LITTLE-RUIZ-SMITH CONSULTING
Consulting
Presents:
The Basics of Capital Budgeting
CPT Kate Little, CPT Ino Ruiz, and CPT Max Smith
Graduate Students, U.S. Army-Baylor MBA/MHA Program
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AGENDA
 Intro Video
 MEDCOM Business Case Analysis
 Learning Objectives
 Capital Budgeting Background
 Cash Flow Estimation
 Breakeven Analysis
 Return on Investment
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Additional Considerations
 Excel Problems
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LEARNING OBJECTIVES
 Explain how managers use project classifications
and post-audits in the capital budgeting process.
 Discuss the role of financial analysis in health
services capital budgeting decisions.
 Explain the key issues involved in cash flow
estimation.
 Describe the usefulness and methods applied in
breakeven and profitability analyses.
 Conduct basic capital budgeting analyses.
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SNL DIGITAL SHORT
CAPITAL BUDGETING
 https://www.youtube.com/watch?v=32WjO7IiHpI
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MEDCOM BUSINESS CASE ANALYSIS
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WHAT IS A BCA?
 A Decision-Making Tool or framework to systematically
identify, analyze, and compare benefits & costs of
alternative courses of action
 A Communication Tool that answers the questions:
 What are the financial and non-financial consequences if
a proposed action or decision is implemented?
 What are the proposed investment’s scope and objectives,
as well as a basis for measuring future performance?
 Which attributes of the project contribute most to the
business objectives?
A tool for making fact – based decisions
Slide 6
WHY DO A BCA?
 Request resources for a new program
 Evaluate on-going programs
 Facilitate lease or buy decisions
 Evaluate organizational change proposals such as
outsourcing (make or buy) or conversion in type of
labor (military, GS, or contract).
 Organizational changes that require a modification
in the way you currently do business .
Slide 7
WHY DO A BCA?
 All projects are receiving more scrutiny
 Increased need for bottom line return
 TMA focus on Prospective Payment System (PPS)
 Responsibilities of Analyst are increasing.
 You must have:
 Technical skills
 General business knowledge
 Financial knowledge
It’s a Changing World!
Slide 8
COMPONENTS OF A BCA
A. Introduction
B. Methods
C. Projections
D. Risks &
Sensitivity
E. Recommendations
& Conclusions
Slide 9
A. Introduction
• Proposed action
• Business objectives and motivation
• Opportunities, threats & constraints
B. Business Case Methods
• Scope and boundaries of the case
• Scenarios analyzed
• Major assumptions
• Cost model
• Rationale for benefits
• Metrics/evaluation criteria
• Data Sources
C. Cost and Benefit Projections across
time (Financial)
D. Risk and Sensitivity Analysis
E. Recommendations and Conclusions
KEYS TO A SUCCESSFUL BCA:
 Determine the real requirements
 Resources, Usage & Outcome
 Analyze the costs & benefits of current system
 Analyze the costs & benefits of the new system
 Determine the development, implementation and
ongoing support costs
 Develop the projected Cash Flow of the project
 Include MEDCOM Consultant’s review
 Link to the AMEDD Strategic Plan
 Use the AMEDD BCA Tool
*BE SKEPTICAL
Slide 10
Insert INO’s Slides
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RETURN ON INVESTMENT
(PROFITABILIT Y) ANALYSIS
 ROI focuses on a project’s expected profitability, but
does not account for T VM
 Any investment returns should be measured either in
dollar terms or in rate of return (percentage)
terms...or both.
 Net present value (NPV) measures a project’s time
value adjusted dollar return.
 Internal rate of return (IRR) measures a project’s rate
of (percentage) return.
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RETURN ON INVESTMENT
Definition
Financial analysis examining a project’s
profitability expressed as a dollar or
percentage return
Essential Tools of Analysis:
Net Present Value, NPV ($)
Internal Rate of Return, IRR (%)
Modified Internal Rate of Return (%)
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NET PRESENT VALUE
NPV is merely the sum of the present values
of the project’s net cash flows.
