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Chapter 19
Capital Project Analysis
Learning Objectives
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Explain who is involved in the capital investment
decision process.
Describe the kinds of decisions that are made in
capital investment decision analysis.
Explain the four stages of the capital decisionmaking process.
List the kind of information that is needed to
evaluate a capital investment project.
Learning Objectives
• Calculate a projects’ net present
value, profitability index, and
equivalent annual cost.
• Explain the concept of a discount rate
and the weighted average cost of
capital.
Capital Project Analysis
• Occurs during the programming phase of the
management control process
• Primarily concerned with new projects that
require a substantial investment outlay and a
long project life (greater than 2 years)
• It is also a yearly estimate of resources that
will be expended for new programs during the
coming year
Figure 19–1 Capital Decision-Making Participants
External Participants
Financing sources - investment bankers, bondrating agencies, bankers, and feasibility
consultants, etc.; collectively, may influence
the amount of money that can be borrowed and
the terms of the borrowing
Rate-setting and rate-controlling agencies –
can limit the amount of money available for
financing capital projects by reducing the
amount of profits that may be retained
External Participants, cont.
Third-party payers - affect both capital
expenditure levels and sources of financing
through reimbursement provisions
Planning agencies – review applications of
capital expenditures and pass
recommendations to the state authority
responsible for final approval or disapproval in
states that require certificate-of-need.
Internal Participants
Board of trustees - responsible for the capital
expenditure and capital financing program of the
health care firm
– Main function - clearly establish defined goals and
objectives, which is the prerequisite to programming phase
of capital expenditure analysis
– Approves preliminary five-year capital expenditure
program, which is linked to strategic financial plan
Planning committee - define, analyze, and propose
programs to help the organization attain its goals and
objectives
Internal Participants, cont.
Finance committee - involved with translating
programs into financing requirements; ensures
adequate financing to meet program requirements
Chief Executive Officer (CEO) - responsible on a dayto-day basis for implementing approved capital
expenditure programs and developing related
financing plans; much of the authority is delegated by
the board of trustees
Department managers - make most of the internal
requests for capital expenditure approval
Internal Participants, cont.
Medical staff – mostly not employees of the
health care firm; place demands for capital
expenditures due to their influence on firm’s
utilization
Controller - facilitates approval of capital
expenditures; assists administrator with
allocating budget to competing departments
Treasurer - for obtaining funds for both shortand long-term programs
Capital Expenditures Classification
• Capital expenditure - a commitment of
resources that is expected to provide benefits
during a reasonably long period, at least two or
more years
• Most important classifications by:
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–
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Period during which the investment occurs
Types of resources invested
Dollar amounts of capital expenditures
Types of benefits received
Period of Investment
• Determining the amount of resources committed to a
capital project depends heavily on the definition of
the period
• Consider example – initiation of programs funded by
grants
– Capital expenditures and additional operating funds for
later periods may be required, if there is a formal or
informal commitment to continue the program for a longer
period
– Long-run capital costs of grant-funded projects must be
identified
Types of Resources Invested
• Capital assets – tangible fixed assets
• Lease – many health care facilities lease a significant
% of their fixed assets (e.g., equipment)
• Operating costs associated with beginning and
continuing capital project
– Lifecycle costing - method for estimating the cost of a
capital project that reflects total costs, both operating and
capital, over the project’s estimated useful life
– Lifecycle costs should be considered for all programs;
doing so may affect selection of alternative projects
Amount of Expenditures
• Control over capital expenditures should be
conditioned by the total amount involved
• Follows one of the patterns:
– Approval required for all capital expenditures
– Approval required for all capital expenditures above a preestablished limit, e.g. $5,000
– No approval required for individual capital expenditure
projects below a total budgeted amount
• Sometimes absolute dollar limit is placed - authorized
capital budget on any items in question
Types of Benefits
• Determine what systems of management control and
evaluation to be used (e.g. investment in medicaloffice building vs. investment in alcoholic rehab unit)
• In health care, benefits differ from those considered
in other industries and may include benefits that are
more important than cost reduction or increase in
profits
• Main categories:
– Operational continuance
– Financial
– Other
Types of Benefits, cont.
• Operational continuance - produces benefits
that permit continued operations of the facility
along present lines
– Main questions:
• Are continued operations in the present form desirable?
