. 17
( 21)


are recorded and plotted. Table 15.2 contains the NPV sensitivity analysis for
the MRI project, assuming that there are two uncertain variables: volume and
salvage value.
Note that the NPV is a constant $82,493 when there is no change
in any of the variables. This situation occurs because a zero percent change
recreates the base case. Managers can examine the Table 15.2 values to get
a feel for which input variable has the greatest impact on the MRI project™s
NPV”the larger the NPV change for a given percentage input change, the
greater the impact. Such an examination shows that the MRI project™s NPV
is more affected by changes in volume than by changes in salvage value. This
result should be somewhat intuitive because salvage value is a single cash
¬‚ow in the analysis, whereas volume in¬‚uences the cash ¬‚ow in each year of
Often, the results of sensitivity analyses are shown in graphical form.
For example, the Table 15.2 sensitivity analysis is graphed in Figure 15.1.
Here, the slopes of the lines show how sensitive the MRI project™s NPV is to
changes in each of the two uncertain input variables”the steeper the slope, the
more sensitive NPV is to a change in the variable. Note that the sensitivity lines
intersect at the base case values”0 percent change from base case level and
$82,493. Also, spreadsheet models are ideally suited for performing sensitivity
analyses because such models both automatically recalculate NPV when an
input value is changed and facilitate graphing.4
Figure 15.1 vividly illustrates that the MRI project™s NPV is very sen-
sitive to volume but only mildly sensitive to changes in salvage value. If a
sensitivity plot has a negative slope, it indicates that increases in the value
of that input variable decrease the project™s NPV. If two projects were be-
ing compared, the one with the steeper sensitivity lines would be regarded as
riskier because a relatively small error in estimating a variable”for example,
volume”would produce a large error in the project™s projected NPV. If infor-
mation was available on the sensitivity of NPV to input changes for Bayside™s
average project, similar judgments regarding the riskiness of the MRI project
could be made but now relative to the ¬rm™s average project.

TABLE 15.2
Net Present Value (NPV)
Change from MRI Project
Base Case Level Volume Salvage Value Sensitivity
’30% ($814,053) ($ 57,215)
’20 (515,193) (10,646)
’10 216,350 35,923
0 82,493 82,493
+10 381,335 129,062
+20 680,178 175,631
+30 979,020 222,200
468 Healthcare Finance

Analysis Graphs

Although sensitivity analysis is widely used in project risk analysis, it
does have severe limitations. For example, suppose that Bayside Memorial
Hospital had a contract with an HMO that guaranteed a minimum MRI usage
at a ¬xed reimbursement rate. In that situation, the project would not be
very risky at all, in spite of the fact that the sensitivity analysis showed NPV
to be highly sensitive to changes in volume. In general, a project™s stand-
alone risk, which is what is being measured by sensitivity analysis, depends
on both the sensitivity of its pro¬tability to changes in key input variables as
well as the ranges of likely values of these variables. Because sensitivity analysis
considers only the ¬rst factor, it can give misleading results. Furthermore,
sensitivity analysis does not consider any interactions among the uncertain
input variables; it considers each variable independently of the others.
In spite of the shortcomings of sensitivity analysis as a risk measure, it
does provide managers with valuable information. First, it provides pro¬tabil-
ity breakeven information for the project™s uncertain variables. For example,
Table 15.2 and Figure 15.1 show that just a few percent decrease in expected
volume makes the project unpro¬table, whereas the project remains pro¬table
even if salvage value falls by more than 10 percent. Although somewhat rough,
this breakeven information is clearly of value to Bayside™s managers.
Second, sensitivity analysis tells managers which input variables are
Chapter 15: Project Risk Assessment and Incorporation

most critical in the sense that differences between realized and forecasted
values have a large impact on pro¬tability. In this example, volume is clearly the
key input variable of the two being examined, so Bayside™s managers should
ensure that the volume estimate is the best possible. A small overestimate in
volume can make the project seem very attractive ¬nancially when evaluated,
yet the actual results could easily be disappointing. The concept here is that
Bayside™s managers have a limited amount of time to spend on analyzing the
MRI project, so the resources expended should be as productive as possible.

1. Brie¬‚y describe sensitivity analysis?
2. What type of risk does it attempt to measure?
3. What are its strengths and weaknesses?

Scenario Analysis
Scenario analysis is a stand-alone risk analysis technique that considers the
sensitivity of NPV to changes in key variables, the likely range of variable
values, and the interactions among variables. To conduct a scenario analysis,
the managers pick a “bad” set of circumstances (i.e., low volume, low salvage
value, and so on), an average or “most likely” set, and a “good set.” The
resulting input values are then used to create a probability distribution of NPV.
To illustrate scenario analysis, assume that Bayside™s managers regard a
drop in weekly volume below 30 scans as very unlikely, and a volume above
50 is also improbable. On the other hand, salvage value could be as low as
$500,000 or as high as $1 million. The most likely (and expected) values are
40 scans per week for volume and $750,000 for salvage value. Thus, volume
of 30 and a $500,000 salvage value de¬ne the lower bound, or worst case
scenario, while volume of 50 and a salvage value of $1 million de¬ne the
upper bound, or best case scenario.
Bayside can now use the worst, most likely, and best case values for the
input variables to obtain the NPV that corresponds to each scenario. Bayside™s
managers used a spreadsheet model to conduct the analysis, and Table 15.3
summarizes the results. The most likely (base) case results in a positive NPV;
the worst case produces a negative NPV; and the best case results in a very
large, positive NPV. These results can now be used to determine the expected
NPV and standard deviation of NPV. For this, an estimate is needed of the
probabilities of occurrence of the three scenarios. Suppose that Bayside™s man-
agers estimate that there is a 20 percent chance of the worst case occurring, a
60 percent chance of the most likely case, and a 20 percent chance of the best
case. Of course, it is very dif¬cult is to estimate scenario probabilities with any
Table 15.3 contains a discrete distribution of returns, so the expected
NPV can be found as follows:
470 Healthcare Finance

Expected NPV = (0.20 — [’$819,844]) + (0.60 — $82,493) + (0.20 — $984,829)
= $82,493.

The expected NPV in the scenario analysis is the same as the base case NPV,
$82,493. The consistency of results occurs because the values of the uncertain
variables used in the scenario analysis”30, 40, and 50 scans for volume and
$500,000, $750,000, and $1,000,000 for salvage value”when coupled with
the scenario probabilities produce the same expected values that were used
in the Table 15.1 base case analysis. If inconsistencies exist between the base
case NPV and the expected NPV in the scenario analysis, the two analyses
have inconsistent input value assumptions.
Using the distribution of NPVs, we can calculate the standard devia-

σNPV = [0.20 — (’$819,844 ’ $82,493)2 + 0.60 — ($82,493 ’ $82,493)2
+ 0.20 — ($984,829 ’ $82,493)2 ]1/2
= $570,688.
The standard deviation of NPV measures the MRI project™s stand-alone risk.
Bayside™s managers can compare the standard deviation of NPV of this project
with the uncertainty inherent in Bayside™s aggregate cash ¬‚ows, or average
project. Often, the coef¬cient of variation (CV) is used to measure the stand-
alone risk of a project: CV = σ NPV / E(NPV) = $570,688 / $82,493 = 6.9
for the MRI project. The CV measures the risk per unit of return and hence
is a better measure of comparative risk than the standard deviation, especially
when projects have widely differing NPVs. If Bayside™s average project has
a CV of 4.0, the MRI project would be judged to be riskier than the ¬rm™s
average project, so it would be classi¬ed as a high-risk project.
Scenario analysis can also be interpreted in a less mathematical way. The
worst case NPV, a loss of about $800,000 for the MRI project, represents
an estimate of the worst possible ¬nancial consequences of the project. If
Bayside can absorb such a loss in value without much impact on its ¬nancial
condition, the project does not represent a signi¬cant ¬nancial danger to the

