chicago Health System takes the discount, paying at the end of the tenth day, its payables will average 10 . $32,666.67 = $326,667, so Chicago Health System will, on average, be receiving $326,667 of credit from its only supplier, Midwestern Medical Supply Company.

Suppose now that the system s managers decide not to take the discount.

What effect will this decision have on the system s financial condition? First, Chicago Health System will begin paying invoices after 30 days, so its accounts payable will increase to 30 . $32,666.67 = $980,000. Midwestern will now be supplying Chicago Health System with $980,000 . $326,667 = $653,333 of additional trade credit. The health system could use this additional credit to pay off bank loans, to expand inventories, to increase fixed assets, to build up its cash account, or even to increase its own accounts receivable.

Note that we used $32,666.67 for average daily sales, which is based on the discounted price of the surgical supplies, regardless of whether Chicago Health System takes the discount. In general, businesses treat the discounted price of supplies as the true cost when reporting expenses on the income statement.

If the business does not take the discount, the cost difference is reported separately on the income statement as an expense called discounts lost. Thus, we used the discounted price to reflect the cost of the supplies in both instances.

Chicago Health System s additional credit from Midwestern has a cost:

It is forgoing a 2 percent discount on its $12 million of purchases, so its costs will rise by $240,000 per year. Dividing this $240,000 cost by the amount of additional credit provides the implicit approximate percentage cost of the added trade credit:

$240,000 Approximate% cost == 36.7%.

$653,333 Assuming that Chicago Health System can borrow from its bank or from other sources at an interest rate less than 36.7 percent, it should not expand its payables by forgoing discounts.

The following equation can be used to calculate the approximate percentage cost, on an annual basis, of not taking discounts:

Discount percent Approximate% cost = 100 .

Discount percent 360 .

.

Days credit received .

Discount period The numerator of the first term, Discount percent, is the cost per dollar of credit, while the denominator in this term, 100 . Discount percent, represents the funds made available by not taking the discount. Thus, the first term is the periodic cost rate of the trade credit in this example, Chicago Health System must spend $2 to gain $98 of credit, for a cost rate of 2 98 = 0.0204 = 2.04%.

The second term shows how many times each year this cost is incurred in this example, 360 (30 . 10) = 360 20 = 18 times. Putting the two terms together, the approximate cost of not taking the discount when the terms are 2/10, net 30 is computed as follows:

2 360 Approximate% cost =.

= 0.0204 .18 98 20 = 0.367 = 36.7%.

The cost of trade credit can be reduced by paying late that is, by paying beyond the date that the credit terms allow. Such a strategy is called stretching. If Chicago Health System could get away with paying Midwestern in 60 days rather than in the specified 30, the effective credit period would become 60 . 10 = 50 days, and the approximate cost would drop from 36.7 percent to (2 98) . (360 50) = 14.7%. In recessionary periods, businesses may be able to get away with late payments to suppliers, but they will also suffer a variety of problems associated with stretching accounts payable and being branded as a slow payer.

On the basis of the preceding discussion, it is clear that trade credit usually consists of two distinct components:

1. Free trade credit. This credit consists of the free credit received during the discount period. For Chicago Health System, the free trade credit amounts to ten days net purchases, or $326,667.

Free trade credit The amount of credit received from a supplier that has no explicit cost attached. In other words, credit received during the discount period.

Costly trade credit The credit taken by a company from a vendor in excess of the free trade credit.

2. Costly trade credit. The costly trade credit is that in excess of the free credit and whose cost is an implicit one based on the forgone discount.

For Chicago Health System, the amount of costly trade credit is $653,333.

From a finance perspective, managers should view trade credit in this way: First, the actual price of supplies is the discounted price that is, the price that would be paid on a cash purchase. Any credit that can be taken without an increase in price is free credit that should be taken. Second, if the discounted price is the actual price, the added amount that must be paid if the discount is not taken is, in reality, a finance charge for granting additional credit. A business should take the additional credit only if the finance charge is less than the cost of alternative credit sources.

Key Equation: Approximate Cost of Trade Credit The approximate cost of the costly portion of trade credit can be calculated as follows:

Discount percent Approximate% cost = 100 .

Discount percent 360 .

.

Days credit received .

Discount period To illustrate, assume a vendor offers terms of 3/10, net 60, which means that a 3 percent discount is offered if the bill is paid in ten days, but the full amount is due in 60 days if the discount is not taken. In this situation, the approximate cost of not taking the discount is 22.3 percent:

3 360 3 360 Approximate% cost = .

