Question

discuss three steps in the capital investment financial analysis: cash flow estimation, project risk assessment, and cost of capital estimation. how might each of these influences a healthcare managers decision to move forward with an investment decision

Answer 1

The Capital investment analysis is a budgeting procedure to assess the capital investments made in project and tells about its profitability. The Cash flow estimates are used for the viability of your long-term investments in the project/projects. Further, The cash flows of a project are estimated using discounted and non-discounted cash flow techniques.

The three steps in the capital investment financial analysis:

Cash flow estimation: The total Cash flow is nothing but cash outflow and cash inflows of the particular project or investment. One has to estimate cash flow (inflows and outflows) while analyzing investment or Project proposal. Generally, Cash flows considered are after tax adjusted.

Project risk assessment: One has to assess the RISK, weather the earnings from the Project and cash flows are lower than estimated. So, the various risks are to be analyzed .. There are standalone risks and contexual risks for the project. These are analyzed by sensitivity, scenario or break-even analysis...etc

Cost of capital estimation: It is nothing but opportunity cost of making a specific investment. it is nothing but rate of return it would have got by investing the same money into a different project or investment. It is also the minimum rate of return investment sure to be get before generating value. The Company Cost of capital consists of both the cost of debt and the cost of equity used for business. The most common method used is Weighted Average Cost of Capital (WACC).

All the above concepts are comes under Capital budgeting:

The steps involved in capital budgeting are 1) Idea generation 2) Analyze various investment or Project proposals 3) Then create the Capital budget. After the decisions made and implemented, one has to compare the actual to initial projected results, and take the necessary steps to correct the implemented projects. The estimation of cash flows  involves Revenue (OPEX) and Deferred revenues (Capex).

Methods of Capital budgeting:

1)Average Rate of Return (ARR) method 2) Payback Period method 3)Discounted Payback method 4) Net Present Value (NPV) 5) Internal rate of Return (ARR)

1)Average Rate of Return (ARR) method :

ARR = (Average Annual Profit after tax/Average Investments)*100

Average Investment = (Initial investment +Salvage value)/2

2) Payback period is the number of years the project takes to recover the initial cost of the investment.

Payback period = Full years until recovery+( urecovered cost at the beginning of last year / Cash-flow during the last year)*12 months

3) Discounted Payback period: It considers the present value of the project estimated cash flows. This is nothing but the number of years a rpoejct can recover its initial investment in present value terms.

4) Net Present Value (NPV): This is done by the totalling the present value of the expected incremental cashflows from a project. The cost of the capital of the firm is used as discount rate.

NPV = CF0 + CF1/(1-k)^1 +CF2/(1+k)^^2+......+CFn/(1+K)^n

CF0 = Initial investment made, so its negative cash flow

CF1 = Cashflow in year 1

CFt = Cashflow at time t

K = Required rate of return for Project/ discount rate

*** IF NPV OF THE PROJECT IS POSITIVE, THE PROJECT IS ACCEPTED, OTHERWISE ITS REJECTED

5 ) Internal rate of return (IRR):

The discount rate at which the present values of the expected cash flows are equal to the present value of the estimated cash out-flows of the project. The discount rate usually will be the firms cost of capital.

Further, We can say this as PV(inflows) = PV(Outflows)

IF IRR > REQUIRED RATE OF RETURN, then ACCEPT the PROJECT

IF IRR < REQUIRED RATE OF RETURN, then REJECT the PROJECT

So, the healthcare managers takes a decision which method out of all the above methods (will follow the industry practice, my guess is mostly NPV or IRR) and takes decision weather to move forward with an investment or reject based on the investment return he would get.