TABLE 15.3
Probability of
MRI Project
Scenario Outcome Volume Salvage Value NPV
Scenario Analysis

Worst case 0.20 30 $ 500,000 ($819,844)
Most likely case 0.60 40 750,000 82,493
Best case 0.20 50 1,000,000 984,829
Expected value 40 $ 750,000 $ 82,493
Standard deviation $570,688
Chapter 15: Project Risk Assessment and Incorporation

hospital. Conversely, if such a loss would mean ¬nancial ruin for the hospital,
its managers might be unwilling to undertake the project, regardless of its
pro¬tability under the most likely and best case scenarios.
While scenario analysis provides useful information about a project™s
stand-alone risk, it is limited in two ways. First, it only considers a few states
of the economy and hence provides information on only a few potential
pro¬tability outcomes for the project. In reality, an almost in¬nite number
of possibilities exist. Although the illustrative scenario analysis contained only
three scenarios, it could be expanded to include more states of the economy”
say, ¬ve or seven. However, there is a practical limit on how many scenarios
can be included in a scenario analysis.
Second, scenario analysis, at least as normally conducted, implies a
very de¬nite relationship among the uncertain variables; that is, the analysis
assumed that the worst value for volume (30 scans per week) would occur
at the same time as the worst value for salvage value ($500,000) because
the worst case scenario was de¬ned by combining the worst possible value of
each uncertain variable. Although this relationship (all worst values occurring
together) may hold in some situations, it may not hold in others. For example,
if volume is low, maybe the MRI will have less wear and tear and hence
be worth more after ¬ve years of use. The worst value for volume, then,
should be coupled with the best salvage value. Conversely, poor volume may
be symptomatic of poor medical effectiveness of the MRI and hence lead to
limited demand for used equipment and a low salvage value. Scenario analysis
tends to create extreme pro¬tability values for the worst and best cases because
it automatically combines all worst and best input values, even if these values
actually have only a remote chance of occurring together.5
A word of warning regarding the relationship between pro¬tability
and risk analyses is in order here. When conducting a scenario analysis, it is
natural to consider both the resulting pro¬tability (NPV in the illustration)
and risk. However, it is possible for inconsistencies in the input variable as-
sumptions to cause the expected NPV from the scenario analysis to differ
from the base case NPV. A scenario analysis is conducted for the sole pur-
pose of assessing a project™s stand-alone risk. A scenario analysis is not
conducted to estimate a project™s pro¬tability. Thus, once the risk determina-
tion has been made (for example, the MRI project was judged to have high
risk), the scenario analysis plays no further role in the project evaluation. As
we will discuss in a later section, the project risk determination feeds back
into the base case analysis to make the ¬nal judgment regarding the project™s
¬nancial worthiness.

1. Brie¬‚y describe scenario analysis.
2. What type of risk does it attempt to measure?
3. What are its strengths and weaknesses?
472 Healthcare Finance

A Subjective Approach to Risk Assessment
In some situations, perhaps in many, it is very dif¬cult to conduct a numerical
risk assessment”the numbers are just too uncertain. In such situations, rather
than ignore differential risk, some healthcare businesses use a more subjective
approach. For example, one large healthcare clinic uses the following ques-
tions to qualitatively assess project risk.

• Does the project require additional market share or represent a new
service initiative?
• Is the project outside of the scope of current management expertise?
• Does the project require dif¬cult to recruit technical specialists?
• Will the project place us in competition with a strong competitor?
• Does the project require the use of new, unproven technology?

To assess project risk, each yes answer is assigned one point. If the project
has zero points, it is judged to have low risk. If it has one or two points, it is
judged to have average risk, while a score of three or more points indicates
high risk.
Although such a subjective approach initially appears to have little
theoretical foundation, a closer examination reveals that each question in the
above list is tied to cash ¬‚ow uncertainty. Thus, the greater the number of
“yes” answers, the greater the cash ¬‚ow uncertainty and hence the greater the
stand-alone risk of the project.

Self-Test 1. Describe how a qualitative approach can be used to assess project risk.

Incorporating Risk Into the Decision Process
Thus far, the MRI illustration has demonstrated that it is dif¬cult to quantify
a project™s riskiness. It may be possible to reach the general conclusion that
one project is more or less risky than another or to compare the riskiness of
a project with the ¬rm as a whole, but it is dif¬cult to develop a really good
measure of project risk. This lack of precision in measuring project risk adds
to the dif¬culties involved in incorporating differential risk into the capital
budgeting decision.
There are two methods for incorporating project risk into the capital
budgeting decision process: (1) the certainty equivalent method, in which a
project™s expected cash ¬‚ows are adjusted to re¬‚ect project risk, and (2) the
risk-adjusted discount rate method, in which differential risk is dealt with by
changing the cost of capital. Although the risk-adjusted discount rate method
is used by most businesses, the certainty equivalent method does have some
Chapter 15: Project Risk Assessment and Incorporation

theoretical advantages. Furthermore, it raises some interesting issues related
to the risk-adjustment process.

The Certainty Equivalent Method
The certainty equivalent (CE) method follows directly from the economic
concept of utility.6 Under the CE approach, managers must ¬rst evaluate a
cash ¬‚ow™s risk, and then specify how much money, with certainty, would be
required to be indifferent between the riskless (certain) sum and the risky
cash ¬‚ow™s expected value. To illustrate, suppose that a rich eccentric offered
someone the following two choices:

1. Flip a coin. If it™s a head, the individual wins $1 million; if it™s a tail, he or
she gets nothing. The expected value of the gamble is (0.5 — $1,000,000)
+ (0.5 — $0) = $500,000, but the actual outcome will be either zero or
$1 million, so the gamble is quite risky.
2. Do not ¬‚ip the coin. Simply pocket $400,000 in cash.

If the individual is indifferent to the two alternatives, $400,000 is de-
¬ned to be his or her certainty equivalent because the riskless $400,000 pro-
vides that individual with the same satisfaction (utility) as the risky $500,000
expected return. In general, investors are risk averse, so the certainty equiv-
alent amount for this gamble will be something less than the $500,000 ex-
pected value. But, each individual would have his or her own certainty equiv-
alent value”the greater the individual™s degree of risk aversion, the lower the
certainty equivalent amount.
The CE concept can be applied to capital budgeting decisions, at least
in theory, in this way:

• Convert each net cash ¬‚ow of a project to its certainty equivalent value.
Here, the riskiness of each cash ¬‚ow is assessed, and a certainty equivalent
cash ¬‚ow is chosen on the basis of that risk. The greater the risk, the
greater the difference between the cash ¬‚ow™s expected value and its lower
certainty equivalent value. (If a cash out¬‚ow is being adjusted, the certainty
equivalent value is higher than the expected value. The unique risk
adjustments required on cash out¬‚ows will be discussed in a later section.)
• Once each cash ¬‚ow is expressed as a certainty equivalent, discount
the project™s certainty equivalent cash ¬‚ow stream by the risk-free
rate to obtain the project™s differential risk-adjusted NPV.7 Here, the term
“differential risk-adjusted” implies that the unique riskiness of the project,
as compared to the overall riskiness of the business, has been incorporated
into the decision process. The risk-free rate is used as the discount rate
because certainty equivalent cash ¬‚ows are analogous to risk-free cash ¬‚ows.
• A positive differential risk-adjusted NPV indicates that the project is
pro¬table even after adjusting for differential project risk.
474 Healthcare Finance

The CE method is simple and neat. Furthermore, it can easily handle
differential risk among the individual net cash ¬‚ows. For example, the ¬nal
year™s certainty equivalent cash ¬‚ow might be adjusted downward an addi-
tional amount to account for salvage value risk if that risk is considered to be
greater than the risk inherent in the operating cash ¬‚ows.
Unfortunately, there is no practical way to estimate a risky cash ¬‚ow™s
certainty equivalent value. There is no benchmark available to help make the
estimate, so each individual would have his or her own estimate, and these
could vary signi¬cantly. Also, the risk assessment techniques”for example,
scenario analysis”focus on pro¬tability and hence measure the stand-alone
risk of a project in its entirety. This process provides no information about the
riskiness of individual cash ¬‚ows, so there is no basis for adjusting each cash
¬‚ow for its own unique risk.

