Many health professionals subscribe to the “how much will my car payment be” method of determining whether or not to purchase an asset (equipment, real estate, etc.) You’ve probably been there when the guy who wants to purchase the latest and greatest piece of technology says “I only need to see _____ patients each week to cover the cost”. And that argument can be persuasive until you dig in and look more closely. The objective process of determining if an asset is valuable to the practice is known as capital budgeting.

Investment assessments are critical business decisions. If a practice invests too heavily in fixed assets, it will have excess capacity and if it invests too little, it may face technological obsolescence and/or inadequate capacity. Capital budgeting uses financial tools to determine the acceptability of a capital investment. Although the tools are objective, much of the underlying data are subjective. Factors such as the discount rate, projected cash flow, maintenance costs, and the salvage (terminal) value of the asset may require educated speculation. In turn, these assumptive variables may be affected by changes in the business environment such as tax laws, technological advances, market demand, effects on other projects, strategic value and competition. Practices should be careful that their assumptive variables are as objective as possible in order to make the best capital investment decisions.

To begin a capital budgeting decision, practices must determine benchmarks (e.g. discount rate and payback period) for its investments. These benchmarks should represent an amount which is equal to or above the rate of return a stockholder can obtain by investing in other sources. These benchmarks are compared against the financial data calculated for a particular investment. Financial tools which are used to determine if the investment will meet the benchmark criteria include (1) net present value, (2) payback and discounted payback period (3) internal rate of return and modified internal rate of return and (4) the profitability index. Notice that the “how much will my car payment be” method is NOT included. The decision-making process for all the valid techniques consists of three steps: (1) Compute the statistic; (2) Compare the computed statistic with the benchmark and; (3) If the projects are mutually exclusive, chose the one with the best statistic.

Net Present Value (NPV) is known as the “purest” of capital budgeting rules. It incorporates the practice’s required rate of return and includes the necessary capital expenditures and startup costs (cash outflows), as well as, the expected income (cash inflows). Any NPV greater than zero represents value above and beyond the investment. In other words, the higher the NPV, the more profitable the project. This method works very well when comparing investments which are mutually exclusive because management can choose the one with the highest NPV. Therefore, the decision rule is: Accept project if NPV >0 Reject project if NPV 0, choose the one with the highest

NPV. The formula for NPV is the sum of all the cash flows’ (inflows less outflows) present value.

Payback period and discounted payback determine how long it takes to recoup the cost of the asset. This method is preferred by many practices because it is easy to compute.  On the surface, it looks similar to the aforementioned “car payment” method; but is not because the “car payment” method only looks at covering expenses.  But the payback method ignores cash flows after the project reaches the payback period. This has serious implications when considering mutually exclusive projects with similar PB but differing cash flows after the PB period is reached. The decision to accept or reject is based upon the company’s arbitrary selection of an acceptable payback period benchmark. The formula for calculating the payback period is a running subtotal of the cumulative sum of the cash flows (inflows less outflows) until that sum exactly equals the initial investment.   To incorporate the time value of money into the equation, we discount the cash flows.

The IRR solves for the discount rate which will make NPV equal to zero. It can give the same accept/reject rate as NPV if the project has cash flows independent of other projects. However, it can give irregular results in the cash flow is not normal. MIRR moves all the negative cash flows to the cost of capital (discounts them to PV) and all the positive cash flows to the project termination date (FV). This makes the MIRR more reliable than the IRR when cash flows are not normal. The IRR and/or MIRR are compared to the benchmark discount rate to evaluate the project. Therefore, the decision rule is:   Accept project if IRR > required cost of capital (stockholders’ required rate of return) and  Reject project if IRR < required cost of capital (stockholders’ required rate of return)
To solve for the IRR, we use the NPV formula for the interest that would make NPV equal zero.

The formula for the MIRR is the same; but the cash flows are arranged differently. The sum of cash flows, if negative, is discounted to present value and, if positive, is calculated to its future value.

Based upon NPV, the profitability index standardizes NPV by dividing it by the initial investment to get a statistic that measures “bang per buck invested”. In other words, it quantifies the percent of return of the initial cost. Used in conjunction with the NPV calculation, it puts projects with differing cost on an even playing field, helping to illuminate the decision-making process for mutually exclusive projects.

As an example of these techniques, suppose XYZ is evaluating upgrading its radiological equipment. The initial capital cost is $100,000. The cost of capital is 8%. The equipment is approximated to have a technological lifetime of 6 years at which time it will have a salvage value of $10,000. This approximated salvage value is based on historical values of radiological equipment sold in health care markets. Cash flows are projected to decrease as the life of the equipment increases due to the possibility of providers using alternate technologies and decreased reimbursement per patient. Maintenance costs are projected to increase due to aging of the equipment.

With an NPV of $7,948 and an IRR of 11%, the above example shows that the equipment does meet the 8% criteria established for the cost of capital. It shows a payback period of just over 4 years and a discounted payback period of almost 5.5 years. Even though the IRR is 11%, the MIRR is only 6%. If management uses only the MIRR for its capital budgeting decision, this asset would not be accepted. The profitability index of 7% shows that the initial investment of $100,000 may earn 7% above the required discount rate. This example also illustrates the benefit of using several techniques to evaluate the investment.

Objective capital budgeting techniques should be used to guide practices into making appropriate investment decisions. NPV remains the gold standard of capital budgeting techniques. However, the assumptive data is subjective and should be obtained, evaluated, and used with care. For example, modifying the cash flows illustrates how easily the data and resulting decision can both change. All assumptions must be fully disclosed.

Once the practice has gathered all the supporting data, it is quick work to calculate NPV, PB, DPB. IRR, MIRR and PI. All the calculations help clarify the investment and they are best used together. During the decision-making process, management can adjust some of the variables to work through possible scenarios and conclude the optimal choice for stockholders.  The analysis takes a few minutes and is gives far better information than the ”how much  will my car payment be” method.