Question

Discuss the capital budget process and why it is necessary to do in healthcare. Discuss briefly the steps of this process.

Answer 1

Capital Budgeting is a process of evaluating a project and to decide wether the project is beneficial or not. We calculate the NPV(net present value) and on the basis of NPVwe decide wether it is beneficial to accept the project or not.

NPV is the present value of expected cash inflow from the project during the project life reduced by the initial investment.

In the Capital Budgeting we have the following steps:

1) Calculation of Initial Investment - To start a project we must require some capital investment for purchase of Asset which is known as initial investment. Initial Investment include Capital Asset, Working capital Requirement. and also we shall reduce the initial investment by any profit from any capital asset. Say for example we need to purchase a new machine at cost of $10 million and if we purchase this machine we can sale old machine at $1 million. So initial Investment in this case will be $9 million.

So initial Investment includes = All the one time Cash outfolw - Benefits achieve from sale of capital asset .

2) Calculation of Operating cash flows (OCF) - Since capital budgeting a decision making procees so in this we cash Operating cash flows and includes only cash items and Ignore non cash items. Since depreciation is a non cash item so we must ignore depreciation but we shall account for any non cash savings in expenses. So tax benefit on depreciation is taken on Operating cash flow.

So OCF = {(Sales - Variable cost )- Fixed Cost}-taxes + Tax benefit on Depreciation

or, OCF = (Sales - variable cost - fixed cost - depreciation) - Tax + Depreciation

3)Present value of OCF = so when we have calculated the OCF, we will know calculate its present value PV for calculating the present value we will dicount the OCF with the required rate of return for the project.

4) Calculation of Terminal Benefits = So at the end of project the machine that we purchased earlier will now be sold and the working capital will be recovered now at the end. We will calculate the After tax benefit on sale and Recovery of Working capital and then We will discount them with the required rate of return to bring their vallues in parity with initial investment.

5) Calculation of NPV - at last the final calulation is NPV. So we have dicounted all the OCF at year 0 and also the same with terminal value. Now we will sum up all the benefits i.e. OCF+Terminal Benfits and then we will reduce the initial investment to find out wether the NPV is positive or not. If NPV is positive we must accept the project and if NPV is negetive we reject.

NPV = PV of OCF + PV of terminal Benefit - Initial investment.

In a indusrty of Healthcare the cost of equipments are too high and when a hospital invest he must take into consideration wether the investment is beneficial or not. Hence a indusrty like Healthcare find neccessary to do capital budgeting before any investment.