The Risk-Adjusted Discount Rate Method
In the risk-adjusted discount rate (RADR) method, expected cash ¬‚ows are
used in the valuation process, and the risk adjustment is made to the discount
rate (the opportunity cost of capital). All average-risk projects are discounted
at the ¬rm™s corporate cost of capital, which represents the opportunity cost
of capital for average-risk projects; high-risk projects are assigned a higher cost
of capital; and low-risk projects are discounted at a lower cost of capital.
One advantage of the RADR method is that the process has a starting
benchmark”the ¬rm™s corporate cost of capital. This discount rate re¬‚ects the
riskiness of the business in the aggregate, or the riskiness of the ¬rm™s average
project. Another advantage is that project risk assessment techniques identify
a project™s aggregate risk”the combined risk of all of the cash ¬‚ows”and the
RADR applies a single adjustment to the cost of capital rather than attempt-
ing to adjust individual cash ¬‚ows. However, the disadvantage is that there
typically is no theoretical basis for setting the size of the RADR adjustment,
so the amount of adjustment remains a matter of judgment.
The RADR method has one additional disadvantage. It combines the
factors that account for time value (the risk-free rate) and the adjustment for
risk (the risk premium): Project cost of capital = Differential risk-adjusted
discount rate = Risk-free rate + Risk premium. The CE approach, on the
other hand, keeps risk adjustment and time value separate: time value is ac-
counted for in the discount rate and risk is accounted for in the cash ¬‚ows.
By lumping together risk and time value, the RADR method compounds the
risk premium over time”just as interest compounds over time, so does the
risk premium. This compounding of the risk premium means that the RADR
method automatically assigns more risk to cash ¬‚ows that occur in the distant
future, and the farther into the future, the greater the implied risk. Because
the CE method assigns risk to each cash ¬‚ow individually, it does not impose
any assumptions regarding the relationship between risk and time.
The RADR method, with a constant discount rate applied to all cash
Chapter 15: Project Risk Assessment and Incorporation

¬‚ows of a project, implies that risk increases with time. This imposes a greater
burden on long-term projects, so, all else the same, short-term projects will
tend to look better ¬nancially than long-term projects. For most projects, the
assumption of increasing risk over time is probably reasonable because cash
¬‚ows are more dif¬cult to forecast the farther one moves into the future.
However, managers should be aware that the RADR approach automatically
penalizes distant cash ¬‚ows, and an additional explicit penalty based solely
on cash ¬‚ow timing is probably not warranted unless some speci¬c additional
source of risk can be identi¬ed.

1. What are the differences between the certainty equivalent (CE) and
risk-adjusted discount rate (RADR) methods for risk incorporation?
2. What assumptions about time and risk are inherent in the RADR

Making the Final Decision
In most project risk analyses, it is impossible to assess quantitatively the
project™s corporate or market risk, so managers are left with only an assess-
ment of the project™s stand-alone risk. However, like the MRI project, most
projects being evaluated are in the same line of business as the ¬rm™s other
projects. Furthermore, the pro¬tability of most businesses is driven by the
national economy. Thus, stand-alone, corporate, and market risk are usually
highly correlated. This suggests that managers can get a feel for the relative
risk of most projects on the basis of the scenario analysis conducted to assess
the project™s stand-alone risk. In Bayside™s case, its managers concluded that
the MRI project has above-average risk, and hence the project was categorized
as a high-risk project.
The business™s corporate cost of capital provides the basis for estimating
a project™s differential risk-adjusted discount rate”average-risk projects are
discounted at the corporate cost of capital, high-risk projects are discounted
at a higher cost of capital, and low-risk projects are discounted at a rate below
the corporate cost of capital. Unfortunately, there is no good way of specifying
exactly how much higher or lower these discount rates should be. Given
the present state of the art, risk adjustments are necessarily judgmental and
somewhat arbitrary.
Bayside™s standard procedure is to add 4 percentage points to its 10
percent corporate cost of capital when evaluating high-risk projects, and to
subtract 2 percentage points when evaluating low-risk projects. Thus, to esti-
mate the high-risk MRI project™s differential risk-adjusted NPV, the project™s
expected (base case) cash ¬‚ows shown in Table 15.1 are discounted at 10%
+ 4% = 14%. This rate is called the project cost of capital, as opposed to the
corporate cost of capital, because it re¬‚ects the risk characteristics of a speci¬c
476 Healthcare Finance

project rather than the aggregate risk characteristics of the business (or average
project). The resultant NPV is ’$200,017, so the project becomes unprof-
itable when the analysis is adjusted to re¬‚ect its high risk. Bayside™s managers
may still decide to go ahead with the MRI project for other reasons, but at
least they know that its expected pro¬tability is not suf¬cient to make up for
its riskiness.

Self-Test 1. How do most ¬rms incorporate differential risk in the capital budgeting
Questions decision process?
2. Is the risk adjustment objective or subjective?
3. What is a project cost of capital ?

Adjusting Cash Out¬‚ows for Risk
Some projects are evaluated on the basis of minimizing the present value
of future costs rather than on the basis of the project™s NPV. This is done
because it is often impossible to allocate revenues to a particular project, and
it is easier to focus on comparative costs when two projects will produce the
same revenue stream. For example, suppose that Bayside Memorial Hospital
must choose one of two ways for disposing of its medical wastes. There is no
question about the need for the project, and the hospital™s revenue stream is
unaffected by which method is chosen. In this case, the decision will be based
on the present value of expected future costs”the method with the lower
present value of costs will be chosen.
Table 15.4 contains the projected annual costs associated with each
method. The in-house system would require a large expenditure at Year 0 to
upgrade the hospital™s current disposal system, but the yearly operating costs
are relatively low. Conversely, if Bayside contracts for disposal services with an
outside contractor, it will only have to pay only $25,000 up-front to initiate
the contract. However, the annual contract fee would be $200,000 a year.8
If both methods were judged to have average risk, then Bayside™s cor-
porate cost of capital, 10 percent, would be applied to the cash ¬‚ows to obtain
the present value (PV) of costs for each method. Because the PVs of costs
for the two waste disposal systems ($784,309 for the in-house system and
$783,157 for the contract method) are roughly equal, on the basis solely of ¬-
nancial considerations, Bayside™s managers are indifferent as to which method
should be chosen.
However, Bayside™s managers believe that the contract method is much
riskier than the in-house method. The cost of modifying the current system is
known almost to the dollar, and operating costs can be predicted fairly well.
Furthermore, with the in-house system, operating costs are under the control
of Bayside™s management. Conversely, if Bayside relies on the contractor for
waste disposal, the hospital is more or less stuck with continuing the contract
Chapter 15: Project Risk Assessment and Incorporation