=.

(100 .

3)(60 .

10) 97 50 = 0.0309 .

7.2 = 0.223 = 22.3%.

In the example, Chicago Health System should take the $326,667 of free credit offered by Midwestern Medical Supply Company. Free credit is good credit. However, the cost rate of the additional $653,333 of costly trade credit is approximately 37 percent. The system has access to bank loans at a 9.5 percent rate, so it does not take the additional credit. Under the terms of trade found in most industries, the costly component involves a relatively high percentage cost, so stronger firms avoid using it.

Short-Term Debt Financing Short-term debt, which is a current liability account, has three primary advantages over long-term debt (discussed in Chapter 11). First, a short-term loan can be obtained much faster than long-term credit. Lenders will insist on a more thorough financial examination before extending long-term credit, and the loan agreement (or bond indenture) will have to be spelled out in considerable detail because a lot can happen during the life of a ten- or 20-year loan (or bond). Thus, if a business requires funds in a hurry, it should look to the short-term credit markets.

Second, if needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for two reasons:

Administrative costs are generally high when raising long-term debt but trivial for short-term debt. Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds may diminish in the near future, it should choose short- term debt for the flexibility it provides.

Long-term loan agreements almost always contain restrictive covenants that constrain the firm s future actions. Short-term debt agreements are generally much less onerous in this regard.

Third, the interest rate on short-term debt generally is lower than the rate on long-term debt because the yield curve normally is upward sloping.

Thus, when coupled with lower administrative costs, short-term debt can have a significant total cost advantage over long-term debt.

In spite of these advantages, short-term debt has one serious disadvantage:

It subjects the firm to more risk than does long-term financing. The increased risk occurs for two reasons. First, if a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term debt, its interest expense can fluctuate widely, at times possibly going quite high. For example, the short-term rate that banks charge large corporations (the prime rate) more than tripled over a two-year period in the early 1980s, rising from 6.25 to 21 percent. Many firms that had borrowed heavily on a short-term basis simply could not meet their rising interest costs, and as a result, bankruptcies hit record levels during that period.

Second, the principal amount on short-term debt comes due on a regular basis. If the financial condition of a business temporarily deteriorates, it may find itself unable to repay this debt when it matures. Furthermore, the business may be in such a weak financial position that the lender will not extend the loan. Such a scenario can result in severe problems for the borrower, which, like unexpectedly high interest rates, could force the business into bankruptcy.

Compensating balance A minimum checking account balance that a business must maintain to compensate the bank for other services or loans.

Line of credit A loan arrangement in which a bank agrees to lend some maximum amount to a business over some designated period.

Commercial banks, whose short-term loans generally appear on firms balance sheets as notes payable, are an important source of short-term financing for many health services businesses. The banks influence is actually greater than it appears from the dollar amounts they lend because banks provide nonspontaneous funds. As a business s financing needs increase, it requests its bank to provide the additional funds. If the request is denied, the firm may be forced to abandon attractive growth opportunities.

Although banks make longer-term loans, the bulk of their lending is on a short-term basis (about two-thirds of all bank loans mature in a year or less). Bank loans to businesses are frequently written as 90-day notes, so the loan must be repaid or renewed at the end of 90 days. When a bank loan is approved, the agreement is executed by signing a promissory note, which is similar to a bond indenture or loan agreement but much less detailed. When the note is signed, the bank credits the borrower s checking account with the amount of the loan, while both cash and notes payable increase on the borrower s balance sheet.

Compensating Balances Banks sometimes require borrowers to maintain a checking account balance equal to 10 to 20 percent of the face amount of a short-term loan. This requirement is called a compensating balance, and such balances raise the effective interest rate on the loan. For example, suppose that Pine Garden nursing home needs an $80,000 bank loan to pay off maturing obligations.

If the loan requires a 20 percent compensating balance, the nursing home must borrow $100,000 to obtain a usable $80,000, assuming that the business does not have an extra $20,000 around to use as a compensating balance.

If the stated interest rate is 8 percent, the effective cost rate is 10 percent:

0.08 . $100,000 = $8,000 in interest expense divided by $80,000 of usable funds equals 10 percent.

