. 16
( 21)


generate revenues for some of the hospital™s other departments. On net, the
two effects are expected to balance out”that is, the cash ¬‚ow loss from other
imaging systems is expected to be offset by the cash ¬‚ow gain from other
services utilized by new MRI patients. Also, the project is estimated to have
negligible net working capital implications, so changes in net working capital
will be ignored in the analysis.

Cash Flow Analysis (Not-for-Pro¬t Businesses)
The ¬rst step in the ¬nancial analysis is to estimate the MRI site™s net cash
¬‚ows. This analysis is presented in Table 14.2. Here are the key points of the
analysis by line number:

• Line 1. Line 1 contains the estimated cost of the MRI system. In general,
capital budgeting analyses assume that the ¬rst cash ¬‚ow, normally an
out¬‚ow, occurs at the end of Year 0. Expenses, or cash out¬‚ows, are
shown in parentheses.
• Line 2. The related site construction expense, $1,000,000, is also
assumed to occur at Year 0.
• Line 3. Annual gross revenues = Weekly volume — Weeks of operation
per year — Charge per scan = 40 — 50 — $500 = $1,000,000 in the ¬rst
year. The 5 percent in¬‚ation rate is applied to all charges and costs that
would likely be affected by in¬‚ation, so the gross revenue amount shown
on Line 3 increases by 5 percent over time.
Although most of the operating revenues and costs would occur more
or less evenly over the year, it is very dif¬cult to forecast exactly when the
TABLE 14.2
Bayside Memorial Hospital: MRI Site Cash Flow Analysis
Cash Revenues and Costs
0 1 2 3 4 5

Chapter 14: The Basics of Capital Budgeting
1. System cost ($1,500,000)
2. Related expenses (1,000,000)
3. Gross revenues $1,000,000 $1,050,000 $ 1,102,500 $1,157,625 $1,215,506
4. Deductions 250,000 262,500 275,625 289,406 303,877
5. Net revenues $ 750,000 $ 787,500 $ 826,875 $ 868,219 $ 911,630
6. Labor costs 50,000 52,500 55,125 57,881 60,775
7. Maintenance costs 150,000 157,500 165,375 173,644 182,326
8. Supplies 30,000 31,500 33,075 34,729 36,465
9. Incremental overhead 10,000 10,500 11,025 11,576 12,155
10. Depreciation 350,000 350,000 350,000 350,000 350,000
11. Operating income $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
12. Taxes 0 0 0 0 0
13. Net operating income $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
14. Depreciation 350,000 350,000 350,000 350,000 350,000
15. Net salvage value 750,000
16. Net cash ¬‚ow ($2,500,000) $ 510,000 $ 535,500 $ 562,275 $ 590,389 $1,369,908

Note: Totals are rounded.

438 Healthcare Finance

¬‚ows would occur. Furthermore, there is signi¬cant potential for large
errors in cash ¬‚ow estimation. For these reasons, operating cash ¬‚ows are
often assumed to occur at the end of each year. Also, the assumption is
that the MRI system could be placed in operation quickly. If this were not
the case, then the ¬rst year™s operating ¬‚ows would be reduced. In some
situations, it might take several years from the ¬rst investment cash ¬‚ow to
the point when the project is operational and begins to generate revenues.
• Line 4. Deductions from charges are estimated to average 25 percent of
gross revenues, so in Year 1, 0.25 — $1,000,000 = $250,000 of gross
revenues would be uncollected. This amount increases each year by the 5
percent in¬‚ation rate.
• Line 5. Line 5 contains the net revenues in each year, Line 3 ’ Line 4.
• Line 6. Labor costs are forecasted to be $50,000 during the ¬rst year, and
they are assumed to increase over time at the 5 percent in¬‚ation rate.
• Line 7. Maintenance fees must be paid to the manufacturer at the end of
each year of operation. These fees are assumed to increase at the 5 percent
in¬‚ation rate.
• Line 8. Each scan uses $15 of supplies, so supply costs in the ¬rst year
total 40 — 50 — $15 = $30,000, and they are expected to increase each
year by the in¬‚ation rate.
• Line 9. If the project is accepted, overhead cash costs will increase by
$10,000 in the ¬rst year. Note that the $10,000 expenditure is a cash cost
that is related directly to the acceptance of the MRI project. Existing
overhead costs that are arbitrarily allocated to the MRI project are not
incremental cash ¬‚ows and thus should not be included in the analysis.
Overhead costs are also assumed to increase over time at the in¬‚ation rate.
• Line 10. Book depreciation in each year is calculated by the straight-line
method, assuming a ¬ve-year depreciable life. For book purposes, the
depreciable basis is equal to the capitalized cost of the project, which
includes the cost of the asset and related construction, less the estimated
salvage value. Thus, the depreciable basis is ($1,500,000 + $1,000,000)
’ $750,000 = $1,750,000, and the straight-line depreciation in each year
of the project™s ¬ve-year depreciable life is $1,750,000 / 5 = $350,000.
Note that depreciation is based solely on acquisition costs, so it is
unaffected by in¬‚ation. Also, note that the Table 14.2 cash ¬‚ows are
presented in a generic format that can be used by both investor-owned
and not-for-pro¬t hospitals. Depreciation expense is not a cash ¬‚ow but an
accounting convention that amortizes the cost of a ¬xed asset over its
revenue-producing life. Because Bayside Memorial Hospital is tax exempt,
and hence depreciation will not affect taxes, and because depreciation is
added back to the cash ¬‚ows on Line 14, depreciation could be totally
omitted from the cash ¬‚ow analysis.
• Line 11. Line 11 shows the project™s operating income in each year,
which is merely net revenues less all operating expenses.
Chapter 14: The Basics of Capital Budgeting

• Line 12. Line 12 contains zeros because Bayside is not-for-pro¬t and
hence does not pay taxes.
• Line 13. Bayside pays no taxes, so the project™s net operating income
equals its operating income.
• Line 14. Because depreciation, a noncash expense, was included on Line
10, it must be added back to the project™s net operating income in each
year to obtain each year™s net cash ¬‚ow.
• Line 15. The project is expected to be terminated after ¬ve years, at which
time the MRI system would be sold for an estimated $750,000. This
salvage value cash ¬‚ow is shown as an in¬‚ow at the end of Year 5 on
Line 15.
• Line 16. The project™s net cash ¬‚ows are shown on Line 16. The project
requires a $2,500,000 investment at Year 0 but then generates cash
in¬‚ows over its ¬ve-year operating life.

The Table 14.2 cash ¬‚ows do not include any allowance for interest
expense. On average, Bayside hospital will ¬nance new projects in accordance
with its target capital structure, which consists of 50 percent debt ¬nancing
and 50 percent equity (i.e., fund) ¬nancing. The costs associated with this
¬nancing mix, including both interest costs and the opportunity cost of equity
capital, are incorporated into the ¬rm™s 10 percent corporate cost of capital.
Because the cost of debt ¬nancing is included in the discount rate that will
be applied to the cash ¬‚ows, recognition of interest expense in the cash ¬‚ows
would be double counting.