TABLE 15.4
Year In-House System Outside Contract
0 ($500,000) ($ 25,000)
Hospital: Waste
1 (75,000) (200,000)
Disposal Analysis
2 (75,000) (200,000)
3 (75,000) (200,000)
4 (75,000) (200,000)
5 (75,000) (200,000)
Present Value of Costs
at a Discount Rate of:
10% ($784,309) ($783,157)
14% ” ($711,616)
6% ” ($867,473)

because it will not have the in-house capability. Because the contractor was
only willing to guarantee the price for one year, perhaps the bid was low-
balled, and large price increases will occur in future years. The two methods
have about the same PV of costs when both are considered to have average
risk, so which method should be chosen if the contract method is judged to
have high risk? Clearly, if the costs are the same under a common discount
rate, the lower-risk in-house project should be chosen.
Now, try to incorporate this intuitive differential risk conclusion into
the quantitative analysis. Conventional wisdom is to increase the corporate
cost of capital for high-risk projects, so the contract cash ¬‚ows would be
discounted using a project cost of capital of 14 percent, which is the rate that
Bayside applies to high-risk projects. But at a 14 percent discount rate, the
contract method has a PV of costs of only $711,616, which is about $70,000
lower than that for the in-house method. If the discount rate was increased to
20 percent on the contract method, it would appear to be $161,000 cheaper
than the in-house method. Thus, the riskier the contract method is judged to
be, the better it looks.
Something is obviously wrong here. To penalize a cash out¬‚ow for
higher-than-average risk, that out¬‚ow must have a higher present value, not
a lower one. Therefore, a cash out¬‚ow that has higher-than-average risk
must be evaluated with a lower-than-average cost of capital. Recognizing this,
Bayside™s managers actually applied a 10% ’ 4% = 6% discount rate to the
high-risk contract method™s cash ¬‚ows. This produces a PV of costs for the
contract method of $867,473, which is about $83,000 more than the PV of
costs for the average-risk in-house method.
The appropriate risk adjustment for cash out¬‚ows is also applicable to
other situations. For example, the City of Detroit offered Ann Arbor Health
Systems the opportunity to use a city-owned building in one of the city™s
blighted areas for a walk-in clinic. The city offered to pay to refurbish the
building, and all pro¬ts made by the clinic would accrue to Ann Arbor.
478 Healthcare Finance

However, after ten years, Ann Arbor would have to buy the building from
the city at the then current-market value. The market value estimate that
Ann Arbor used in its analysis was $1,000,000, but the realized cost could
be much greater, or much less, depending on the economic condition of the
neighborhood at that time. The project™s other cash ¬‚ows were of average
risk, but this single out¬‚ow had high risk, so Ann Arbor lowered the discount
rate that it applied to this one cash ¬‚ow. This action created a higher present
value on a cost (out¬‚ow) and hence lowered the project™s NPV.

Self-Test 1. Why are some projects evaluated on the basis of present value of costs?
Questions 2. Is there any difference between the risk adjustments applied to cash
in¬‚ows and cash out¬‚ows? Explain your answer.
3. Can differential risk adjustments be made to single cash ¬‚ows or must
the same adjustment be made to all of a project™s cash ¬‚ows?

Subsidiary Costs of Capital
In theory, project costs of capital should re¬‚ect both a project™s differential
risk and its differential debt capacity. The logic here is that if a project™s optimal
¬nancing mix is signi¬cantly different from the business in the aggregate, then
the weights used in estimating the corporate cost of capital do not re¬‚ect the
weights appropriate to the project. Because of the dif¬culties encountered
in estimating a project™s debt capacity (its optimal capital structure), such
adjustments are rarely made in practice.
Even though it is not common to make capital structure adjustments
for individual projects, ¬rms often make both capital structure and risk adjust-
ments when developing subsidiary costs of capital. To illustrate, a for-pro¬t
healthcare system might have one subsidiary that invests primarily in real es-
tate for medical uses and another subsidiary that runs an HMO. Clearly, each
subsidiary has its own unique business risk and optimal capital structure. The
low-risk, high debt capacity real estate subsidiary could have a cost of capital
of 10 percent, while the high-risk, low debt capacity HMO subsidiary could
have a cost of capital of 14 percent. The health system itself, which consists
of 50 percent real estate assets and 50 percent HMO assets, would have a
corporate cost of capital of 12 percent.
If all capital budgeting decisions within the system were made on the
basis of the overall system™s 12 percent cost of capital, the process would be
biased in favor of the higher-risk HMO subsidiary. The cost of capital would
be too low for the HMO subsidiary and too high for the real estate subsidiary.
Over time, this cost of capital bias would result in too many HMO projects
being accepted and too few real estate projects, which would skew the business
line mix toward HMO assets and hence increase the overall riskiness of the
¬rm. The solution to the cost of capital bias problem is to use subsidiary
Chapter 15: Project Risk Assessment and Incorporation

costs of capital, rather than the overall corporate cost of capital, in the capital
budgeting decision process.
Unlike individual project costs of capital, subsidiary costs of capital
often can be estimated with some con¬dence because it is usually possible
to identify publicly traded ¬rms that are predominantly in the same line of
business as the subsidiary. For example, the cost of capital for the HMO sub-
sidiary could be estimated by looking at the debt and equity costs and capital
structures of the major for-pro¬t HMOs such as Humana and United Health
Group. With such market data at hand, it is relatively easy to develop sub-
sidiary costs of capital. As a ¬nal check, the weighted average of the subsidiary
costs of capital should equal the ¬rm™s corporate cost of capital.

1. In theory, should project cost of capital estimates include capital
structure effects?
2. Should all subsidiaries of a ¬rm use the ¬rm™s corporate cost of capital
as the benchmark rate in making capital budgeting decisions?
3. How might a business go about estimating its subsidiary costs of

An Overview of the Capital Budgeting Decision Process
The discussion of capital budgeting thus far has focused on how managers
evaluate individual projects. For capital planning purposes, health services
managers also need to forecast the total number of projects that will be
undertaken and the dollar amount of capital needed to fund these projects.
The list of projects to be undertaken is called the capital budget, and the
optimal selection of new projects is called the optimal capital budget.
While every healthcare provider estimates its optimal capital budget in
its own unique way, some procedures are common to all ¬rms. The procedures
followed by Seattle Health System are used to illustrate the process:

• The chief ¬nancial of¬cer (CFO) estimates the system™s corporate cost of
capital. As discussed in Chapter 13, this estimate depends on market
conditions, the business risk of the system™s assets in the aggregate, and its
optimal capital structure.
• The CFO then scales the corporate cost of capital up or down to re¬‚ect
the unique risk and capital structure features of each division. To illustrate,
assume that the system has three divisions. For simplicity, the divisions are
identi¬ed as LRD, ARD, and HRD, which stand for low-risk, average-risk,
and high-risk divisions.
• Managers within each of the divisions evaluate the riskiness of the
proposed projects within their divisions; categorizing each project as
having low risk (LRP), average risk (ARP), or high risk (HRP). These
480 Healthcare Finance

project risk classi¬cations are based on the riskiness of each project relative
to the other projects in the division, not to the system in the aggregate.
• Each project is then assigned a project cost of capital that is based on the
divisional cost of capital and the project™s relative riskiness within that
division. As discussed previously, this project cost of capital is then used to
discount the project™s expected net cash ¬‚ows. From a ¬nancial
standpoint, all projects with positive NPVs are acceptable, while those with
negative NPVs should be rejected. Subjective factors are also considered,
and these factors may result in an optimal capital budget that differs from
the one established solely on the basis of ¬nancial considerations.

Figure 15.2 summarizes Seattle Health System™s overall capital budget-
ing process. It uses the same adjustment amounts as does Bayside: 4 percent-
age points for high risk and two percentage points for low risk. Thus, the cor-
porate cost of capital is adjusted upward to 14 percent in the high-risk division
and downward to 8 percent in the low-risk division. The same adjustment”
4 percentage points upward for high-risk projects and 2 percentage points
downward for low-risk projects”is applied to differential risk projects within
each division. The end result is a range of project costs of capital within the
system that runs from 18 percent for high-risk projects in the high-risk division
to 6 percent for low-risk projects in the low-risk division.
This process creates a capital budget that incorporates each project™s
debt capacity (at least at the divisional level) and riskiness. However, managers

Seattle Health
System: Project
Costs of Capital
Chapter 15: Project Risk Assessment and Incorporation

also must consider other possible risk factors that may not have been included
in the quantitative analysis. For example, could a project under considera-
tion signi¬cantly increase the system™s liability exposure? Conversely, does the
project have any strategic value or social value or other attributes that could
affect its pro¬tability? Such additional factors must be considered, at least sub-
jectively, before a ¬nal decision can be made. Typically, if the project involves
new products or services and is large (in capital requirements) relative to the
size of the ¬rm™s average project, then the additional subjective factors will be
very important to the ¬nal decision; one large mistake can bankrupt a ¬rm,
and “bet the company” decisions are not made lightly. On the other hand, the
decision on a small replacement project would be made mostly on the basis
of numerical analysis.
Ultimately, capital budgeting decisions require an analysis of a mix of
objective and subjective factors such as risk, debt capacity, pro¬tability, med-
ical staff needs, and social value. The process is not precise, and often there
is a temptation to ignore one or more important factors because they are so
nebulous and dif¬cult to measure. Despite the imprecision and subjectivity, a
project™s risk, as well as its other attributes, should be assessed and incorpo-
rated into the capital budgeting decision process.