The discount rate used is called the project
cost of capital. If we assume that the
illustrative project has average risk, its project
cost of capital is equal to the corporate cost
of capital. In our examples I’ll use 10%.
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APPLYING NPV
 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. Sum is defined as the project’s
net present value.
 If NPV is:
 positive-project is expected to be profitable
 zero- project breaks even in economic sense
 negative-project is expected to be unprofitable
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NET PRESENT VALUE
(REMEMBER MICRO?!)
0
1
2
3
5
4
10%
-$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 = net present value (NPV)
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NET PRESENT VALUE
USING EXCEL
 Also discussed in Chapter 9
 Dollar ROI measure that uses discounted cash flow techniques
10%
(See Excel)
$
$
$
$
$
$
Project Cost of Capital
(2,500,000.00)Cash Flow 0
510,000.00 Cash Flow 1
535,500.00 Cash Flow 2
562,275.00 Cash Flow 3
590,389.00 Cash Flow 4
1,369,908.00 Cash Flow 5
$82,493.00 =NPV (A1,A3:A7)+A2
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INTERNAL RATE OF RETURN (IRR)
 Like NPV, IRR is also a discounted cash flow (DCF) ROI
measure.
 NPV-measures project’s dollar profitability
 IRR-measures a project’s percentage profitability
 IRR is defined as the discount rate that equates the present
value of the project’s expected cash outflow, so IRR is:
 Simply that discount that forces the NPV of the project to equal
zero.
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INTERNAL RATE OF RETURN
0
1
2
3
5
4
11.1%
-$2500K
$510,000
$535.500
$562,275
$590, 389
$1,369,908
$459,046
$433,842
$410,021
$387,509
$809,321
$
261 = net present value (NPV) ≈ $𝟎
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INTERNAL RATE OF RETURN
(USING EXCEL)
 Also discussed in Chapter 9
 Percent ROI measure that uses discounted cash flow
techniques
10%
Project Cost of Capital
$
$
$
$
$
$
(2,500,000.00)Cash Flow 0
510,000.00 Cash Flow 1
535,500.00 Cash Flow 2
562,275.00 Cash Flow 3
590,389.00 Cash Flow 4
1,369,908.00 Cash Flow 5
(See Excel)
11.1% =IRR (A2:A7,A1)
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IRR VS NPV
For this example:
This project has a 11.1% IRR
But… it also has a 10% Cost of Capital
This results is a $82,493 NPV
NPV and IRR are substitutes for each other,
Projects deemed profitable by NPV will also be
deemed profitable by IRR
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MODIFIED INTERNAL RATE OF RETURN
(MIRR)
• We have NPV and IRR – Why do we need MIRR!? MIRR
uses a more correct reinvestment rate and allows
calculation of non-normal project cash flows…
Sometimes, it’s the only function that will work.
• MIRR uses a more accurate reinvestment rate
• Assumes that positive cash flows are reinvested at the firm's cost
of capital, not at the IRR of project
MIRR and IRR Relationship
MIRR < IRR => Cost of Capital < IRR
MIRR > IRR => Cost of Capital > IRR
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MODIFIED INTERNAL RATE OF RETURN
0
-$2500K
1
$510,000
2
3
$535.500
$562,275
5
4
$590, 389
$1,369,908
$649,428
$680,353
@10%
$712,750
$746,691
$4,159,130
@10.7%
≈$2,500,000
$0
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MODIFIED INTERNAL RATE OF RETURN
(MIRR)
 Percent ROI measure that uses discounted cash flow
techniques and a separate reinvestment rate for the cash
flows
10%
(See Excel)
$
$
$
$
$
$
Project Cost of Capital
10%
Re-investment Rate
(2,500,000.00)Cash Flow 0
510,000.00 Cash Flow 1
535,500.00 Cash Flow 2
562,275.00 Cash Flow 3
590,389.00 Cash Flow 4
1,369,908.00 Cash Flow 5
10.7% =MIRR (A3:A8,A1,A2)
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MODIFIED INTERNAL RATE OF RETURN
(MIRR)
 https://www.youtube.com/watch?v=b1cFoh5cMPA
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CAPITAL BUDGETING IN NOT-FOR-PROFIT
BUSINESS
 Capital budgeting techniques up until this point are
appropriate for use by all businesses when assessing the
financial impact of a proposed project, a not -for-profit
firm has the additional consideration of meeting its
charitable mission.