Cash Flow Analysis (For-Pro¬t Businesses)
The Table 14.2 cash ¬‚ow analysis can be easily modi¬ed to re¬‚ect tax impli-
cations if the analyzing ¬rm is a for-pro¬t business. To illustrate, assume that
the MRI project is being evaluated by Ann Arbor Health Systems, an investor-
owned hospital chain. Assume also that all of the project data presented earlier
apply to Ann Arbor, except that the MRI falls into the MACRS ¬ve-year class
for tax depreciation and the ¬rm has a 40 percent tax rate.
Table 14.3 contains Ann Arbor™s cash ¬‚ow analysis. Note the following
differences from the not-for-pro¬t analysis performed in Table 14.2:

• Line 10. Depreciation expense must be modi¬ed to re¬‚ect tax
depreciation rather than book depreciation. Tax depreciation is
calculated using the Modi¬ed Accelerated Cost Recovery System (MACRS)
as speci¬ed in current tax laws. Each year™s tax depreciation is found by
multiplying the asset™s depreciable basis, without reduction by the
estimated salvage value, by the appropriate depreciation factor. In this
illustration, the depreciable basis is $2,500,000, and the MRI system falls
into the MACRS ¬ve-year class, so the MACRS factors speci¬ed by the
tax code are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06, in Years 1 to 6,
Healthcare Finance
TABLE 14.3
Ann Arbor Health Systems: MRI Site Cash Flow Analysis
Cash Revenues and Costs
0 1 2 3 4 5

1. System cost ($1,500,000)
2. Related expenses (1,000,000)
3. Gross revenues $ 1,000,000 $ 1,050,000 $ 1,102,500 $ 1,157,625 $ 1,215,506
4. Deductions 250,000 262,500 275,625 289,406 303,877
5. Net revenues $ 750,000 $ 787,500 $ 826,875 $ 868,219 $ 911,630
6. Labor costs 50,000 52,500 55,125 57,881 60,775
7. Maintenance costs 150,000 157,500 165,375 173,644 182,326
8. Supplies 30,000 31,500 33,075 34,729 36,465
9. Incremental overhead 10,000 10,500 11,025 11,576 12,155
10. Depreciation 500,000 800,000 475,000 300,000 275,000
11. Operating income $ 10,000 ($ 264,500) $ 87,275 $ 290,389 $ 344,908
12. Taxes 4,000 (105,800) 34,910 116,156 137,963
13. Net operating income $ 6,000 ($ 158,700) $ 52,365 $ 174,233 $ 206,945
14. Depreciation 500,000 800,000 475,000 300,000 275,000
15. Net salvage value 510,000
16. Net cash ¬‚ow ($2,500,000) $ 506,000 $ 641,300 $ 527,365 $ 474,233 $ 991,945

Note: Totals are rounded.
Chapter 14: The Basics of Capital Budgeting

respectively. Thus, the tax depreciation in Year 1 is 0.20 — $2,500,000 =
$500,000, in Year 2 the depreciation is 0.32 — $2,500,000 = $800,000,
and so on.4
• Line 12. Taxable ¬rms must reduce the operating income on Line 11 by
the amount of taxes. Taxes, which appear on Line 12, are computed by
multiplying the Line 11 pre-tax operating income by the ¬rm™s marginal
tax rate. For example, the project™s taxes for Year 1 are 0.40 — $10,000 =
$4,000. The taxes shown for Year 2 are a negative $105,800. In this year,
the project is expected to lose $264,500, and hence Ann Arbor™s taxable
income, assuming that its existing projects are pro¬table, will be reduced
by this amount if the project is undertaken. This reduction in Ann Arbor™s
overall taxable income would lower the ¬rm™s tax bill by T — Reduction in
taxable income = 0.40 — $264,500 = $105,800.5
• Line 14. The MACRS depreciation is added back in Line 14.
• Line 15. Investor-owned ¬rms will normally incur a tax liability on the
sale of a capital asset at the end of the project™s life. According to the IRS,
the value of the MRI system at the end of Year 5 is the tax book value,
which is the depreciation that remains on the tax books. For the MRI, ¬ve
years worth of depreciation would be taken, so only one year of
depreciation remains. The MACRS factor for Year 6 is 0.06, so by the end
of Year 5, Ann Arbor has expensed 0.94 of the MRI™s depreciable basis and
the remaining tax book value is 0.06 — $2,500,000 = $150,000. Thus,
according to the IRS, the value of the MRI system is $150,000. When
Ann Arbor sells the system for its estimated salvage value of $750,000, it
realizes a “pro¬t” of $750,000 ’ $150,000 = $600,000, and it must
repay the IRS an amount equal to 0.4 — $600,000 = $240,000. The
$240,000 tax bill recognizes that Ann Arbor took too much depreciation
on the MRI system, so it represents a recapture of the excess tax bene¬t
taken over the ¬ve-year life of the system. The $240,000 in taxes reduces
the cash ¬‚ow received from the sale of the MRI equipment, so the salvage
value net of taxes is $750,000 ’ $240,000 = $510,000.

As can be seen by comparing Line 16 in Tables 14.2 and 14.3, all else the
same, the taxes paid by investor-owned ¬rms tend to reduce a project™s net
operating cash ¬‚ows and net salvage value and hence reduce the project™s
¬nancial attractiveness.

Replacement Analysis
Bayside™s MRI project was used to illustrate how the cash ¬‚ows from an ex-
pansion project are analyzed. All ¬rms, including Bayside Memorial Hospital,
also make replacement decisions, in which a new asset is being considered to
replace an existing asset which could, if not replaced, continue in operation.
The cash ¬‚ow analysis for a replacement decision is somewhat more complex
442 Healthcare Finance

than for an expansion decision because the cash ¬‚ows from the existing asset
must be considered.
Again, the key to cash ¬‚ow estimation is to focus on the incremental
cash ¬‚ows. If the new asset is acquired, the existing asset can be sold, so
the current market value of the existing asset is a cash in¬‚ow in the analysis.
When considering the operating ¬‚ows, the incremental ¬‚ows are the cash ¬‚ows
expected from the replacement asset less the ¬‚ows that the existing asset would
produce if not replaced. By applying the incremental cash ¬‚ow concept, the
correct cash ¬‚ows can be estimated for replacement decisions.

Self-Test 1. Brie¬‚y, how is a project cash ¬‚ow analysis constructed?
Questions 2. Is it necessary to include depreciation expense in a cash ¬‚ow analysis by
a not-for-pro¬t provider? Explain your answer.
3. What are the key differences in cash ¬‚ow analyses performed by
investor-owned and not-for-pro¬t businesses?
4. How do expansion and replacement cash ¬‚ow analyses differ?

Breakeven Analysis
Breakeven analysis was ¬rst introduced in Chapter 5 in conjunction with
breakeven volume in an accounting pro¬t analysis. Now, the breakeven con-
cept is reapplied in a project analysis setting. In project analyses, many differ-
ent types of breakeven can be determined. Rather than discuss all the possible
types of breakeven, the focus here is on one type”time breakeven.
Payback is de¬ned as the expected number of years required to recover
the investment in a project, so payback, or payback period, measures time
breakeven. To illustrate, consider the net cash ¬‚ows for the MRI project
contained in Table 14.2. The best way to determine the MRI™s payback is
to construct the project™s cumulative cash ¬‚ows as shown in Table 14.4. The
cumulative cash ¬‚ow at any point in time is merely the sum of all the cash
¬‚ows (with proper sign indicating an in¬‚ow or out¬‚ow) that have occurred
up to that point. Thus, in Table 14.4, the cumulative cash ¬‚ow at Year 0
is ’$2,500,000; at Year 1 it is ’$2,500,000 + $510,000 = ’$1,990,000;
at Year 2 it is ’$2,500,000 + $510,000 + $535,500 = ’$1,990,000 +
$535,500 = ’$1,454,500; and so on.
As shown in the rightmost column of Table 14.4, the $2,500,000
investment in the MRI project will be recovered at the end of Year 5 if the
cash ¬‚ow forecasts are correct. Furthermore, if the cash ¬‚ows are assumed to
come in evenly during the year, breakeven will occur $301,836 / $1,369,908
= 0.22 years into Year 5, so the MRI project™s payback is 4.22 years.
Initially, payback was used by managers as the primary ¬nancial evalua-
tion tool in project analyses. For example, a business might accept all projects
with paybacks of ¬ve years or less. However, payback has two serious de¬cien-
Chapter 14: The Basics of Capital Budgeting