Lines of Credit One common type of short-term loan is the line of credit, sometimes called a revolving credit agreement or just revolver. The contract on such loans specifies the maximum credit the bank will extend to the borrower over some specified period of time. For example, on December 31 a bank loan officer might indicate to Pine Garden s manager that the bank regards the nursing home as being good for up to $80,000 during the forthcoming year. If, on January 10, Pine Garden borrows $15,000 against the line, this would be called taking down $15,000 of the credit line. This take-down would be credited to the nursing home s checking account at the bank, and before repayment of the $15,000, Pine Garden could borrow additional amounts up to a total of $80,000 outstanding at any one time. Lines of credit are generally for one year or less, and borrowers typically have to pay an up-front commitment fee of about 0.5 to 1 percent of the total amount of the line. Interest is paid only on the amount of the credit line that is actually used. As a general rule, the rate of interest on credit lines is pegged to the prime rate, so the cost of the loan can vary over time if interest rates change. Pine Garden s rate was set at prime plus 0.5 percentage points.

Secured Short-Term Debt Generally, short-term debt used by healthcare providers is unsecured, meaning that no specific assets are pledged as collateral. Given a choice, it is ordinarily better to borrow on an unsecured basis because the administrative costs associated with secured loans are often high. However, weak businesses may find that they can borrow only if they put up some form of security to protect the lender or that they can borrow at a much lower rate by using security. Within the healthcare sector, the most common form of collateral is accounts receivables.

Accounts receivable financing involves either the pledging of receivables or the selling of receivables. The pledging of accounts receivable is characterized by the fact that the lender not only has a claim against the dollar amount of the receivables but also has recourse against the pledging firm. This means that if the person or firm that owes the receivable does not pay, the business that borrows against the receivable must take the loss. Therefore, the risk of default on the accounts receivable pledged remains with the borrowing firm.

When receivables are pledged, the payer is not ordinarily notified about the pledging, and payments are made on the receivables in the same way as when receivables are not used as loan security.

The second form of receivables financing is factoring, or selling accounts receivable. In this type of secured financing, the receivables account is purchased by the capital supplier, generally without recourse to the selling business. In a typical factoring transaction, the buyer of the receivables pays the seller about 90 to 95 percent of the face value of the receivables. When receivables are factored, the person or business that owes the receivable is often notified of the transfer and is asked to make payment directly to the company that bought the receivables. Because the factoring firm assumes the risk of default on bad accounts, it must perform a credit check on the receivables prior to the purchase. Accordingly, factors, which are the firms that buy receivables, can provide not only money but also a credit department for the borrower.

Incidentally, the same financial institutions that make loans against pledged receivables also serve as factors. Thus, depending on the circumstances and the wishes of the borrower, a financial institution will provide either form of receivables financing.

Because healthcare providers tend to carry relatively large amounts of receivables, such businesses are prime candidates for receivables financing. The selling of these receivables, especially by hospitals that are experiencing liquidity problems, represents one way to reduce carrying costs and stimulate cash flow.

Although receivables financing is a way to reduce current assets and financing costs, critics contend that such programs are too expensive. Because of the costs involved, most receivables financing programs are used by providers that have serious liquidity (cash flow) problems, although programs are being developed that can provide benefits even to well-run businesses that are not facing a liquidity crunch.

SELF-TEST QUESTIONS 1. What are accruals, and what is their role in short-term financing?

2. What is the difference between free and costly trade credit?

3. How might a hospital that expects to have a cash shortage sometime during the coming year make sure that needed funds will be available?

4. What is the current asset most commonly pledged as security for short-term loans?

Key Concepts This chapter examines current asset management and financing. The key concepts of this chapter are as follows:

The goal of current asset management and financing is to support the business s operations at the lowest possible cost without taking undue risks.

The primary goal of cash management is to reduce the amount of cash held to the minimum necessary to conduct business in a financially efficient manner.

Float is the difference between the balance shown on a business s (or individual s) checkbook and the balance shown on the bank s books.

Float management techniques include accelerating collections and controlling disbursements.

Lockboxes are used to accelerate collections. A concentration banking system consolidates the collections into a centralized pool that can be managed more efficiently than a large number of individual accounts.

Three techniques for controlling disbursements are payables centralization, zero-balance accounts, and controlled disbursement accounts.

Businesses can reduce their cash balances by holding marketable securities. Marketable securities serve both as a substitute for cash and as a temporary investment for funds that will be needed in the near future. Safety is the primary consideration when selecting marketable securities.

The implementation of a sophisticated cash management system is costly, and all cash management actions must be evaluated to ensure that the benefits exceed the costs.

A cash budget, which is the primary cash management tool, forecasts the cash inflows and outflows of an organization with the goal of identifying expected surpluses and shortfalls.

In general, monthly cash budgets are used for planning purposes, while weekly or daily budgets are used for cash management purposes.