• Which alternative investment project can achieve
continued operations in the most desirable way?
– Example – requirement to install sprinkler system
in a nursing home; failure to do so may result in
discontinuance of operations
Types of Benefits, cont.
• Financial - either reduced costs or increased profits to
the organization
– If the major benefits are financial, traditional capital
budgeting methods may be more appropriate
• Other – investments range from projects that activate
major new medical areas (e.g. outpatient services) to
projects that improve employee working conditions
(e.g. employee gymnasiums)
– Benefits may be more difficult to quantify and evaluate
Capital Decision-Making Process
• Allocation of limited resources to specific
project areas that directly affects the
efficiency, effectiveness and, ultimately, the
continued viability of the organization
• Main interrelated stages:
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Generation of project information
Evaluation of projects
Decisions about which projects to fund
Project implementation and reporting
Generation of Project Information
• Information is gathered that can be analyzed and
evaluated later
• Main categories of information needed for
expenditure proposal evaluation:
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–
–
–
–
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Alternatives available
Resources available
Incremental Cost data
Incremental Benefit data
Prior performance
Risk projection
Project Information Types
• Alternatives available – must be considered to
evaluate capital expenditures (e.g. different
manufacturers, different methods of financing)
• Resources available – must be allocated among
numerous investment opportunities; may force
department managers to submit only projects that are
in the department’s best interests
• Cost data - lifecycle costs of a project should be
presented; limiting cost information to capital costs
can be counterproductive
Project Information Types, cont.
• Benefit data – quantitative (financial) and qualitative
(unquantifiable benefits)
• Prior performance - comparison of prior actual
results with forecast results gives a decision maker
some idea of the reliability of forecasting
• Risk projection – “what-if” questions (e.g. how would
costs and benefits change if volume changed?);
programs with extremely high proportions of fixed or
sunk costs are much more sensitive to changes in
volume and thus more risky
Project Evaluation
• Based on solvency and cost
• Solvency – ability to show positive rate of return in
the long run; operation of an insolvent program
eventually can threaten the solvency of the entire
organization
• Cost - organization needs to select projects that
contribute most to the attainment of its objectives,
given resource constraints
= > Cost-benefit analysis
– Cost-effectiveness analysis - projects that are eventually
selected should cost the least to provide the service
Decisions About Funding Projects
• Decision makers possess lists of possible
projects that may be funded
• Each project should represent the lowest cost
of providing the desired service or output
• Various benefit data on each project should be
described
Decision Making Example
• Consider example – how many projects out of 3 will be
funded?
• Projects –hemodialysis unit, burn care unit, commercial lab
• Relevant decision criteria:
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Solvency
Incremental management time required
Public image
Medical staff approval
• Decision makers must weight the criteria according to their
preferences, because none of the projects dominates
Decision Making Example, cont.
Project Implementation and Reporting
• Expenditure control systems should be focused on
whether the projected benefits are actually being
realized as forecast
• Benefits of establishing capital expenditure review
program:
– Highlights differences between planned versus actual
performance that may permit corrective action
– May result in more accurate estimates
– Forecasts by individuals with a continuous record of biased
forecasts can be adjusted to reflect that bias
Justification of Capital Expenditures
• Initiated by a department or responsibility-center
manager through the completion of a capital
expenditure approval form
• Approval provides a detailed summary of:
– Amount and type of expenditure
– Attainment of key decision criteria
– Detailed financial analysis
• Small capital expenditures (under $2,000) usually not
subjected to detailed analysis and do not require
justification
Justification of Capital Expenditures,
cont.
Replacement items are specially recognized:
– Expenditure less than $20,000 may not be subject
to review
– Higher limit due to replacement items being
essential to operational continuance of existing
operations
– Not evaluated as closely as expenditures for new
pieces of equipment
Justification of Capital Expenditures,
cont.
• Capital expenditure review process should focus on best
alternatives
• Overall criteria of selection process:
– Need (management goals, hospital goals)
– Economic feasibility
– Acceptability (physicians, employees, community)
• Non-financial criteria also important
• Key aspect of the capital expenditure approval process is the
financial or economic feasibility of the project measured by
summary statistic:
– Discounted cash-flow method (DCF)
– Nondiscounted cash-flow method
Discounted Cash-Flow Methods
• DCF methods are based on time value concept
of money
• Main methods and areas of application:
– Net present value - capital financing alternative
– Profitability index - capital expenditures with
financial benefits
– Equivalent annual cost - capital expenditures with
nonfinancial benefits
Net Present Value (NPV)
• Discounted cash inflows less discounted cash
outflows and initial investment outlay
• The NPV presents the return on investment expressed
in dollar terms.