TABLE 14.4
Year Annual Cash Flows Cumulative Cash Flows
0 ($2,500,000) ($2,500,000)
Hospital: MRI
1 510,000 (1,990,000)
Site Annual and
2 535,500 (1,454,500)
3 562,275 (892,225) Cumulative
4 590,389 (301,836) Cash Flows
5 1,369,908 1,068,072

cies when it is used as a project selection criterion. First, payback ignores all
cash ¬‚ows that occur after the payback period. To illustrate, Bayside might
be evaluating a competing project that has the same cash ¬‚ows as the MRI
project in Years 0 through 5. However, the alternative project might have a
cash in¬‚ow of $2 million in Year 6. Both projects would have the same pay-
back, 4.22 years, and hence be ranked the same, even though the alternative
project clearly is better from a ¬nancial perspective. Second, payback ignores
the opportunity costs associated with the capital employed. For these reasons,
payback generally is no longer used as the primary evaluation tool.6
However, payback is useful in capital investment analysis. The shorter
the payback, the more quickly the funds invested in a project will become
available for other purposes and hence the more liquid the project. Also, cash
¬‚ows expected in the distant future are generally regarded as being riskier
than near-term cash ¬‚ows, so shorter payback projects generally are less risky
than those with longer paybacks. Therefore, payback is often used as a rough
measure of a project™s liquidity and risk.

1. What is payback?
2. What are the bene¬ts of payback?
3. What are its de¬ciencies when used as the primary evaluation tool?

Pro¬tability (Return on Investment) Analysis
Up to this point, the chapter has focused on cash ¬‚ow estimation and break-
even analysis. Perhaps the most important element in a project™s ¬nancial
analysis is its expected pro¬tability, which generally is assessed by return on
investment (ROI) measured either in dollars or in percentage rate of return.
In the next sections, we discuss one dollar measure and one rate of return

Net Present Value (NPV)
Net present value (NPV), which was ¬rst discussed in Chapter 9, is a dollar
ROI measure that uses discounted cash ¬‚ow (DCF) techniques, so it is often
referred to as a DCF pro¬tability measure. To apply the NPV method:
444 Healthcare Finance

• Find the present (Time 0) value of each net cash ¬‚ow, including both
in¬‚ows and out¬‚ows, when discounted at the project™s cost of capital.
• Sum the present values. This sum is de¬ned as the project™s net present
• If the NPV is positive, the project is expected to be pro¬table, and the
higher the NPV, the more pro¬table the project. If the NPV is zero, the
project just breaks even in an economic sense. If the NPV is negative, the
project is expected to be unpro¬table.

With a project cost of capital of 10 percent, the NPV of Bayside™s MRI project
is calculated as follows:

Financial calculators and spreadsheets have NPV functions that easily perform
the mathematics if given the cash ¬‚ows and cost of capital.
The rationale behind the NPV method is straightforward. An NPV of
zero signi¬es that the project™s cash in¬‚ows are just suf¬cient to (1) return the
capital invested in the project and (2) provide the required rate of return on
that capital (meet the opportunity cost of capital). If a project has a positive
NPV, it is generating excess cash ¬‚ows, and these excess cash ¬‚ows are available
to management to reinvest in the business and, for investor-owned ¬rms, to
pay dividends. If a project has a negative NPV, its cash in¬‚ows are insuf¬cient
to compensate the ¬rm for the capital invested or perhaps even insuf¬cient to
recover the initial investment, so the project is unpro¬table and acceptance
would cause the ¬nancial condition of the ¬rm to deteriorate. For investor-
owned ¬rms, NPV is a direct measure of the contribution of the project to
shareholder wealth, so NPV is considered by many academics and practitioners
to be the best measure of project pro¬tability.
The NPV of the MRI project is $82,493, so on a present value basis,
the project is expected to generate a cash ¬‚ow excess of over $80,000 after all
costs, including the opportunity cost of capital, have been considered. Thus,
the project is pro¬table and its acceptance would have a positive impact on
Bayside™s ¬nancial condition.

Internal Rate of Return (IRR)
Like NPV, internal rate of return (IRR) is also a discounted cash ¬‚ow (DCF)
measure of pro¬tability. However, whereas NPV measures a project™s dollar
Chapter 14: The Basics of Capital Budgeting

pro¬tability, IRR measures a project™s percentage pro¬tability (i.e., its ex-
pected rate of return).
Mathematically, IRR is de¬ned as the discount rate that equates the
present value of the project™s expected cash in¬‚ows to the present value of
the project™s expected cash out¬‚ows, so the IRR is simply that discount rate
that forces the NPV of the project to equal zero. Financial calculators and
spreadsheets have IRR functions that calculate IRRs very rapidly. Simply input
the project™s cash ¬‚ows, and the computer or calculator computes the IRR.
For Bayside™s MRI project, the IRR is that rate that causes the sum
of the present values of the cash in¬‚ows to equal the $2,500,000 cost of the

When all of the MRI project™s cash ¬‚ows are discounted at 11.1 percent, the
NPV of the project is approximately zero. Thus, the MRI project™s IRR is
11.1 percent. Put another way, the project is expected to generate an 11.1
percent rate of return on its $2,500,000 investment. Note that the IRR is like
a bond™s yield to maturity: it is the rate of return expected on the investment
assuming all the cash ¬‚ows anticipated actually occur.
If the IRR exceeds the project cost of capital, a surplus is projected to
remain after recovering the invested capital and paying for its use, and this sur-
plus accrues to the ¬rm™s stockholders (in Bayside™s case, to its stakeholders).
If the IRR is less than the project cost of capital, however, taking on the project
imposes an expected ¬nancial cost on the ¬rm™s stockholders or stakeholders.
The MRI project™s 11.1 percent IRR exceeds the its 10 percent project cost
of capital. Thus, as measured by IRR, the MRI project is pro¬table and its
acceptance would enhance Bayside™s ¬nancial condition.

Comparison of the NPV and IRR Methods
Consider a project with a zero NPV. In this situation, the project™s IRR
must equal its cost of capital. The project has zero expected pro¬tability, and
acceptance would neither enhance nor diminish the ¬rm™s ¬nancial condition.
To have a positive NPV, the project™s IRR must be greater than its cost of
capital, and a negative NPV signi¬es a project with an IRR less than its cost of
capital. Thus, projects that are deemed pro¬table by the NPV method will also
be deemed pro¬table by the IRR method. In the MRI example, the project
446 Healthcare Finance

would have a positive NPV for all costs of capital less than 11.1 percent. If
the cost of capital were greater than 11.1 percent, the project would have a
negative NPV. In effect, the NPV and IRR are perfect substitutes for each
other in measuring whether or not a project is pro¬table.7

Self-Test 1. Brie¬‚y describe how to calculate net present value (NPV) and internal
Questions rate of return (IRR).
2. What is the rationale behind each method?
3. Do the two methods lead to the same conclusions regarding project
pro¬tability? Explain your answer.

Some Final Thoughts on Breakeven and Pro¬tability Analyses
Although we have discussed only one breakeven and two pro¬tability mea-
sures, there are many other measures commonly used in project ¬nancial anal-
yses.8 Today, virtually all capital budgeting decisions of ¬nancial consequence
are analyzed by computer, and hence the mechanics of calculating and listing
numerous breakeven and pro¬tability measures is easy. Because each measure
contributes slightly different information about the ¬nancial consequences of
a project, managers should not focus on only one or two ¬nancial measures. A
thorough ¬nancial analysis of a new project includes numerous ¬nancial mea-
sures, and capital budgeting decisions are enhanced if all information inherent
in all measures is considered in the process.

