Capital Budgeting

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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determine whether their organization's long term investments such as new machinery purchases, replacement of old or outdated machinery, new facilities, introduction of new products, and research development projects are worth funding and potentially opening the company to increased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

Brunzell, T., Liljeblom, E., Vaihekoski, M., (March, 2013). Determinants of Capital Budgeting

 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