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Capital Budgeting
It has never
been more important for hospital executives to understand the importance of capital
budgeting; this is the planning process companies use to help determine
whether their organization's long term investments such as new
machinery purchases, replacement of old or outdated machinery, new facilities, introduction
of new products, and research development projects are worth funding and
potentially opening the company to increased financial risk against the firm's capitalization structure,
which involve debt, equity or retained earnings. Decision makers have to
understand the corporate effect of allocating resources for major capital, or
investment, expenditures. The primary objectives of hospital executives should
be in regards to capital budgeting and investments, is to increase the value of
the organization for the shareholders. (Cleverley, Cleverley, Song, 2011)
Capital Budgeting:
Discounted Cash Flow (DCF), Net Present Value (NPV)
Capital
budgeting as have been discussed to this point, is primarily concerned with the
stratified allocation of the firm's capital resources dispersed between prioritized
competing projects and investments. Each potential project's value should be
estimated using a DCF valuation, to find its NPV. This system of valuation
requires estimating the size and timing of all the incremental cash flows from
the project. The NPV is significantly affected by the discount rate, so in selecting
the proper rate, sometimes referred to as the hurdle rate, it is critical decision point, and imperative that
the right decision is made. The hurdle rate is defined as the minimum acceptable rate of return on an
investment. This rate should reflect the riskiness of the investment, most typically
measured by the volatility of cash flows,
and is crucial to take into account the financing mix (Unknown, 2014).
It must be understood when capital
budgeting plans long-term corporate financial projects, those plans are related
to investments funded through and affecting the firm's capital
structure. Further, management strategically allocate the firm's
limited resources between contesting opportunities, which is another focus of
capital budgeting. Additionally, one of many tentacles of capital budgeting, is
setting criteria to discern which projects should receive investment funding that
increase the value of the organization, and determine whether to finance specified
investments with equity or debt capital. Investments should be made on the
basis of value-added to the future of the corporation. Capital budgeting
projects may include a wide variety of investments including, expansion
policies, mergers and acquisitions. When no such value can be added, and cash
surplus exists and is not needed, then management is expected to pay out some
or all of those surplus earnings in the form of cash dividends (Unknown, 2014).
Most of the accounting
programs associated with capital budgeting does not take into consideration the
time
value of money; this principle dictates that time has
an evaluative impact on the value of cash flow series. Cash of nominal equal value over a time can result in
different effective value cash
flows that has financial bearings on future cash flows and can render some
transactions less valuable over time. If a company had time series of identical
cash flows, the cash flow with the most recent history is the transaction of the
most value, each future cash flow series become less valuable than the previous
cash flow series. Thus, a cash flow streams of today are more valuable than an
identical cash flow series in the future. This decrease occur because the discount factor represents an expected rate of return of each cash
flow series in different investments with identical risk. With each additional
period, the present value of a subsequent future cash flow series decreases. (Brunzell, Liljeblom,
Vaiheoski, 2013)
Factors Influencing Capital
Budgeting:
- Availability
of funds
- Structure
of capital
- Taxation
Policy
- Government
Policy
- Lending
Policies of Financial Institutions
- Immediate
need of the Project
- Earnings
- Capital
Return
- Economic
Value of the Project
- Working
Capital
- Accounting
Practice
- Trend of
Earning
- Size of
Business
- Risk of
the business
- Forecast
of the market
- Political
unrest
- Geographical
Condition
Accounting Rate of Return (AAR):
Many formal accounting skills are employed
in capital budgeting, including techniques such as AAR, also known as average
rate of return. The use of ARR are key financial ratios practices used for
decision making in capital budgeting. This system does not take into account the
concept of the time value of money. What ARR does is calculate
the return generated from net income of the proposed capital investment. The
ARR is only a percentage return. For example, if ARR = 12%, then it would mean the
venture is projected to earn twelve cents on every dollar invested annually. When
the ARR is equal or greater than the required rate of return, the project is approved.