Self-Test 1. Evaluate the following statement: The dif¬culty in calculating numerous
Questions breakeven and pro¬tability measures restricts the amount of information
available in capital budgeting analyses.
2. Should capital budgeting analyses look at only one breakeven or
pro¬tability measure? Explain your answer.

Capital Budgeting in Not-for-Pro¬t Businesses
Although the capital budgeting techniques discussed to this point are appro-
priate for use by all businesses when assessing the ¬nancial impact of a pro-
posed project, a not-for-pro¬t ¬rm has the additional consideration of meet-
ing its charitable mission. In this section, two models that extend the capital
budgeting decision to include the charitable mission are discussed.

Net Present Social Value (NPSV) Model 9
The ¬nancial analysis techniques discussed so far have focused exclusively on
the cash ¬‚ow implications of a proposed project. Some healthcare businesses,
particularly not-for-pro¬t providers, have the goal of producing social ser-
vices along with commercial services. For such ¬rms, the proper analysis of
Chapter 14: The Basics of Capital Budgeting

proposed projects must, at least in theory, systematically consider the social
value of a project along with its pure ¬nancial, or cash ¬‚ow, value.
When social value is considered, the total net present value (TNPV ) of
a project can be expressed as follows:

Here, NPV represents the conventional NPV of the project™s cash ¬‚ow stream
and NPSV is the net present social value of the project. The NPSV term,
which represents managers™ assessment of the social value of a project, clearly
differentiates capital budgeting in not-for-pro¬t ¬rms from that in investor-
owned ¬rms. In evaluating each project, a project is acceptable if its TNPV
is greater than or equal to zero. This means that the sum of the project™s
¬nancial and social values is at least zero, so when both facets of value are
considered, the project has positive, or at least non-negative, worth. Probably
not all projects will have social value, but if a project does, it is considered
formally in this decision model. However no project should be accepted if its
NPSV is negative, even if its TNPV is positive. Furthermore, to ensure the
¬nancial viability of the ¬rm, the sum of the conventional NPVs of all projects
initiated in a planning period must equal or exceed zero.10 If this restriction
were not imposed, social value could displace ¬nancial value over time, and a
business cannot continue to provide social value without ¬nancial integrity.
NPSV is the sum of the present (Year 0) values of each year™s social
value. In essence, the suppliers of fund capital to a not-for-pro¬t ¬rm never
receive a cash return on their investment. Instead, they receive a return on
their investment in the form of social dividends. These dividends take the form
of services with social value to the community such as charity care, medical
research and education, and a myriad of other services that, for one reason
or another, do not pay their own way. Services provided to patients at a price
equal to or greater than the full cost of production do not create social value.
Similarly, if governmental entities purchase care directly for bene¬ciaries of
a program or support research, the resulting social value is created by the
funding organization as opposed to the service provider.
In estimating a project™s NPSV, ¬rst, it is necessary to estimate in dollar
terms the social value of the services provided in each year. When a project
produces services to individuals who are willing and able to pay for those
services, the value of those services is captured by the amount that they actually
pay. Thus, the value of the services provided to those who cannot pay, or to
those who cannot pay the full amount, can be estimated by the average net
price paid by those individuals who are able to pay. Next, a discount rate must
be applied to the social value cash ¬‚ows. In general, providers should require
a return on their social value stream that approximates the return available on
the equity investment in for-pro¬t ¬rms that offer the same services.
This approach to valuing social services has intuitive appeal, but certain
implementation problems merit further discussion.
448 Healthcare Finance

• Price is a fair measure of value only if the payer has the capacity to judge
the true value of the service provided. Many observers of the health
services industry would argue that information asymmetries between the
provider and the purchaser inhibit the ability of the purchaser to judge
true value.
• The fact that most payments for healthcare services are made by
third-party payers may result in price distortions. For example, insurers
may be willing to pay more for services than an individual would pay in
the absence of insurance, or the market power of some insurers, such as
Medicare, may result in a price that is less than individuals would be
willing to pay.
• A great deal of controversy exists over the true value of treatment in many
situations. Suppose that some people are entitled to whatever healthcare is
available, regardless of cost, and are not required to personally pay for the
care. Even though society as a whole must cover the cost, people may
demand a level of care that is of questionable value. For example, should
large sums be spent to keep a comatose 92-year old alive for a few more
days? If the true value to society of such an expenditure is zero, assigning a
high social value just because that is its cost makes little sense.

Although the NPSV model formalizes the capital budgeting decision
process applicable to not-for-pro¬t healthcare ¬rms, few organizations actually
attempt to quantify NPSV. However, not-for-pro¬t providers should, at a
minimum, subjectively consider the social value inherent in projects under

Project Scoring
Managers of not-for-pro¬t ¬rms, as well as many managers of investor-owned
¬rms, recognize that non¬nancial factors should be considered in any capital
budgeting analysis. The NPSV model examines only one other factor, and it
is dif¬cult to implement in practice. Thus, many ¬rms use a quasi-subjective
project scoring approach to capital budgeting decisions that attempts to capture
both ¬nancial and non¬nancial factors. Table 14.5, which is used by Bayside
Memorial Hospital, illustrates one such approach.
Bayside ranks projects on three dimensions: stakeholder, operational,
and ¬nancial. Within each dimension, multiple factors are examined and as-
signed scores that range from two points for very favorable impact to minus
one point for negative impact. The scores within each dimension are added to
obtain scores for each of the three dimensions, and then the dimension scores
are summed to obtain a total score for the project. The total score gives Bay-
side™s managers a feel for the relative values of projects under consideration
when all factors, including ¬nancial, are taken into account.
Bayside™s managers recognize that the scoring system is completely ar-
bitrary, so a project with a score of ten, for example, is not necessarily twice
Chapter 14: The Basics of Capital Budgeting

TABLE 14.5
Relative Score
Criteria 2 1 0 “1 Memorial
Hospital: Project
Stakeholder Factors Scoring Matrix
Physicians Strongly support Support Neutral Opposed
Employees Helps morale a lot Helps morale a little No effect Hurts morale
Visitors Greatly enhances visit Enhances visit No effect Hurts image
Social value High Moderate None Negative

Operational Factors
Outcomes Greatly improves Improves No effect Hurts outcomes
Length of stay Documented decrease Anecdotal decrease No effect Increases
Technology Breakthrough Improves current Adds to current Lowers
Productivity Large decrease in FTEs Decrease in FTEs No change in FTEs Adds FTEs

Financial Factors
Life cycle Innovation Growth Stabilization Decline
Payback Less than 2 years 2“4 years 4“6 years Over 6 years
IRR Over 20% 15“20% 10“15% Less than 10%
Correlation Negative Uncorrelated Somewhat positive Highly positive

Stakeholder factor score
Service factor score
Financial factor score
Total score

as good as a project that scores ¬ve. Nevertheless, Bayside™s project scoring
approach forces its managers to address multiple issues when making capital
budgeting decisions and it does provide a relative ranking of projects under
consideration. Although Bayside™s approach should not be used at other orga-
nizations without modi¬cation for ¬rm- and industry-unique circumstances,
it does provide insights into how a ¬rm-unique matrix might be developed.

1. Describe the net present social value (NPSV) model of capital
2. Describe the construction and use of a project-scoring matrix.