1. Describe a typical capital budgeting decision process.
2. Are decisions made solely on the basis of quantitative factors? Explain
your answer.

Capital Rationing
Standard capital budgeting procedures assume that businesses can raise virtu-
ally unlimited amounts of capital to meet capital budgeting needs. Presum-
ably, as long as a business is investing the funds in pro¬table (i.e., positive
NPV) projects, it should be able to raise the debt and equity needed to fund
all worthwhile projects. Additionally, standard capital budgeting procedures
assume that a business raises the capital needed to ¬nance its optimal capital
budget roughly in accordance with its target capital structure.
This picture of a ¬rm™s capital ¬nancing/capital investment process is
probably appropriate for most investor-owned ¬rms. However, not-for-pro¬t
¬rms do not have unlimited access to capital. Their equity capital is limited
to retentions, contributions, and grants, and their debt capital is limited to
the amount supported by the equity capital base. Thus, it is likely that not-
for-pro¬t ¬rms, and even investor-owned ¬rms on occasion, will face periods
in which the capital needed for investment in new projects will exceed the
amount of capital available. This situation is called capital rationing.
If capital rationing exists, and hence the business has more acceptable
projects than capital, then, from a ¬nancial perspective, the ¬rm should
482 Healthcare Finance

accept that set of capital projects that maximizes aggregate NPV and still meets
the capital constraint. This approach could be called “getting the most bang
for the buck” because it picks those projects that have the most positive impact
on the ¬rm™s ¬nancial condition.9 In healthcare businesses, priority may be
assigned to some low or even negative NPV projects. This is ¬ne as long as
these projects are offset by the selection of pro¬table projects, which would
prevent the low-pro¬tability priority projects from eroding the ¬rm™s ¬nancial

Self-Test 1. What is capital rationing?
Questions 2. From a ¬nancial perspective, how are projects chosen when capital
rationing exists?

Key Concepts
This chapter, which continued the discussion of capital budgeting started in
Chapter 14, focused on risk assessment and incorporation. The key concepts
of this chapter are:
• Three separate and distinct types of project risk can be identi¬ed and
de¬ned: (1) stand-alone risk, (2) corporate risk, and (3) market risk.
• A project™s stand-alone risk is the relevant risk if it were the sole project of
a not-for-pro¬t ¬rm. It is a function of the project™s pro¬t uncertainty and
is generally measured by the standard deviation of NPV. Stand-alone risk
is often used as a proxy for both corporate and market risk because (1)
corporate and market risk are often impossible to measure and (2) the
three types of risk are usually highly correlated.
• Corporate risk re¬‚ects the contribution of a project to the overall riskiness
of the business. Corporate risk ignores stockholder diversi¬cation, so it is
the relevant risk for most not-for-pro¬t ¬rms.
• Market risk re¬‚ects the contribution of a project to the overall riskiness of
stockholders™ well-diversi¬ed portfolios. In theory, market risk is the
relevant risk for investor-owned ¬rms, but many people argue that
corporate risk is also relevant to stockholders, and it is certainly relevant to
a ¬rm™s other stakeholders.
• Two techniques are commonly used to assess a project™s stand-alone risk:
(1) sensitivity analysis and (2) scenario analysis.
• Sensitivity analysis shows how much a project™s pro¬tability”for example,
as measured by NPV”changes in response to a given change in an input
variable such as volume, with other things held constant.
• Scenario analysis de¬nes a project™s best, most likely, and worst cases and
then uses these data to measure its stand-alone risk.
• In many situations, it is impractical to conduct a quantitative project risk
Chapter 15: Project Risk Assessment and Incorporation

assessment. In such situations, many healthcare businesses use a
qualitative approach to risk assessment.
• Projects are generally classi¬ed as high risk, average risk, or low risk on the
basis of their stand-alone risk assessment. High-risk projects are evaluated
at a project cost of capital that is greater than the ¬rm™s corporate cost of
capital. Average-risk projects are evaluated at the ¬rm™s corporate cost of
capital, while low-risk projects are evaluated at a rate less than the
corporate cost of capital.
• If a large organization has several divisions that operate in different
business lines, it is best to estimate and use divisional costs of capital as the
starting point in a project analysis.
• When evaluating risky cash out¬‚ows, the risk adjustment process is
reversed”that is, lower rates are used to discount more risky cash ¬‚ows.
• Capital rationing occurs when a business does not have access to
suf¬cient capital to fund all pro¬table projects. Under such conditions, the
best ¬nancial outcome results from accepting the set of projects that has
the highest aggregate NPV.
• Ultimately, capital budgeting decisions require an analysis of a mix of
objective and subjective factors such as risk, debt capacity, pro¬tability,
medical staff needs, and service to the community. The process is not
precise, but good managers do their best to ensure that none of the
relevant factors are ignored.

This chapter concludes our discussion of capital investment decisions. The
next chapter examines current asset management and ¬nancing.

15.1 a. Why is risk analysis so important to the capital budgeting process?
b. Describe the three types of project risk. Under what situation is each
of the types most relevant to the capital budgeting decision?
c. Which type of risk is easiest to measure in practice?
d. Are the three types of project risk usually highly correlated? Explain
your answer.
e. Why is the correlation among project risk measures important?
15.2 a. Brie¬‚y describe sensitivity analysis.
b. What are its strengths and weaknesses?
15.3 a. Brie¬‚y describe scenario analysis.
b. What are its strengths and weaknesses?
15.4 a. How is project risk incorporated into a capital budgeting analysis?
b. Suppose that two mutually exclusive projects are being evaluated on
the basis of cash costs. How would risk adjustments be applied in
this situation?
484 Healthcare Finance

15.5 What is the difference between the corporate cost of capital and a
project cost of capital?
15.6 What is meant by the term capital rationing ? From a purely ¬nancial
standpoint, what is the optimal capital budget under capital rationing?
15.7 Santa Roberta Clinic has estimated its corporate cost of capital to be
11 percent. What are reasonable values for the project costs of capital
for low-risk, average-risk, and high-risk projects?
15.8 Under what conditions should a business estimate divisional costs of

15.1 The managers of Merton Medical Clinic are analyzing a proposed
project. The project™s most likely NPV is $120,000, but, as evidenced
by the following NPV distribution, there is considerable risk involved:

Probability NPV
0.05 ($700,000)
0.20 (250,000)
0.50 120,000
0.20 200,000
0.05 300,000

a. What are the project™s expected NPV and standard deviation of
b. Should the base case analysis use the most likely NPV or expected
NPV? Explain your answer.
15.2 Heywood Diagnostic Enterprises is evaluating a project with the
following net cash ¬‚ows and probabilities:
Year Prob = 0.2 Prob = 0.6 Prob = 0.2
0 ($100,000) ($100,000) ($100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 30,000 40,000 50,000