The revenue cycle includes all activities associated with billings and collections for services provided.

The revenue cycle can be broken down into four activity categories, depending on when they occur: (1) before-service activities, (2) at-service activities, (3) after-service activities, and (4) continuous activities.

When a business sells goods to a customer on credit, an account receivable is created.

Businesses use aging schedules and average collection period (ACP) data to monitor overall revenue cycle performance.

In addition, metrics are used to monitor the performance of individual revenue cycle activities.

Proper supply chain (inventory) management requires close coordination among the marketing, purchasing, patient services, and finance departments. Because the cost of holding inventory can be high and stock-outs can be disastrous, inventory management is important.

Just-in-time (JIT) systems are used to minimize inventory costs and, simultaneously, to improve operations.

The advantages of short-term debt are the speed with which short- term loans can be arranged, increased flexibility, and the fact that short-term interest rates are generally lower than long-term rates.

The principal disadvantages of short-term credit are that borrowers must bear extra risk because lenders can demand payment on short notice and that the cost of the loan will increase if interest rates rise.

Accruals, which are recurring short-term liabilities, represent free spontaneous credit.

(continued) (continued from previous page) Accounts payable, or trade credit, arises spontaneously as a result of purchases on credit. Businesses should use all the free trade credit they can obtain, but they should use costly trade credit only if it is less expensive than alternative sources of short-term debt.

Bank loans are an important source of short-term credit. When a bank loan is approved, a promissory note is signed.

Banks sometimes require borrowers to maintain compensating balances, which are deposit requirements set at between 10 and 20 percent of the loan amount. Compensating balances raise the effective rate of interest on bank loans.

Lines of credit, or revolving credit agreements, are formal understandings between the bank and the borrower in which the bank agrees to extend some maximum amount of credit to the borrower over some specified period.

Sometimes a borrower will find that it is necessary to borrow on a secured basis, in which case the borrower uses assets, primarily accounts receivable in the healthcare sector, as collateral for the loan.

This chapter focuses on the revenue cycle and current accounts management rather than the long-term concepts covered in earlier chapters. In the final chapter in the text (Chapter 17), we cover financial performance analysis.

Questions 16.1 a. What is the goal of cash management?

b. Briefly describe float and the following associated cash management techniques:

Receipt acceleration Disbursement control 16.2 a. What is a cash budget, and how is it used?

b. Should depreciation expense appear on a cash budget? Explain your answer.

16.3 a. Give two reasons why businesses hold marketable securities.

b. Which types of securities are most suitable for holding as marketable securities?

633 c. Suppose Southwest Regional Medical Center has just raised $6 million in new capital that it plans to use to build three freestanding clinics, one each year over the next three years. (For the sake of simplicity, assume that equal payments have to be made at the end of each of the next three years.) What securities should be bought for the firm s marketable securities portfolio, assuming that the firm has no other excess cash? (Hint: Consider both the type and maturity of the securities.) d. Now, consider the situation faced by the Huntsville Physical Therapy Group. It has accumulated $20,000 in cash above its target cash balance, and it has no immediate needs for this excess cash. However, the firm may at any time need some part or all of the $20,000 to meet unforeseen cash needs. What securities should be bought for the firm s marketable securities portfolio?

16.4 a. What is meant by the term revenue cycle?

b. What are the three sets of activities that comprise the revenue cycle?

c. What is the overall goal of revenue cycle management?

16.5 a. Define the term average collection period (ACP).

b. How is ACP used to monitor overall revenue cycle performance?

c. What is an aging schedule?

d. How is an aging schedule used to monitor overall revenue cycle performance?

16.6 a. What is a metric?

b. What role do metrics play in revenue cycle management?

16.7 a. What is a just-in-time (JIT) inventory system?

b. What are the advantages and disadvantages of JIT systems?

c. Can JIT inventory systems be used by healthcare providers?

Explain your answer.

16.8 Describe the three major sources of short-term financing.

16.9 a. What is the difference between free trade credit and costly trade credit?

b. Should businesses use all the free trade credit that they can get?

Explain your answer.

c. Should businesses use all the costly trade credit they can get?

Explain your answer.

16.10 Explain briefly how healthcare providers typically obtain secured short-term financing, if such financing is needed.

Problems 16.1 On a typical day, Park Place Clinic writes $1,000 in checks. It generally takes four days for those checks to clear. Each day the clinic typically receives $1,000 in checks that take three days to clear. What is the clinic s average net float?