The Post-Audit
Capital budgeting is not a static process. If there is a long lag between a
project™s acceptance and its implementation, any new information concerning
either capital costs or the project™s cash ¬‚ows should be analyzed before the
¬nal start-up occurs. Furthermore, the performance of each project should be
monitored throughout the project™s life. The process of formally monitoring
project performance over time is called the post-audit. It involves comparing
450 Healthcare Finance

actual results with those projected, explaining why differences occur, and
analyzing potential changes to the project™s operations, including replacement
or termination.
The post-audit has several purposes:

• Improve forecasts. When managers systematically compare projections to
actual outcomes, there is a tendency for estimates to improve. Conscious
or unconscious biases that occur can be identi¬ed and, one hopes,
eliminated; new forecasting methods are sought as the need for them
becomes apparent; and managers tend to do everything better, including
forecasting, if they know that their actions are being monitored.
• Develop historical risk data. Post-audits permit managers to develop
historical data on new project analyses regarding risk and expected rates of
return. These data can then be used to make judgments about the relative
risk of future projects as they are evaluated.
• Improve operations. Managers run businesses, and they can perform at
higher or lower levels of ef¬ciency. When a forecast is made, for example,
by the surgery department, the department director and medical staff is, in
a sense, putting their reputations on the line. If costs are above predicted
levels and volume is below expectations, the managers involved will strive,
within ethical bounds, to improve the situation and to bring results into
line with forecasts. As one hospital CEO put it: “You academics worry
only about making good decisions. In the health services industry, we also
have to worry about making decisions good.”
• Reduce losses. Post-audits monitor the performance of projects over
time, so the ¬rst indication that termination or replacement should be
considered often arises when the post-audit indicates that a project is
performing poorly.

Self-Test 1. What is a post-audit?
Questions 2. Why are post-audits important to the ef¬ciency of a business?

Using Capital Budgeting Techniques in Other Contexts
The techniques developed in this chapter can help health services managers
make a number of different types of decisions in addition to project selection.
One example is the use of NPV and IRR to evaluate corporate merger op-
portunities. Healthcare companies often acquire other companies to increase
capacity, to expand into other service areas, or for other reasons. A key element
of any merger analysis is the valuation of the target company. Although the
cash ¬‚ows in such an analysis may be structured differently than in project
analysis, the same evaluation tools are applied. We will discuss business valua-
tion in more detail in Chapter 18.
Chapter 14: The Basics of Capital Budgeting

Managers also use capital budgeting techniques when deciding whether
or not to divest assets or reduce staf¬ng. Like capital budgeting, these actions
require an analysis of the impact of the decision on the ¬rm™s cash ¬‚ows.
When eliminating personnel, businesses typically spend money up-front in
severance payments but then receive bene¬ts in the form of lower wages
and bene¬ts in the future. When assets are sold, the pattern of cash ¬‚ows
is reversed”that is, cash in¬‚ows occur when the asset is sold, but any future
cash in¬‚ows associated with the asset are sacri¬ced. (If future cash ¬‚ows are
negative, the decision, at least from a ¬nancial perspective, should be easy.)
In both situations, the techniques discussed in this chapter, perhaps with
modi¬cations, can be applied to assess the ¬nancial consequences of the action.

1. Can capital budgeting tools be used in different settings? Explain your

Key Concepts
This chapter discussed the basics of capital budgeting. The key concepts of
this chapter are:
• Capital budgeting is the process of analyzing potential expenditures on
¬xed assets and deciding whether the ¬rm should undertake those
• A capital budgeting ¬nancial analysis consists of ¬ve steps: (1) estimate the
investment outlay on the project, (2) estimate the expected cash in¬‚ows
from the project, (3) assess the riskiness of those ¬‚ows, (4) estimate the
appropriate cost of capital at which to discount those ¬‚ows, and (5)
determine the project™s pro¬tability and breakeven characteristics.
• The most critical and most dif¬cult step in analyzing a project is
estimating the incremental cash ¬‚ows that the project will generate.
• In determining incremental cash ¬‚ows, opportunity costs (i.e., the cash
¬‚ows forgone by using an asset) must be considered, but sunk costs (i.e.,
cash outlays that cannot be recouped) are not included. Furthermore, any
impact of the project on the ¬rm™s other projects must be included in the
• Tax laws generally affect investor-owned ¬rms three ways: (1) taxes reduce
a project™s operating cash ¬‚ows, (2) tax laws prescribe the depreciation
expense that can be taken in any year, and (3) taxes affect a project™s
salvage value cash ¬‚ow.
• Capital projects often require an investment in net working capital in
addition to the investment in ¬xed assets. Such increases represent a cash
outlay that, if material, must be included in the analysis. The investment in
net working capital is recovered when the project is terminated.
• A project may have some strategic value that is not accounted for in the
452 Healthcare Finance

estimated cash ¬‚ows. At a minimum, strategic value should be noted and
considered qualitatively in the analysis.
• The effects of in¬‚ation must be considered in project analyses. The best
procedure is to build in¬‚ation effects directly into the component cash
¬‚ow estimates.
• Time breakeven, which is measured by the payback period, provides
managers with insights concerning a project™s liquidity and risk.
• Project pro¬tability is assessed by return on investment (ROI) measures.
The two most commonly used ROI measures are net present value and
internal rate of return.
• Net present value (NPV), which is simply the sum of the present values of
all the project™s net cash ¬‚ows when discounted at the project™s cost of
capital, measures a project™s expected dollar pro¬tability. An NPV greater
than zero indicates that the project is expected to be pro¬table after all
costs, including the opportunity cost of capital, have been considered.
Furthermore, and the higher the NPV, the more pro¬table the project.
• Internal rate of return (IRR), which is the discount rate that forces a
project™s NPV to equal zero, measures a project™s expected rate of return.
If a project™s IRR is greater than its cost of capital, the project is expected
to be pro¬table, and the higher the IRR, the more pro¬table the project.
• The NPV and IRR pro¬tability measures provide identical indications of
pro¬tability”that is, a project that is judged to be pro¬table by its NPV
will also be pro¬table by its IRR.
• The net present social value (NPSV) model formalizes the capital
budgeting decision process for not-for-pro¬t ¬rms.
• Firms often use project scoring to subjectively incorporate a large number
of factors, including ¬nancial and non¬nancial, into the capital budgeting
decision process.
• The post-audit is a key element in capital budgeting. By comparing actual
results with predicted results, managers can improve both operations and
the cash ¬‚ow estimation process.
• Capital budgeting techniques are used in a wide variety of settings in
addition to project evaluation.

The discussion of capital investment decisions will continue in Chapter 15,
which focuses on risk assessment and incorporation.

14.1 a. What is capital budgeting? Why are capital budgeting decisions so
important to businesses?
b. What is the purpose of placing capital projects into categories such as
mandatory replacement, or expansion of existing products, services,
or markets?
Chapter 14: The Basics of Capital Budgeting

c. Should ¬nancial analysis play the dominant role in capital budgeting
decisions? Explain your answer.
d. What are the ¬ve steps of capital budgeting analysis?
14.2 Brie¬‚y de¬ne the following cash ¬‚ow estimation concepts.
a. Incremental cash ¬‚ow
b. Cash ¬‚ow versus accounting income
c. Sunk cost
d. Opportunity cost
e. Net working capital
f. Strategic value
g. In¬‚ation effects
14.3 Describe the following project breakeven and pro¬tability measures.
Be sure to include each measure™s economic interpretation.
a. Payback
b. Net present value (NPV)
c. Internal rate of return (IRR)
14.4 Critique this statement: NPV is a better measure of project pro¬tability
than IRR because it leads to better capital investment decisions.
14.5 a. Describe the net present social value (NPSV) model.
b. What is a project scoring matrix?
14.6 What is a post-audit? Why is the post-audit critical to good investment
decision making?
14.7 From a purely ¬nancial perspective, are there situations in which a
business would be better off choosing a project with a shorter payback
over one that has a larger NPV?