The Year 5 values include salvage value. Heywood™s corporate cost of
capital is 10 percent.
a. What is the project™s expected (i.e., base case) NPV assuming
average risk? (Hint: The base case net cash ¬‚ows are the expected
cash ¬‚ows in each year.)
b. What are the project™s most likely, worst, and best case NPVs?
c. What is the project™s expected NPV on the basis of the scenario
d. What is the project™s standard deviation of NPV?
Chapter 15: Project Risk Assessment and Incorporation

e. Assume that Heywood™s managers judge the project to have
lower-than-average risk. Furthermore, the company™s policy is to
adjust the corporate cost of capital up or down by 3 percentage
points to account for differential risk. Is the project ¬nancially
15.3 Consider the project contained in Problem 14.7 in Chapter 14.
a. Perform a sensitivity analysis to see how NPV is affected by changes
in the number of procedures per day, average collection amount,
and salvage value.
b. Conduct a scenario analysis. Suppose that the hospital™s staff
concluded that the three most uncertain variables were number of
procedures per day, average collection amount, and the equipment™s
salvage value. Furthermore, the following data were developed:
Number of Average Equipment
Scenario Probability Procedures Collection Salvage Value
Worst 0.25 10 $ 60 $100,000
Most likely 0.50 15 80 200,000
Best 0.25 20 100 300,000

c. Finally, assume that California Health Center™s average project has
a coef¬cient of variation of NPV in the range of 1.0“2.0. (Hint:
Coef¬cient of variation is de¬ned as the standard deviation of
NPV divided by the expected NPV.) The hospital adjusts for risk
by adding or subtracting 3 percentage points to its 10 percent
corporate cost of capital. After adjusting for differential risk, is the
project still pro¬table?
d. What type of risk was measured and accounted for in Parts b and c?
Should this be of concern to the hospital™s managers?
15.4 The managers of United Medtronics are evaluating the following four
projects for the coming budget period. The ¬rm™s corporate cost of
capital is 14 percent.
Project Cost IRR
A $15,000 17%
B 15,000 16
C 12,000 15
D 20,000 13

a. What is the ¬rm™s optimal capital budget?
b. Now, suppose Medtronics™s managers want to consider differential
risk in the capital budgeting process. Project A has average risk, B
has below-average risk, C has above-average risk, and D has average
risk. What is the ¬rm™s optimal capital budget when differential
risk is considered? (Hint: The ¬rm™s managers lower the IRR of
high-risk projects by 3 percentage points and raise the IRR of
low-risk projects by the same amount.)
486 Healthcare Finance

15.5 Allied Managed Care Company is evaluating two different computer
systems for handling provider claims. There are no incremental
revenues attached to the projects, so the decision will be made on the
basis of the present value of costs. Allied™s corporate cost of capital is 10
percent. Here are the net cash ¬‚ow estimates in thousands of dollars:

Year System X System Y
0 ($500) ($1,000)
1 (500) (300)
2 (500) (300)
3 (500) (300)

a. Assume initially that the systems both have average risk. Which one
should be chosen?
b. Assume that System X is judged to have high risk. Allied accounts
for differential risk by adjusting its corporate cost of capital up or
down by 2 percentage points. Which system should be chosen?
15.6 University Health System has three divisions: Real Estate, with an
8 percent cost of capital; Health Services, with a 10 percent cost of
capital; and Managed Care, with a 12 percent cost of capital. The
system™s risk adjustment procedures call for adding 3 percentage points
to adjust for high risk and subtracting 2 percentage points for low risk.
Construct a diagram such as the one in Figure 15.2 that illustrates the
range of project costs of capital for the system.

1. The three types of risk relevant to capital budgeting decisions were ¬rst discussed
in Chapter 10. A review of the applicable sections might be useful for some
2. For an algebraic representation of the relationships among stand-alone,
corporate, and market risk, see Louis C. Gapenski, “Project Risk De¬nition
and Measurement in a Not-For-Pro¬t Setting,” Health Services Management
Research (November 1992): 216“224.
3. Two other methods, decision tree analysis and Monte Carlo simulation, also
are used to assess project risk. Decision tree analysis is particularly useful
when a project is structured with a series of decision points (i.e., stages) that
allow cancellation prior to full implementation. For more information on
both methods, see Louis C. Gapenski, Understanding Health Care Financial
Management (Chicago: Health Administration Press, 2003), Chapter 12.
4. Spreadsheet programs have Data Table functions that automatically perform
sensitivity analyses. After the table is roughed in, the spreadsheet automatically
calculates and records the NPV (or some other pro¬tability measure) values in
the appropriate locations on the table.
5. Monte Carlo simulation overcomes the de¬ciencies inherent in scenairo analysis,
but it has some de¬ciencies of its own.
Chapter 15: Project Risk Assessment and Incorporation

6. Utility theory is used by economists to explain how individuals make choices
among risky alternatives.
7. The risk-free rate does not incorporate the tax advantages of debt ¬nancing, so
it must be adjusted by using the corporate cost of capital equation.
8. For the sake of simplicity, in¬‚ation effects are ignored in this illustration.
9. The pro¬tability index (PI) is often used to measure pro¬tability under capital
rationing. The PI is de¬ned as the PV of cash in¬‚ows divided by the PV of cash
out¬‚ows. The higher the PI, the greater the “bang for the buck.”

Allen, R. J. 1989. “Proper Planning Reduces Risk in New Technology Acquisitions.”
Healthcare Financial Management (December): 48“56.
Ang, J. S., and W. G. Lewellen. 1982. “Risk Adjustment in Capital Investment Project
Evaluations.” Financial Management (Summer): 5“14.
Capettini, R., C. W. Chow, and J. E. Williamson. 1990. “Breakdown Approach Helps
Managers Select Projects.” Healthcare Financial Management (November):
Gapenski, L. C. 1992. “Accuracy of Investment Risk Models Varies.” Healthcare
Financial Management (April): 40“52.
. 1992. “Project Risk De¬nition and Measurement in a Not-for-Pro¬t Set-
ting.” Health Services Management Research (November): 216“224.
. 1990. “Using Monte Carlo Simulation to Help Make Better Capital Invest-
ment Decisions.” Hospital & Health Services Administration (Summer): 207“
Gup, B. E., and S. W. Norwood, III. 1981. “Divisional Cost of Capital: A Practical
Approach.” Financial Management (Spring): 20“24.
Hastie, K. L. 1974. “One Businessman™s View of Capital Budgeting.” Financial
Management (Winter): 36“43.
Hertz, D. B. 1964. “Risk Analysis in Capital Investments.” Harvard Business Review
(January-February): 96“106.
Holmes, R. L., R. E. Schroeder, and L. F. Harrington. 1999. “Using Microcomput-
ers to Improve Capital Decision Making.” Journal of Health Care Financing
(Spring): 52“59.
. 2000. “Objective Risk Adjustment Improves Calculated ROI for Capital
Projects.” Healthcare Financial Management (December): 49“52.
Lewellen, W. G., and M. S. Long. 1972. “Simulation Versus Single-Value Estimates
in Capital Expenditure Analysis.” Decision Sciences (October): 19“33.
Ryan, J. B., and J. L. Gocke. 1988. “Incorporating Risk Into the Investment Deci-
sion.” Topics in Health Care Financing (Fall): 49“65.
Ryan, J. B., and M. E. Ward (eds). 1992. “Capital Management.” Topics in Health
Care Financing (Fall): 1“88.
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sional Hurdle Rates and the Cost of Capital.” Financial Management (Spring):
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Other Topics
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Learning Objectives
After studying this chapter, readers will be able to:

• Describe alternative current asset investment and ¬nancing policies.
• Discuss in general terms how businesses manage cash and
marketable securities.
• Discuss the key elements of receivables and inventory management.
• Explain the alternatives available for short-term ¬nancing, including
the use of security.