When it is less than the desired rate, it should be rejected. When comparing competing
investments, the higher the ARR, the more appealing the investment is to the
company. More than half of large corporations use ARR when appraising contending
assignment. (Cleverley, et al, 2011)
Payback Period:
Payback period in capital budgeting is another accounting principle
corporate executives should be keenly aware off when deciding project
priorities, it refers to the period of time required to recover the funds
expended in an investment, or the time it takes to reach the break-even point. An illustration of this
is a $10,000 investment with return payments totaling $5,000 per year would require
a two-year payback period. The time value of money is not factored into this
equation. The essence of a payback period is to measure how long investments takes
to pay for itself, all things being equal, the obvious preference is for shorter
payback periods. Payback period popularity is largely due to its simplicity despite
some recognized limitations; used to as a tool to analyze often used because of
its ease of application and understanding for most individuals, regardless of
academic training. When skillfully used to compare similar investments, it is
most effective, however as a stand-alone instrument the payback period has little
decision-making power. (Cleverley, et al, 2011)
Slow-Down in
Collections:
Beyond the previous list of items and
the previous discussed items, two areas critical to capital budgeting are areas
of slow-downs in collections and revenue declines. These two areas of a hospital’s
accounting practices can detrimentally affect its profitability. Cash flow is vital to the operation of any business,
hospitals are no different. It helps companies keep up with short-term expenses
along with debt payment obligations, while fueling long-term investment
opportunities. A slowdown in cash flow or collections can result from a variety
of factors, but be certain, it is an issue that require immediate attention.
Collections represents the period between the creation of a bill and the actual
cash or debt collection from the customer (Cleverley, et al. 2011). Also
collections is one of four very vital parts of a cash budget, and when the applications
of collections are correctly instituted, it can help to minimize collections
issues.
Properly employing the collections element of cash budgeting is crucial to
effectively instituting the collections process, for instance, the collections
period significantly influences the need for cash assets. Healthcare financial professionals
should be cognizant of the fact that when sales are expected to increase,
longer collection periods might require the financing of larger amounts of
working capital in the form of increased receivables. This is because payment
for production, such as supplies and labor at the beginning of the cycle and
receive payment from customers at the end of the cycle, this illustrates the
need to concentrate on static measures of liquidity, such as a current ratio. The
faster receivable assets can be turned into cash is an extremely important
element in corporate liquidity (Cleverly, et al, 2011).
Receivables in the cash management scheme of
accounting is one of the more critical elements but not exclusive area of
importance. Receivables can account for as much as 40% to 50% of a hospital’s
total investment in current assets. In terms of collections, there are three
features associated with accounts receivable management, is that it minimize
lost charges, it minimize write-offs for uncollectable accounts, and minimize
the accounts receivable collections cycle (Cleverly, et al, 20110). For
collections to be successful and to have minimum effect of the organization a
sound cash management plan and further a very structured capital budget has to
be in place and followed vigilantly. Additionally, maintaining
and enforcing strict credit policies with your buyers is a way to improve your
cash flow related to accounts receivables. And poor investment choices contribute
substantially to a hospital’s ability to collect, but with prudent investment
schemes collections difficulties can be abated (Unknown, 2014).
Decline in Revenue
Revenue declination in the
healthcare markets are causes for intense financial scrutiny, and can come from
any number of variables. A review of the hospital’s charge description master (CDM),
to assure that charges are accurately documented, could reveille discrepancies
in service charges. With charged services at some institutions north of 20,000
items, this could be an extensive migration process. An intense review of
receipts and charges to make certain that provided services have accurately
been priced. Incorrect charges for services accounted for 8% of billing errors,
and $3 billion dollars for in-patient stays in American hospitals in 2013 (Brunzell, et
al,. 2013). Hospitals by way of healthcare providers
can attempt to mitigate revenue loss by price setting, payer contract
negotiation, and billing/coding management (Cleverley, et al 2011).
Price setting is the
process of establishing specific pricing for services provided. The list of
services can be voluminous, larger facilities can have as many as 80,000
provisioned services. Though this is and can be a very important element of
pricing for the institution, even though most revenue functions have little to
do with services provided, Medicaid and Medicare are fixed-fee services on a
schedule which is unrelated to any specific prices which can comprise as much
of 80% from most nursing homes with the remaining 20% of nursing home business
being affected by set prices (Brunzell, et al,. 2013). Contract negotiation is vital for any healthcare
organization that gain considerable revenue from commercial insurers. The
demise of many new organizations is the negotiations of payment schedules lower
than the cost of the services provided. And lastly, billing and coding; these
entities are important to the provider and the institution because if not
correctly documented on claim forms, delivered services will not be paid for.
Or if on secondary visits proper coding is not documented a lower rated service
could be attributed to that visit and therefore inaccurate pricing (Cleverley,
et al., 2011).
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References
Methods and Hurdle Rates, Accounting & Finance, 53 (1), pg. 85-110
Cleverley, J, Cleverley, W, Song, P. (2011), Management Control
Process, Essentials of
Health Care Finance, 7
Unknown, (2014), Capital Budgeting Techniques, Practical Financial Management:
International, 7, pg. 449-474