14.1 Winston Clinic is evaluating a project that costs $52,125 and has
expected net cash in¬‚ows of $12,000 per year for eight years. The ¬rst
in¬‚ow occurs one year after the cost out¬‚ow, and the project has a cost
of capital of 12 percent.
a. What is the project™s payback?
b. What is the project™s NPV? Its IRR?
c. Is the project ¬nancially acceptable? Explain your answer.
14.2 Better Health, Inc., is evaluating two investment projects, each of
which requires an up-front expenditure of $1.5 million. The projects
are expected to produce the following net cash in¬‚ows:
Year Project A Project B
1 $ 500,000 $2,000,000
2 1,000,000 1,000,000
3 2,000,000 600,000
a. What is each project™s IRR?
454 Healthcare Finance

b. What is each project™s NPV if the cost of capital is 10 percent?
5 percent? 15 percent?
14.3 Capitol Healthplans, Inc., is evaluating two different methods for
providing home health services to its members. Both methods involve
contracting out for services, and the health outcomes and revenues are
not effected by the method chosen. Therefore, the incremental cash
¬‚ows for the decision are all out¬‚ows. Here are the projected ¬‚ows:

Year Method A Method B
0 ($300,000) ($120,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)

a. What is each alternative™s IRR?
b. If the cost of capital for both methods is 9 percent, which method
should be chosen? Why?
14.4 Great Lakes Clinic has been asked to provide exclusive healthcare
services for next years™ World Exposition. Although ¬‚attered by the
request, the clinic™s managers want to conduct a ¬nancial analysis of the
project. There will be an up-front cost of $160,000 to get the clinic
in operation. Then, a net cash in¬‚ow of $1 million is expected from
operations in each of the two years of the Exposition. However, the
clinic has to pay the organizers of the exposition a fee for the marketing
value of the opportunity. This fee, which must be paid at the end of the
second year, is $2 million.
a. What are the cash ¬‚ows associated with the project?
b. What is the project™s IRR?
c. Assuming a project cost of capital of 10 percent, what is the project™s
14.5 Assume that you are the chief ¬nancial of¬cer at Porter Memorial
Hospital. The CEO has asked you to analyze two proposed capital
investments”Project X and Project Y. Each project requires a net
investment outlay of $10,000, and the cost of capital for each project
is 12 percent. The projects™ expected net cash ¬‚ows are:

Year Project X Project Y
0 ($10,000) ($10,000)
1 6,500 3,000
2 3,000 3,000
3 3,000 3,000
4 1,000 3,000
Chapter 14: The Basics of Capital Budgeting

a. Calculate each project™s payback period, net present value (NPV),
and internal rate of return (IRR).
b. Which project (or projects) is ¬nancially acceptable? Explain your
14.6 The director of capital budgeting for Big Sky Health Systems, Inc.,
has estimated the following cash ¬‚ows in thousands of dollars for a
proposed new service:
Year Expected Net Cash Flow
0 ($100)
1 70
2 50
3 20
The project™s cost of capital is 10 percent.
a. What is the project™s payback period?
b. What is the project™s NPV?
c. What is the project™s IRR?
14.7 California Health Center, a for-pro¬t hospital, is evaluating the
purchase of new diagnostic equipment. The equipment, which costs
$600,000, has an expected life of ¬ve years and an estimated pre-tax
salvage value of $200,000 at that time. The equipment is expected
to be used 15 times a day for 250 days a year for each year of the
project™s life. On average, each procedure is expected to generate
$80 in collections, which is net of bad debt losses and contractual
allowances, in its ¬rst year of use. Thus, net revenues for Year 1 are
estimated at 15 — 250 — $80 = $300,000.
Labor and maintenance costs are expected to be $100,000 during
the ¬rst year of operation, while utilities will cost another $10,000
and cash overhead will increase by $5,000 in Year 1. The cost for
expendable supplies is expected to average $5 per procedure during the
¬rst year. All costs and revenues, except depreciation, are expected to
increase at a 5 percent in¬‚ation rate after the ¬rst year.
The equipment falls into the MACRS ¬ve-year class for tax
depreciation and hence is subject to the following deprecation
Year Allowance
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
456 Healthcare Finance

The hospital™s tax rate is 40 percent, and its corporate cost of capital is
10 percent.
a. Estimate the project™s net cash ¬‚ows over its ¬ve-year estimated life.
(Hint: Use the following format as a guide.)


0 1 2 3 4 5

Equipment cost
Net revenues
Less: Labor/maintenance costs
Utilities costs
Incremental overhead
Operating income
Net operating income
Plus: Depreciation
Plus: Equipment salvage value
Net cash ¬‚ow

b. What are the project™s NPV and IRR? (Assume for now that the
project has average risk.)
14.8 You have been asked by the president and CEO of Kidd Pharmaceuticals
to evaluate the proposed acquisition of a new labeling machine for
one of the ¬rm™s production lines. The machine™s price is $50,000,
and it would cost another $10,000 for transportation and installation.
The machine falls into the MACRS three-year class, and hence the tax
depreciation allowances are 0.33, 0.45, and 0.15 in Years 1, 2, and
3, respectively. The machine would be sold after three years because
the production line is being closed at that time. The best estimate of
the machine™s salvage value after three years of use is $20,000. The
machine would have no effect on the ¬rm™s sales or revenues, but it is
expected to save Kidd $20,000 per year in before-tax operating costs.
The ¬rm™s tax rate is 40 percent and its corporate cost of capital is 10
a. What is the project™s net investment outlay at Year 0?
b. What are the project™s operating cash ¬‚ows in Years 1, 2, and 3?
c. What are the terminal cash ¬‚ows at the end of Year 3?
d. If the project has average risk, is it expected to be pro¬table?
14.9 The staff of Jefferson Memorial Hospital has estimated the following
net cash ¬‚ows for a satellite food services operation that it may open in
its outpatient clinic:
Chapter 14: The Basics of Capital Budgeting

Year Expected Net Cash Flow
0 ($100,000)
1 30,000
2 30,000
3 30,000
4 30,000
5 30,000
5 (salvage value) 20,000

The Year 0 cash ¬‚ow is the investment cost of the new food service,
while the ¬nal amount is the terminal cash ¬‚ow. (The clinic is expected
to move to a new building in ¬ve years.) All other ¬‚ows represent net
operating cash ¬‚ows. Jefferson™s corporate cost of capital is 10 percent.
a. What is the project™s IRR?
b. Assuming the project has average risk, what is its NPV?
c. Now, assume that the operating cash ¬‚ows in Years 1“5 could be
as low as $20,000 or as high as $40,000. Furthermore, the salvage
value cash ¬‚ow at the end of Year 5 could be as low as $0 or as high
as $30,000. What is the worst case and best case IRR? The worst
case and best case NPV?