In our discussion of ¬nancial management leading up to this chapter, the
general focus has been on long-term, strategic decisions. This chapter covers
another important element of healthcare ¬nance”the management of short-
term (current) assets and their ¬nancing. Unlike long-term ¬nancial manage-
ment, the management of current assets is highly dependent on the speci¬c
type of provider organization (i.e., hospital versus clinic versus nursing home).
Thus, our treatment of this topic is somewhat basic and generic in nature. Our
discussion begins with an overview of short-term ¬nancial management and
the policy decisions that health services managers must make regarding the
level of current assets and their ¬nancing. A brief discussion of the manage-
ment of each current asset account is then provided. The chapter closes with
a discussion of the various types of short-term ¬nancing used by healthcare

An Overview of Short-Term Financial Management
Short-term ¬nancial management involves all current assets and most current
liabilities. The primary goal of short-term ¬nancial management is to support
the operations of the business at the lowest possible cost. Clearly, a business
must have the current assets necessary to meet its operational requirements.
However, it is imprudent to hold too high a level of current assets because of
the costs of carrying them.
492 Healthcare Finance

To both illustrate the requirement for short-term ¬nancing, and to
review the current asset and current liability accounts, consider the situation
facing Sun Coast Clinics, a for-pro¬t operator of four ambulatory care clinics
in South Florida. Table 16.1 contains the ¬rm™s December 2004 and April
2005 balance sheets. The provision of ambulatory care services in this part
of Florida is a seasonal business. The peak season for Sun Coast is December
through April, when the population of the area soars because of winter tourism
and the arrival of the “snow birds” (i.e., retired individuals who typically live
in the north during the summer and fall months but move to residences in
Florida for the winter).
In December of each year, Sun Coast has just ¬nished its slow season
and is preparing for its busy season. Thus, the ¬rm™s accounts receivable are
relatively low, but its cash and marketable securities and inventories are rela-
tively high. By the end of April, Sun Coast has completed its busy season, so its
accounts receivable are relatively high, but its cash and marketable securities
and inventories are relatively low in preparation for the slow summer season.
On the current liabilities side, Sun Coast™s accounts payable and accruals are
relatively high at the end of April, just after the busy season.
Consider what happens to Sun Coast™s total current assets and to-
tal current liabilities over the December to April period. Current assets in-
crease from $200,000 to $240,000, so the ¬rm must increase its capital by
$40,000”an increase on the assets side of the balance sheet must be ¬nanced
by an increase on the liabilities and equity side. However, the higher volume
of both purchases and labor expenditures associated with increased services
causes accounts payable and accruals to increase spontaneously by $20,000,

TABLE 16.1
December 2004 April 2005
Sun Coast
Clinics, Inc.:
Cash and marketable securities $ 30 $ 20
End-of-Month Accounts receivable 155 210
Balance Sheets Inventories 15 10
(in thousands) Total current assets $200 $240
Net ¬xed assets 500 500
Total assets $700 $740

Accounts payable $ 30 $ 40
Accruals 15 25
Notes payable 85 105
Current portion of long-term debt 20 20
Total current liabilities $150 $190
Long-term debt 150 140
Common equity 400 410
Total liabilities and equity $700 $740
Chapter 16: Current Asset Management and Financing

from $30,000 + $15,000 = $45,000 in December to $40,000 + $25,000
= $65,000 in April. The net result is an additional $40,000 ’ $20,000 =
$20,000 current asset ¬nancing requirement in April, which Sun Coast ob-
tained from the bank as a short-term loan (notes payable). Therefore, at the
end of April, Sun Coast showed notes payable of $105,000, up from $85,000
in December.
These ¬‚uctuations for Sun Coast result from seasonal factors. Similar
¬‚uctuations in current asset requirements, and hence in ¬nancing needs, can
occur because of business cycles; typically, current asset requirements and
¬nancing needs contract during recessions and expand during boom times.
In the next section, two policy issues regarding current assets and ¬nancing
are discussed.

1. What is the goal of short-term ¬nancial management?
2. Describe how seasonal volume ¬‚uctuations in¬‚uence both current asset
levels and ¬nancing requirements.

Current Asset Investment and Financing Policies
Current asset ¬nancial policy involves two basic questions:

1. What is the appropriate level for current assets, both in total and by
speci¬c accounts?
2. How should current assets be ¬nanced?

In this section, these two questions are discussed in detail.

Current Asset Investment Policies
Figure 16.1 shows three alternative policies for a single hospital regarding
the total amount of current assets carried. Essentially, current asset investment
policies differ in that different amounts of current assets are carried to support
a given volume level. The line with the steepest slope represents a high current
asset investment policy. Here, relatively large amounts of cash, marketable se-
curities, and inventories are carried, and utilization is stimulated by the use of
a credit policy that provides liberal ¬nancing to patients and a corresponding
high level of receivables. Conversely, with the low current asset investment
policy, the holdings of cash, securities, inventories, and receivables are mini-
mized at each volume level.
Under conditions of certainty (i.e., when utilization, operating costs,
collection times, and so on are known) all healthcare providers would hold
only minimal levels of current assets and hence follow a low current asset
investment policy. Any larger amounts would increase the need for current
asset ¬nancing, and hence increase costs, without a corresponding increase
494 Healthcare Finance

Current Assets
Current Asset (millions of dollars)




0 50 100 150 200
(thousands of patient days)

in pro¬ts. Any smaller holdings would involve late payments to labor and
suppliers, operating inef¬ciencies because of inventory shortages, and lower
utilization because of an overly restrictive credit policy.
However, the picture changes when uncertainty is introduced. Now,
the provider must carry the minimum amounts of cash and inventories to
meet expected needs, plus additional amounts, or safety stocks, which enable
the business to deal with realizations that differ from expectations. Similarly,
accounts receivable levels are determined by credit terms (i.e., payer mix and
collections policy), and the tougher the credit terms, the lower the receivables
for any given level of sales. With a low current asset investment policy, the
business would hold minimal levels of safety stocks for cash and inventories,
and it would have a tight credit policy. A low policy generally provides the
highest expected return on the business™s investment in current assets, but it
entails the greatest risk, while the converse is true under a high current asset
investment policy. The moderate policy falls in between the two extremes in
terms of expected risk and return.
The pro¬t penalty for holding excess current assets is very much de-
pendent on the cost of ¬nancing current asset holdings. Therefore, corporate
policy regarding the level of current assets is never set in isolation. It is always
established on the basis of current ¬nancing costs and in conjunction with
Chapter 16: Current Asset Management and Financing

the ¬rm™s current asset ¬nancing policy. In addition, current asset holdings
are in¬‚uenced by the amount of business risk (primarily volume uncertainty).
The more dif¬cult it is to predict utilization, the greater the amount of safety
stocks held.

Current Asset Financing Policies
Most businesses experience seasonal ¬‚uctuations, as illustrated previously with
Sun Coast Clinics. Similarly, most businesses must build up current assets
when the economy is strong, but they then sell off inventories and reduce
receivables when the economy slacks off. Still, current assets never drop to
zero, and this realization forces us to introduce a concept of asset maturi-
ties that differs from the short-term/long-term categories used in ¬nancial
To illustrate the new concept, which classi¬es assets as either perma-
nent or temporary, consider Sun Coast Clinics. Table 16.1 suggests that, at
this stage in its life, seasonality causes the ¬rm™s total assets to ¬‚uctuate be-
tween $700,000 and $740,000. Thus, Sun Coast has $700,000 in permanent
assets, de¬ned as the amount of total assets required to sustain operations dur-
ing seasonal (or cyclical) lows. Sun Coast™s permanent assets are composed
of $500,000 of permanent ¬xed assets and $200,000 in permanent current
assets. In addition, Sun Coast carries seasonal, or temporary, current assets that
¬‚uctuate from zero to a maximum of $40,000 during the high season. No
additional ¬xed assets are needed during the high season because the busi-
ness has suf¬cient ¬xed assets to accommodate peak volume. The manner in
which the permanent and temporary current assets are ¬nanced de¬nes the
¬rm™s current asset ¬nancing policy.
The proper framework for evaluating current asset ¬nancing policies
requires the use of the concept of permanent and temporary assets. Thus,
for ¬nancing purposes, assets are not classi¬ed by their accounting de¬ni-
tions of current and long term but as either permanent or temporary. The key
here is that each dollar of cash, each individual receivable, and each dollar of
inventory may well be short term in the sense that these items will be quickly
turned over or converted to cash. However, as each individual current asset
item is converted, it will be replaced by a like item if it is permanent in nature,
and hence the dollar amounts of such short-term assets are carried perma-
nently over the long term. The implication is that the accounting de¬nition of
current assets, although useful for many purposes, does not provide managers
with the correct guidance regarding the ¬nancing of such assets.
One ¬nancing policy, maturity matching, which is sometimes called
a moderate ¬nancing policy, calls for a business to match asset and liability
maturities as shown in Panel (a) of Figure 16.2”that is, permanent assets
are ¬nanced with permanent capital (i.e., equity and long-term debt), and
temporary assets are ¬nanced with temporary capital (i.e., short-term debt).
This strategy limits the risk that a business will be unable to pay off its maturing
496 Healthcare Finance