• Only incremental cash flows should be considered ,
i.e. the additional cash inflows and outflows that
accrue as a result of taking on the capital project
• Not included – sunk and financing costs (financing
costs are represented by discount rate)
Net Present Value, cont.
• When comparing two alternatives, the one with the highest
NPV should be selected
• Consider example – asset can be financed with 4-year annual
$1,000 lease payment or can be purchased for $2,800.
• In this case, select the project with the lowest NPV cost.
• Assume the discount rate is 10% (can reflect both borrowing
or investment cost)
• Present value (PV) cost of lease = $3,169 compared to the PV
cost of purchase = $2,800
• The purchase alternative is the lowest cost alternative method
of financing
Cost Reimbursement
• Means that facility would be entitled to
reimbursement for depreciation if the asset was
purchased, or the facility would be entitled to the rent
payment if the asset was leased
• Effects are declining in the era of prospective
payment and capitation, except for designated critical
access hospitals and other groups under Medicare
• Example – PV of reimbursed cash inflow under
straight-line depreciation with 20% of capital
expenses reimbursed by third-party cost payers
Present Value of Reimbursement, cont.
• Asset purchased: organization would pay $2,800
immediately
– For each of the next four years, it would be reimbursed for
the noncash expense item of depreciation in the amount of
$700 per year ($2,800 ÷ 4)
– But, because only 20% of patients are capital cost payers
(covered by third-party payers who reimburse the facility
for capital costs), only $140 per year would be received
(.20 × $700)
• Asset leased: organization would be reimbursed for lease
payment of $1,000 per year
– But: because only 20 percent of the patients are capital
cost payers, only $200 (.20 × $1,000) would be paid
Present Value of Reimbursement
NPV of Financing Alternatives
NPV of Financing Alternatives, cont.
• Best method of financing is purchase:
– Annual expenses will be $700 in depreciation, compared
with $1,000 per year with the leasing plan
– Lower NPV
• Caution: relative ratings regarding NPV could change
quickly, given higher percentages of capital cost
reimbursement
– If 80% of capital costs reimbursed, leasing’s NPV (–$634)
is better (i.e., less negative) than purchasing’s NPV (–
$1,025)
Profitability Index
• Compares rates of return of competing projects
• Useful when the benefits of the projects are mostly
financial (e.g. capital project that saves costs)
• When funding is limited, projects with the highest
rate of return per dollar of capital investment are
best candidates for selection
Profitability Index, cont.
• Consider example: investment in laundry service shared
with a group of hospitals
• Investment cost - $100,000
• Savings in operating costs : $20,000 per year for 10year project
• Discount rate : 10%
Present value of operating savings = $20,000  6.145 = $122,900
NPV = $122,900 – $100,000 = $22,900
Profitability index =
$22,900
= .229
$100,000
Profitability Index, cont.
• Profitability indices >0 imply that the project
is earning at a rate greater than the discount
rate
• With no funding constraints, all projects with
profitability indices >0 should be funded
• In most situations, funding constraints do exist,
and only a portion of those projects with
positive profitability indices are actually
accepted
Profitability Index and Cost
Reimbursement
• Need to adjust initial NPV of $22,900 to reflect the effects of
cost reimbursement
• The firm can receive 50% of the annual depreciation of
$10,000 ($100,000/10) or $5,000 per year as a reimbursement
cash flow
– PV of this stream, $30,725 is added to the initial NPV of $22,900
• Savings of $20,000 per year reduce reimbursable costs by
$10,000 annually
– PV of the loss is $61,450 subtracted from initial NPV
• Cost reimbursement thus reduces increased costs associated
with new programs, but it also reduces the cost savings
associated with new programs
Equivalent Annual Cost
• The expected average cost, considering both
capital and operating cost, over the life of the
project
• Primarily important when selecting capital
projects for which alternatives exist
Equivalent annual cost =
Sprinkler Systems
• Example: investment in sprinkler system to
maintain license
• Two alternatives:
– System A: $5,000 in investment and annual
maintenance of $500 annually for 10 years
– System B: $10,000 in investment and annual
maintenance of $200 for 20 years
• Discount rate: 10%
Sprinkler Systems, cont.