1. Within not-for-pro¬t providers, project losses can be offset by contributions and
grants. However, long-run ¬nancial sustainability is best assured by striving for
operating pro¬tability.
2. To emphasize the dif¬culties involved, one manager with a good sense of humor
developed the following principles of capital budgeting cash ¬‚ow estimation:

• It is very dif¬cult to forecast cash ¬‚ows, especially those that occur in the
• Those who live by the crystal ball soon learn how to eat ground glass.
• The moment someone forecasts cash ¬‚ows, they know that they are
wrong”they just don™t know by how much and in what direction.
• If someone makes a correct forecast, never let the bosses forget.
• An expert in cash ¬‚ow estimation is someone who has been right at least

Neither the dif¬culty nor the importance of cash ¬‚ow estimation can be
overstated. However, if the principles discussed in the text are observed, errors
that often arise in the process can be minimized.
3. In most situations, the strategic value of a project stems from managerial
(or real ) options brought about by the project that may or may not be used
(exercised). One way to assess the value of these options is to use option pricing
techniques that were ¬rst developed to value stock options, which confer upon
their holders the right, but not the obligation, to buy or sell a particular stock at
458 Healthcare Finance

a speci¬ed price. For more information, see Eugene F. Brigham and Michael C.
Ehrhardt, Financial Management: Theory and Practice (Ft. Worth, TX: Harcourt
College Publishers, 2002), Chapter 15.
4. As stated in Chapter 2, tax laws are complex and change often. Therefore, this
book does not include a complete discussion of the MACRS system. For more
information, see either the IRS publication pertaining to depreciation or any of
the tax guidebooks available at local bookstores.
5. If Ann Arbor did not have taxable income to offset in Year 2, and had no taxable
income to offset in the three previous years, the loss would have to be carried
forward, and hence the tax bene¬t would not be immediately realized. In this
situation, the tax shield value of the loss would be reduced because it would be
pushed into the future rather than recognized immediately.
6. The discounted payback is a breakeven measure similar to the conventional
payback, except that the cash ¬‚ows in each year are discounted to Year 0 by
the project™s cost of capital (but kept at their original positions on the time
line) prior to calculating the payback. Thus, the discounted payback solves the
conventional payback™s problem of not considering the project™s cost of capital
in the payback calculation.
7. However, when mutually exclusive projects are being analyzed (i.e., two or more
projects are being investigated but only one can be chosen), NPV and IRR
rankings can con¬‚ict”that is, Project A could have the higher NPV, but Project
B could have the higher IRR. In such situations, the NPV method is generally
considered to be the best measure of pro¬tability.
8. For example, the modi¬ed IRR (MIRR) has advantages over the straight IRR,
and the pro¬tability index (PI ) gives decision makers information about a
project™s cost effectiveness (i.e., the project™s bang for the buck). For more
information on MIRR, see Louis C. Gapenski, Understanding Healthcare
Financial Management (Chicago: Health Administration Press, 2003),
Chapter 11.
9. This section is drawn primarily from an article by J. R. C. Wheeler and J. P.
Clement. See “Capital Expenditure Decisions and the Role of the Not-for-Pro¬t
Hospital: An Application of the Social Goods Model,” Medical Care Review
(Winter 1990): 467“486.
10. Not-for-pro¬t providers can use contributions to offset some, or even all, of
any aggregate negative NPV created by the acceptance of projects with positive
social value.

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Learning Objectives
After studying this chapter, readers will be able to:

• Describe the three types of risk relevant to capital budgeting
• Discuss the techniques used in project risk assessment.
• Conduct a project risk assessment.
• Explain how risk is incorporated into the capital budgeting process.

Chapter 14 covered the basics of capital budgeting, including cash ¬‚ow esti-
mation, breakeven analysis, and pro¬tability measures. This chapter extends
the discussion of capital budgeting to include risk analysis, which is composed
of three elements: de¬ning the type of risk relevant to the project, measur-
ing the project™s risk, and incorporating that risk assessment into the capital
budgeting decision process. Although risk analysis is a key element in all ¬nan-
cial decisions, the importance of capital investment decisions to a healthcare
business™s success or failure makes risk analysis vital in such decisions.
The higher the risk associated with an investment, the higher its re-
quired rate of return. This principle is just as valid for healthcare businesses
that make capital expenditure decisions as it is for individuals who make per-
sonal investment decisions. Thus, the ultimate goal in project risk analysis is
to ensure that the cost of capital used as the discount rate in a project™s prof-
itability analysis properly re¬‚ects the riskiness of that project. The corporate
cost of capital, which was covered in detail in Chapter 13, re¬‚ects the cost of
capital to the organization based on its aggregate risk”that is, based on the
riskiness of the ¬rm™s average project. In project risk analysis, a project™s risk
is assessed relative to the ¬rm™s average project: Does the project have average
risk, below-average risk, or above-average risk? The corporate cost of capital
is then adjusted to re¬‚ect any differential risk, resulting in a project cost of
capital. In general, high-risk projects are assigned a project cost of capital that
is higher than the corporate cost of capital, average risk projects are evaluated
at the corporate cost of capital, and low-risk projects are assigned a discount
rate that is less than the corporate cost of capital.
462 Healthcare Finance

Types of Project Risk
Three separate and distinct types of ¬nancial risk can be de¬ned in a capital
budgeting context:

1. Stand-alone risk. Stand-alone risk assumes the project is held in isolation
and hence ignores portfolio effects both within the ¬rm and among equity
2. Corporate risk. This type of risk views the risk of a project within the
context of the ¬rm™s portfolio of projects.
3. Market risk. Market risk views the project from the perspective of a
shareholder who holds a well-diversi¬ed portfolio of stocks.1

The type of risk that is most relevant to a particular capital budgeting deci-
sion depends on the number of projects the business holds and its form of

Stand-Alone Risk
Conceptually, stand-alone risk is only relevant in one situation: when a not-
for-pro¬t ¬rm is evaluating its ¬rst project. In this situation, the project will be
operated in isolation and no portfolio diversi¬cation is present”the business
does not have a collection of different projects nor does it have stockholders
who hold portfolios of stocks of different companies. Although stand-alone
risk is generally not relevant in real-world decision making, the other types
of risk, which are more relevant, are very dif¬cult (if not impossible) to
measure. In practice, most project risk analyses measure stand-alone risk and
then subjective adjustments are applied to convert the project™s assessed stand-
alone risk to either corporate or market risk.
Stand-alone risk is present in a project whenever there is a chance of a
return that is less than the expected return. In effect, a project is risky whenever
its cash ¬‚ows are not known with certainty. Stand-alone risk is measured by
the standard deviation of the project™s pro¬tability, as measured typically by
net present value (NPV) or internal rate of return (IRR), or by the coef¬cient
of variation. The larger the standard deviation or coef¬cient of variation, the
greater the risk.

Corporate Risk
In reality, businesses typically offer a myriad of different products or services in
many different markets and hence can be thought of as having a large num-
ber (i.e., hundreds or even thousands) of individual projects. For example,
MinuteMan Healthcare, a New England HMO, offers healthcare services to
a large number of diverse employee groups in numerous service areas, and
each different group could be considered to be a separate project. In this
situation, the stand-alone risk of a project under consideration by MinuteMan
Chapter 15: Project Risk Assessment and Incorporation

is not relevant because the project will not be held in isolation. The relevant
risk of a new project to MinuteMan is its contribution to the HMO™s overall
risk, or the impact of the project on the variability of the business™s overall
pro¬tability. This type of risk, which is most relevant when the project is part
of a not-for-pro¬t ¬rm™s portfolio of projects, is called corporate risk.
Conceptually, a project™s corporate risk is measured by its corporate
beta, which re¬‚ects the volatility of the project™s pro¬tability relative to that of
the ¬rm as a whole, which has a corporate (aggregate) beta of 1.0. A project
with a corporate beta of 1.5 has returns that are more volatile than the ¬rm™s
average project and hence has high corporate risk. Similarly, a project with
a corporate beta of 0.5 has returns that are less volatile than the aggregate
business and hence has low corporate risk. A project™s corporate risk depends
on the context (i.e., the ¬rm™s other projects), so a project may have high
corporate risk to one ¬rm but low corporate risk to another, particularly when
the two ¬rms operate in widely different industries.