16.2 Drugs R Us operates a mail-order pharmaceutical business on the West Coast. The firm receives an average of $325,000 in payments per day. On average, it takes four days for the firm to receive payment, from the time customers mail their checks to the time the firm receives and processes them. A lockbox system that consists of ten local depository banks and a concentration bank in San Francisco would cost $6,500 per month. Under this system, customers checks would be received at the lockbox locations one day after they are mailed, and the daily total would be wired to the concentration bank at a cost of $9.75 each. Assume that the firm could earn 10 percent on marketable securities and that there are 260 working days and hence 260 transfers from each lockbox location per year.

a. What is the total annual cost of operating the lockbox system?

b. What is the dollar benefit of the system to Drugs R Us?

c. Should the firm initiate the lockbox system?

16.3 Suppose one of the suppliers to Seattle Health System offers terms of 3/20, net 60.

a. When does the system have to pay its bills from this supplier?

b. What is the approximate cost of the costly trade credit offered by this supplier? (Assume 360 days per year.) 16.4 Langley Clinics, Inc., buys $400,000 in medical supplies each year (at gross prices) from its major supplier, Consolidated Services, which offers Langley terms of 2.5/10, net 45. Currently, Langley is paying the supplier the full amount due on Day 45, but it is considering taking the discount, paying on Day 10, and replacing the trade credit with a bank loan that has a 10 percent annual cost.

a. What is the amount of free trade credit that Langley obtains from Consolidated Services? (Assume 360 days per year throughout this problem.) b. What is the amount of costly trade credit?

c. What is the approximate annual cost of the costly trade credit?

d. Should Langley replace its trade credit with the bank loan?

Explain your answer.

e. If the bank loan is used, how much of the trade credit should be replaced?

16.5 Milwaukee Surgical Supplies, Inc., sells on terms of 3/10, net 30. Gross sales for the year are $1,200,000, and the collections department estimates that 30 percent of the customers pay on the tenth day and take discounts, 40 percent pay on the thirtieth day, and the remaining 30 percent pay, on average, 40 days after the purchase. (Assume 360 days per year.) a. What is the firm s average collection period?

b. What is the firm s current receivables balance?

c. What would be the firm s new receivables balance if Milwaukee Surgical toughened up on its collection policy, with the result that all nondiscount customers paid on the thirtieth day?

d. Suppose that the firm s cost of carrying receivables was 8 percent annually. How much would the toughened credit policy save the firm in annual receivables carrying expense? (Assume that the entire amount of receivables had to be financed.) 16.6 Fargo Memorial Hospital has annual net patient service revenues of $14,400,000. It has two major third-party payers, plus some of its patients are self-payers. The hospital s patient accounts manager estimates that 10 percent of the hospital s paying patients (its self-payers) pay on Day 30, 60 percent pay on Day 60 (Payer A), and 30 percent pay on Day 90 (Payer B). (Five percent of total billings end up as bad debt losses, but that is not relevant for this problem.) a. What is Fargo s average collection period? (Assume 360 days per year throughout this problem.) b. What is the firm s current receivables balance?

c. What would be the firm s new receivables balance if a newly proposed electronic claims system resulted in collecting from third-party payers in 45 and 75 days, instead of in 60 and 90 days?

d. Suppose the firm s annual cost of carrying receivables was 10 percent. If the electronic claims system costs $30,000 a year to lease and operate, should it be adopted? (Assume that the entire receivables balance has to be financed.) 16.7 Integrated Health Associates (IHA) is in the process of preparing a cash budget for December. IHA had the following results for the past three months:

Amount of the month s revenue Net patient still uncollected (i.e., in accounts service revenue receivable) at the end of November September $150,000 $ 0 October 120,000 12,000 November 180,000 54,000 IHA has no uncollectible accounts. In December, IHA is expecting $200,000 in net patient service revenue. If IHA expects the same pattern of cash collection as in previous months, what should be budgeted for total cash collections in December in IHA s cash budget?

16.8 Pediatric Partners has forecasted billed charges for the first six months of the year as shown in the table below. Based on historic collection patterns, Pediatric Partners expects to collect charges as follows: 5 percent within 30 days, 85 percent within 60 days, and 5 percent within 90 days. The remaining 5 percent is expected to be uncollectible. What should be budgeted for cash collections in each of the months January through June?

Month Billed Charges Cash Collections January $ 99,000 ?

February 99,000 ?

March 99,000 ?

April 105,000 ?

May 105,000 ?

June 105,000 ?

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