Equivalent annual cost of a $5,000 sprinkler system:
Present value of operating costs
= $500  6.145 = $3,073
Present value of investment = $5,000
Equivalent annual cost =
$3,073  $5,000
 $1,314
6.145
Equivalent annual cost of a $10,000 sprinkler system:
Present value of operating costs
Present value of investment = $10,000
Equivalent annual cost =
$1,703 + $10,000 = $1,375
8.514
= $200  8.514 = $1,703
Sprinkler Systems, cont.
• $5,000 sprinkler system would produce the
lowest equivalent annual cost (EAC) of $1,314
per year, compared with the $1,375 EAC of
the $10,000 system
• Note: EAC method allows to compare projects
with different lives, assuming that technology
will not change
• Subjective weight should be given to projects
of shorter duration
EAC and Accounting Costs
• Not identical; annual reported accounting cost
for the two alternatives would be the annual
depreciation expenses plus the maintenance
cost:
Accounting expense per year ($5,000 sprinkler system) =
$5,000
 $500  $1,000
10
Accounting expense per year ($10,000 sprinkler system) =
$10,000
 $200  $700
20
EAC and Accounting Costs, cont.
• Not incorporating time-value concept of
money can produce misleading results, as it
does in the previous example
• Second alternative is not the lowest cost
alternative when the cost of capital is included
• Savings of $5,000 in investment cost between
the two systems can be used either to generate
additional investment income or to reduce
outstanding indebtedness
EAC and Cost Reimbursement
In the sprinkler example, consider the effects of cost
reimbursement (assume 50% cost will be reimbursed):
• EAC of a $5,000 sprinkler system:
– PV of reimbursed operating costs = $500 x 6.145 x .50
= $1,536.25
– PV of reimbursed depreciation = $5000/10 x 6.145 x .50
= $1,536.25
– EAC with cost based reimbursement =
$1,314 – (1,526.25+1,536.25)/ 6.145 = $814
EAC and Cost Reimbursement
In the sprinkler example, consider the effects of cost
reimbursement (assume 50% cost will be reimbursed):
• EAC of a $10,000 sprinkler system:
– PV of reimbursed operating costs = $200 x 8.514 x .50
= $851.40
– PV of reimbursed depreciation = $10,000/20 x 8.514 x .50
= $2,128.50
– EAC with cost based reimbursement =
$1,375 – (851.40 +2,128.50)/ 8.514 = $1,025
EAC & Cost Reimbursement
• In this example, the effect of cost
reimbursement did not change the decision.
• The lower-cost sprinkler system is still the best
alternative.
Discount Rate
• In health care, discount rate is important, but not critical, as
decision making is not solely based on financial considerations
• Change in relative ranking of projects is much more likely to
result from an accurate forecast of cash flows than from an
alternative discount rates
• However, the choice of discount rate may affect desirability of
alternative projects so it is important to consider.
• Primary methods for defining the cost of capital for use in
DCF analysis:
– Cost of specific financing source
– Yield achievable on other investments
– Weighted cost of capital
Discount Rate Selection
• Cost of specific financing source - sometimes
used as the discount rate (e.g. firm borrows
money at 8%)
• Yield rate - the investment yield possible in the
firm’s security portfolio (e.g. firm earns 10%
on security investments)
Discount Rate Selection
• Weighted average cost of capital (WACC) – most
widely used method:
Weighted Average Cost of Capital = [ Debt/(Debt+Equity)
 Cost of debt ] + [ Equity/(Equity+Debt)  Cost of equity]
• Represents the marginal cost of capital to the firm,
recognizing capital consists of both debt and equity
• The major challenge is defining cost of equity for
NFP firms. One solution is to use a the cost of equity
for a similar IO firm.
Valuation
• More hospitals are buying or acquiring related
health care businesses (e.g. other hospitals,
nursing homes, physician practices)
• Main question – what is the value of business
acquired?
• Acquired business – capital expenditure that
needs to be evaluated