Market Risk
Market risk is generally viewed as the most relevant risk for projects being
evaluated by investor-owned businesses. The goal of shareholder wealth max-
imization implies that a project™s returns, as well as its risk, should be de¬ned
and measured from the shareholders™ perspective. The riskiness of an individ-
ual project, as seen by a well-diversi¬ed shareholder, is not the riskiness of
the project as if it were owned and operated in isolation (which is de¬ned as
stand-alone risk) nor is it the contribution of the project to the riskiness of
the ¬rm (which is de¬ned as corporate risk). Most shareholders hold a large
diversi¬ed portfolio of stocks of many ¬rms, which can be thought of as a
very large diversi¬ed portfolio of individual projects. Thus, the risk of any
single project as seen by a ¬rm™s stockholders is its contribution to the risk-
iness of a well-diversi¬ed stock portfolio, which is measured by the project™s
market beta.
A project™s market beta measures the volatility of the project™s returns
relative to the returns on a well-diversi¬ed portfolio of stocks. To managers
of investor-owned ¬rms, a project™s market risk relative to the market risk of
the ¬rm™s other projects is measured by comparing the project™s market beta
to the ¬rm™s market beta. A project with a market beta higher than the ¬rm™s
market beta has higher-than-average market risk, where average is de¬ned as
the market risk of the ¬rm™s stock.

1. What are the three types of project risk?
2. How is each type of project risk measured, both in absolute and relative
464 Healthcare Finance

Relationships Among Stand-Alone, Corporate, and Market Risk
After discussing the three different types of project risk, and the situations
in which each is relevant, it is tempting to say that stand-alone risk is almost
never important because not-for-pro¬t ¬rms should focus on a project™s cor-
porate risk and investor-owned ¬rms should focus on a project™s market risk.
Unfortunately, the situation is not quite that simple.
First, it is almost impossible in practice to quantify a project™s corporate
or market risk. Fortunately, as will be demonstrated in the next section, it
is possible to get a rough idea of the relative stand-alone risk of a project.
Thus, managers can make statements such as Project A has above-average risk,
Project B has below-average risk, or Project C has average risk, all in the stand-
alone sense. After a project™s stand-alone risk has been assessed, the primary
factor in converting stand-alone risk to either corporate or market risk is
correlation. If a project™s returns are expected to be highly positively correlated
with the ¬rm™s returns, high stand-alone risk translates to high corporate risk.
Similarly, if the ¬rm™s returns are expected to be highly correlated with the
stock market™s returns, high corporate risk translates to high market risk. The
same analogies hold when the project is judged to have average or low stand-
alone risk.
Most projects will be in a ¬rm™s primary line of business. Because
all projects in the same line of business are generally affected by the same
economic factors, such projects™ returns are usually highly correlated. When
this situation exists, a project™s stand-alone risk is a good proxy for its corporate
risk. Furthermore, most projects™ returns are also positively correlated with the
returns on other assets in the economy”most assets have high returns when
the economy is strong and low returns when the economy is weak. When this
situation holds, a project™s stand-alone risk is a good proxy for its market risk.
Thus, for most projects, the stand-alone risk assessment also gives good
insights into a project™s corporate and market risk. The only exception is when
a project™s returns are expected to be independent of or negatively correlated
to the ¬rm™s average project. In these situations, considerable judgment is
required because the stand-alone risk assessment will overstate the project™s
corporate risk. Similarly, if a project™s returns are expected to be independent
of or negatively correlated to the market™s returns, the project™s stand-alone
risk overstates its market risk.2

Self-Test 1. Name and de¬ne the three types of risk relevant to capital budgeting.
Questions 2. How are these risks related?

Risk Analysis Illustration
To illustrate project risk analysis, consider Bayside Memorial Hospital™s evalu-
ation of a new MRI system that was ¬rst presented in Chapter 14. Table 15.1
Chapter 15: Project Risk Assessment and Incorporation

contains the project™s cash ¬‚ow analysis. If all of the project™s component cash
¬‚ows were known with certainty, the project™s projected pro¬tability would
be known with certainty, and hence the project would have no risk. However,
in virtually all project analyses, future cash ¬‚ows and hence pro¬tability are
uncertain and in many cases highly uncertain, so risk is present.
The starting point for analyzing a project™s risk involves estimating
the uncertainty inherent in the project™s cash ¬‚ows. Most of the individual
cash ¬‚ows in Table 15.1 are subject to uncertainty. For example, volume was
projected at 40 scans per week. However, utilization would almost certainly
be higher or lower than the 40 scan forecast. In effect, the volume estimate is
really an expected value taken from some probability distribution of potential
utilization, as are many of the other values listed in Table 15.1.
The nature of the component cash ¬‚ow distributions and their corre-
lations with one another determine the nature of the project™s pro¬tability
distribution and thus the project™s risk. In the following sections, two tech-
niques for assessing a project™s risk are discussed: sensitivity analysis and sce-
nario analysis.3

1. What condition creates project risk?
2. What makes one project riskier than another?

Sensitivity Analysis
Many of the variables that determine a project™s cash ¬‚ows are subject to
some type of probability distribution rather than known with certainty. If
the realized value of such a variable is different from its expected value, the
project™s pro¬tability will differ from its expected value. Sensitivity analysis is
a technique that indicates exactly how much a project™s pro¬tability (NPV or
IRR) will change in response to a given change in a single input variable, with
other things held constant.
Sensitivity analysis begins with a base case developed using expected
values (in the statistical sense) for all uncertain variables. To illustrate, assume
that Bayside™s managers believe that all of the MRI project™s component
cash ¬‚ows are known with certainty except for weekly volume and salvage
value. The expected values for these variables (volume = 40 and salvage
value = $750,000) were used in Table 15.1 to obtain the base case NPV
of $82,493. Sensitivity analysis is designed to provide managers the answers
to such questions as these: What if volume is more or less than the expected
level? What if salvage value is more or less than expected?
In a typical sensitivity analysis, each uncertain variable is changed by a
¬xed percentage amount above and below its expected value, while all other
variables are held constant at their expected values. Thus, all input variables
except one are held at their base case values. The resulting NPVs (or IRRs)
Healthcare Finance
TABLE 15.1
Bayside Memorial Hospital: MRI Site Cash Flow Analysis
Cash Revenues and Costs
0 1 2 3 4 5

1. System cost ($1,500,000)
2. Related expenses (1,000,000)
3. Gross revenues $1,000,000 $1,050,000 $1,102,500 $1,157,625 $ 1,215,506
4. Deductions 250,000 262,500 275,625 289,406 303,877
5. Net revenues $ 750,000 $ 787,500 $ 826,875 $ 868,219 $ 911,630
6. Labor costs 50,000 52,500 55,125 57,881 60,775
7. Maintenance costs 150,000 157,500 165,375 173,644 182,326
8. Supplies 30,000 31,500 33,075 34,729 36,465
9. Incremental overhead 10,000 10,500 11,025 11,576 12,155
10. Depreciation 350,000 350,000 350,000 350,000 350,000
11. Operating income $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
12. Taxes 0 0 0 0 0
13. Net operating income $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
14. Depreciation 350,000 350,000 350,000 350,000 350,000
15. Net salvage value 750,000
16. Net cash ¬‚ow ($2,500,000) $ 510,000 $ 535,500 $ 562,275 $ 590,389 $ 1,369,908

Pro¬tability Measures:
Net present value (NPV) = $82,493.
Internal rate of return (IRR) = 11.1%.
Chapter 15: Project Risk Assessment and Incorporation


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