 2 Models that extend Capital Budgeting to the charitable
mission are:
 Net Present Social Value (NPSV)
 Project Scoring
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NET PRESENT SOCIAL VALUE
 Not-for-profit providers have a goal of producing social
services along with commercial services.
 Not-for-profit firms should 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
TNPV = NPV + NPSV
*NPSV models formalizes the capital budgeting decision
process applicable to not-for-profit healthcare firms, few
organizations actually attempt to quantify NPSV.
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NET PRESENT SOCIAL VALUE
 The NPSV term represents the managers assessment of the
social value of a project, clearly dif ferentiates capital
budgeting in not-for-profit firms vs. that in investor owned
firms.
 Examples include: charity care, medical research, and education
 Not all projects will have a positive NPSV, some may have a
negative NPSV
 To ensure the financial viability of a firm the conventional NPV
of all a firms projects should equal or exceed zero.
 When estimating a project’s NPSV, first it is necessary to
estimate in dollars the social value provided.
 A discount rate must also be applied to the social value cash
flows.
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PROJECT SCORING
 Non-financial factors should be considered in any Capital
Budgeting analysis
 Many firms use quasi -subjective Project Scoring in an attempt
to capture these non-financial factors
 Scores are completely arbitrary but it forces managers to
address multiple issues and helps to rank possible projects
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PROJECT SCORING
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PROJECT SCORING
REMEMBER MDMP-COA COMPARISON?
Criteria
Weight
(1, 2, 3, etc.)
COA
COA 1-Ferrari
COA 2-Truck
COA 3- Large
Van
MPG
Price
Capacity
(Cargo)
Capacity (PAX)
AWD
TOTAL
Golfing or Bowling? Bowling, Be Consistent!
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PROJECT SCORING
REMEMBER MDMP-COA COMPARISON?
Criteria
(Weight)
COA
(1, 2, 3, etc.)
COA 1-Ferrari
COA 2-Truck
COA 3Motorcycle
MPG
1
1
2
3
Price
2
1
2
3
Capacity
(Cargo)
4
2
3
1
Capacity (PAX)
3
2
3
1
AWD
4
3
3
2
TOTAL
N/A
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PROJECT SCORING
REMEMBER MDMP-COA COMPARISON?
Criteria
(Weight)
COA
(1, 2, 3, etc.)
COA 1-Ferrari
COA 2-Truck
COA 3Motorcycle
MPG
1
1 (1)
2 (2)
3 (3)
Price
2
1 (2)
2 (4)
3 (6)
Capacity
(Cargo)
4
2 (8)
3 (12)
1 (4)
Capacity (PAX)
3
2 (6)
3 (9)
1 (3)
AWD
4
3 (12)
3 (12)
2 (8)
TOTAL
N/A
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THE POST AUDIT
 Capital Budgeting is not a static process
 Long lag between acceptance and implementation, may
create new information concerning capital costs or the
project’s cash flows -which should be analyzed before the final
start up
 Monitor performance throughout the project’s life (just like
the new initiatives LTC Kim discussed in Pop. Health)
 Post- Audit:
 Compares actual results against projected
 Abandonment
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POST-AUDIT PURPOSES
Improve Forecasts
Develop Historical Risk Data
Improve Operations
Reduce Losses
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USING CAPITAL BUDGETING TECHNIQUES
IN OTHER CONTEXTS
 Corporate Mergers
 Divest assets or reduce staf fing -severance payments
 Selling Assets
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LITTLE-RUIZ-SMITH CONSULTING
Consulting
Questions?
Time for EXCEL Examples!!!
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