Current Asset
Chapter 16: Current Asset Management and Financing

obligations. For example, suppose Sun Coast borrows on a one-year basis and
uses the funds obtained to build and equip a new clinic. Cash ¬‚ows from the
clinic (i.e., pro¬ts plus depreciation) would almost never be suf¬cient to pay
off the loan at the end of only one year, so the loan must be renewed at that
time. If interest rates increase during the year, Sun Coast™s new debt would
cost more. Even worse, if the lender refused to renew the loan, Sun Coast
would have problems. Had the clinic been ¬nanced with long-term ¬nancing,
however, the required loan payments would have been better matched with
cash ¬‚ows from pro¬ts and depreciation, and the problem of loan renewal
would not have arisen.1
Panel (b) of Figure 16.2 illustrates an aggressive ¬nancing policy. Here,
the ¬rm ¬nances all of its ¬xed assets with long-term capital but part of its per-
manent current assets with short-term, nonspontaneous credit. A look back
at Table 16.1 will show that Sun Coast actually follows this strategy. Assum-
ing that the $20,000 current portion of long-term debt will be re¬nanced
with new long-term debt, Sun Coast has $500,000 in net ¬xed assets and
$570,000 of long-term capital, leaving only $70,000 of long-term capital to
¬nance $200,000 in permanent current assets. Additionally, Sun Coast has a
minimum of $45,000 of costless, spontaneous short-term credit (accounts
payable and accruals). Thus, Sun Coast uses $85,000 of short-term notes
payable to help ¬nance its permanent level of current assets.
Returning to Figure 16.2, the term relatively is used in the title for
Panel (b) because there can be different degrees of aggressiveness. For exam-
ple, the dashed line in Panel (b) could have been drawn below the line that des-
ignates ¬xed assets, indicating that all of the permanent current assets and part
of the ¬xed assets were ¬nanced with short-term credit. Such a policy would
be highly aggressive, and the business would be very much subject to dangers
from rising interest rates as well as to loan renewal problems. However, short-
term debt usually is cheaper than long-term debt, and some managers are
willing to sacri¬ce safety for the chance of higher pro¬ts.
As shown in Panel (c) of Figure 16.2, the dashed line could also be
drawn above the line that designates permanent current assets, indicating that
permanent capital is being used to ¬nance all permanent asset requirements
and also to meet some, or all, of the temporary credit demands. In the sit-
uation depicted in the graph, the ¬rm uses a small amount of short-term,
nonspontaneous credit to meet its peak requirements, but it also meets a part
of its seasonal needs by storing liquidity in the form of marketable securities
during the off-season. The humps above the dashed line represent short-term
¬nancing, and the troughs below the dashed line represent short-term security
holdings. Panel (c) represents a very safe, conservative ¬nancing policy.
As with current asset investment policy, the choice among alternative ¬-
nancing policies involves a risk/return trade-off. The aggressive policy, with its
high use of generally lower cost short-term debt, has the highest expected re-
turn but the highest risk, while the conservative policy has the lowest expected
498 Healthcare Finance

return and lowest risk. The maturity matching policy falls between the ex-
tremes. Unfortunately, there is no underlying ¬nance theory that managers
can use to pick the “correct” ¬nancing policy. Often, ¬rms that have low
business risk elect to take on higher-than-average ¬nancial risk. Thus, such
¬rms tend to have more debt in their target capital structures and are more
likely to use an aggressive current asset ¬nancing policy. Conversely, ¬rms with
high business risk usually take a conservative view regarding added ¬nancial
risk, whether that risk arises from a high level of debt or an aggressive current
asset ¬nancing policy.

Self-Test 1. What two key issues does current asset policy involve?
Questions 2. What factors in¬‚uence the current asset investment decision?
3. What is meant by the term permanent assets ?
4. What is meant by the term temporary assets ?
5. What factors in¬‚uence the current asset ¬nancing decision?

Cash Management
Businesses need cash, which includes both actual cash in hand and that held
in commercial checking accounts, to pay for labor and materials, to buy
¬xed assets, to pay taxes, to service debt, and so on. However, cash is a
nonearning asset ”it provides no return. Thus, the goal of cash management
is to minimize the amount of cash the business must hold to conduct its
normal activities, but at the same time, have suf¬cient cash on hand to support
operations. Maintaining suf¬cient cash ensures that a business is liquid, which
means that it can meet its cash obligations as they become due. Conversely,
a business that is illiquid cannot easily generate the cash needed to meet its
obligations, and thus its operations suffer.2
A key element in a business™s cash management process is the cash
budget, which we discussed in Chapter 8. In essence, the cash budget tells
managers how effective they are in applying the cash management techniques
discussed in the following sections.

Using Float
Float is de¬ned as the difference between the balance shown on the bank™s
records and the balance shown on a business™s or individual™s checkbook.
Suppose that a business writes, on the average, checks in the amount of $5,000
each day, and it takes six days for these checks to clear and to be deducted from
the ¬rm™s bank account. This will cause the ¬rm™s own checkbook to show a
balance that is 6 — $5,000 = $30,000 smaller than the balance on the bank™s
records; this difference is called disbursement ¬‚oat.
Suppose that the ¬rm also receives checks in the amount of $5,000
daily, but it loses four days while they are being deposited and cleared. This
Chapter 16: Current Asset Management and Financing

will result in 4 — $5,000 = $20,000 of collections ¬‚oat. In total, the ¬rm™s
net ¬‚oat ”the difference between the $30,000 disbursement ¬‚oat and the
$20,000 collections ¬‚oat”will be $10,000.
If the ¬rm™s own collection and clearing process is more ef¬cient than
that of the recipients of its checks, which is generally true of larger, more ef¬-
cient ¬rms, the ¬rm could actually show a negative balance on its own books
but have a positive balance on the records of its bank. Some ¬rms indicate that
they never have positive book cash balances. One medical equipment manu-
facturer stated that its bank™s records show an average cash balance of about
$200,000, while its own book balance is minus $200,000”it has $400,000
of net ¬‚oat. Obviously the ¬rm must be able to forecast its disbursements and
collections accurately in order to make such heavy use of ¬‚oat.
Basically, a ¬rm™s net ¬‚oat is a function of its ability to speed up col-
lections on checks received and to slow down collections on checks written. Some
techniques used to manage ¬‚oat are discussed in the next two sections.

Managers have searched for ways to collect receivables faster since the day that Acceleration of
credit transactions began. Although cash collection is the responsibility of a Receipts
¬rm™s managers, the speed with which checks are cleared is dependent on the
banking system. Several techniques are now used both to speed collections and
to get funds where they are needed, but the three most popular are lockbox
services, concentration banking, and electronic claims processing. Here are
some points to note about lockbox services and concentration banking. The
discussion of electronic claims processing occurs later in this chapter.
Lockboxes are one of the oldest cash management tools, and virtually
all banks that offer cash management services also offer lockbox services.
In a lockbox system, incoming checks are sent to post of¬ce boxes rather
than to corporate headquarters. For example, Health SouthWest, a regional
HMO headquartered in Oklahoma City, has its Texas members send their
payments to a box in Dallas, its New Mexico members send their checks to
Albuquerque, and so on, rather than have all checks sent to Oklahoma City. A
local bank collects the contents of each lockbox and deposits the checks into
the company™s local account. The bank then provides the HMO with daily


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