Capital Decision Making
Mace Ross
Northcentral University
Professor Van Orden
June 5, 2014
The
approval of all new projects and equipment in any big business and in
healthcare comes down to one question; Does
it fit into the budget? The budget
that gets referred to when this question gets asked is the capital budget. The term capital is used to describe the
tangible source of funds available to finance noncurrent future projects for an
organization, it can also be thought of as a ratio of debt to equity (Cleverley, Song, &
Cleverley, 2011, p. 517). The idea of
capital budgeting is essentially using an organizations current knowledge of
assets and resources to forecast and justify expenditures for future projects
and equipment (Cleverley, Song, & Cleverley, 2011, p. 517). Financial managers use capital budgeting as a
tool to comprehend the amount of current resources and what those resources are
capable of. Cleverley, Song, & Cleverley
make the statement that “the capital budget is a yearly estimate of resources
that will be expended for new programs during the coming years” (2011,
p.420-21). Cleverley, Song, &
Cleverley also state that the ongoing management and control process of
monitoring investment is referred to as capital project analysis (2011, p
420). This paper will serve to describe
the four stages of the capital decision making process, discuss common methods
of assessment for capital budgeting such as net present value, profitability
index and equivalent annual cost. Additionally a discussion of how the capital
decision making process’ and profitability estimates apply to situation such as
slowdowns in collections and declines in revenues.
The
process that an organization utilizes to make capital decisions moves through
four stages. First the generation of the
project information, this stage is vital for the success of the project. Within the generation of project information
stage individuals gather information that is analyzed and evaluated at a later
time for the capital expenditure proposal.
Typically information of significant value includes; available
alternatives, available resources, cost data, benefit data, prior performance,
risk projection (Cleverley, Song, & Cleverley, 2011, p. 426). Available alternatives is a very wise place
to invest time in gathering information, having a backup plan that will still
accomplish the desired goal or leave the organization in a favorable position
may save an organization from closing its doors when the initial plan
fails. The availability of resources
plays a major role in the approval projects.
Without information as to where the funding and resources will being
coming from to finance a project it will never even be brought up for capital
expenditure proposal. The idea of
resource availability goes in tandem with cost data, without a timeline of what
it is going to cost to complete the project the organization will be unable to
determine the amount of resources necessary to see the project through to
completion. Benefit data can be very influential in getting a capital
expenditure proposal approved. Benefit
data will include information as to the return of investment that the project
will generate financially but it should also include information on the
benefits that the organization will see in functionality throughout its system
as a result of completing the project.
Information in regards to the prior performance of projects and the
individuals that managed them can provide some insight into the likelihood of
success with the current endeavor.
Lastly in the generation of project information stage is information
concerned with project risk. In this
portion of information generation it is important to ask the what if questions.
Cleverley,
Song, & Cleverley ask a very important what
if question for big business and healthcare organizations, how would costs
and benefits change if volume changed? (2011, p.427). It is long recognized that volume of service
is a pivotal variable in the forecasting of capital expenditures. Cleverley, Song, & Cleverley suggest
evaluating projections for highest, lowest and most likely volumes of service
can help determine the risk for a given project (2011, p. 427). A reduction in the volume of service would
manifest in a reduction and slow down in collections and decrease in revenue
generation, thus illustrating the importance of asking what if.
In
the stage of project evaluation two major areas of financial criteria are
analyzed; solvency and cost. The idea of
solvency is that an organization can meet its long-term financial
obligations. In terms of project
evaluation the idea of solvency is to confirm resources and the duration that
those resources will last to see a project through. Cleverley, Song, &
Cleverley recognize that “Operation of an insolvent program eventually can
threaten the solvency of the entire organization: (2011, p. 427). Cost is the second financial factor that is
detailed in the evaluation stage. The
method of analysis to determine if a cost is worthy is the cost-benefit
method. All project that reach the
evaluation stage must contribute to the attainment of the goals and objectives
of the organization. In cost-benefit
analysis information that was previously gather is now brought forth and
evaluated. This allows for the best most
cost efficient version of the project that will produce the desired result can
be visualized.
After
collecting all the information in regards to a project or projects it is time
to make a decision on which project will be approved for capital
expenditure. The final decision of
expenditure approval rests on the needs of the organization, which project
provides the best cost-benefit ratio, and the availability of resources. Once a project has been approved it moves
into the project implementation and reporting stage. This stage is critical to ensuring that the
initial intentions of the project are reached and that expenditures do not
stray from their original estimates.
Cleverley, Song, & Cleverley make note of three important values
that this stage brings; It highlights differences between planned versus actual
performance that may permit corrective action, allows for more accurate
estimates by ensure that individuals are held accountable for their estimates,
it also allows for forecast bias to be recognized and accounted for in future
forecasts (2011, p. 428). An article by Metha
highlights the fact that no matter how well this stage is planned out on paper
it is only truly successful when its implementation is followed through, the
authors suggest that successful implementation is dependent on the human
element.
The most important aspect,
which is often lost in the enthusiasm of selecting and/or developing a project
control system, is the feasibility and effectiveness of implementing it within
the framework of the projects’ needs and requirements… Some of the elements
which can and do make a difference in the success or failure of a project
management system are as follows: involvement and support of higher management,
the human element and interaction, overall implementation strategy and
approach, and the effectiveness of the project control (Mehta, 2008, p. 34)
Prior
to finalizing a project it is important to use different methods of statistical
analysis to attempt to forecast a projects financial performance. As previously mentioned changes in the volume
of service, slowdown in collections, or declines in revenues can greatly impact
an organization. Three tools that
financial managers use to help forecast the financial situations that an
organization will be entering into after taking on a new project include; net
present value, profitability index, and equivalent annual cost. Cleverley,
Song, & Cleverley state that net present value (NPV) analysis is a helpful
way to compare different methods of capital financing (2011, p. 429). NPV accounts for all cash flows into and out
of an organization as the result of taking on a project, when attempting to
decide between two different projects the one with the higher NPV is the choice
that will bring more cash flow into the company (Cleverley, Song, &
Cleverley, 2011, p.426).
Recent literature suggests
that the NPV method of strategically planning for capital budget expenditures
may be falling to the way side for a more up to date method called real options
reasoning. Williams and Hammes suggest
that NPV cannot account for the value of delaying a decision, operating
flexibility, or strategic interaction.
To account for these unique characteristics of investment the authors
suggest using the real options method.
Real options are investment
opportunities that are characterized by a limited commitment that creates
future decision rights. Thinking of
capital budgeting decisions as real options means thinking of strategic and
capital investments as similar to financial stock options. Proponents of real options suggest that this
form of strategic thinking and investment is inherently more beneficial than
NPV approach…a real options approach marries the theory of financial options to
foundational ideas in strategy, organizational theory, and complex systems
(Williams and Hammes, 2007, p. 171).
The real options method allows for an organization to
invest a minimal amount to move forward with a project and then learn more
about how the project or equipment will work for them opposed to going all in
as with the NPV method. The real options
method allows an organization to strategically capital budget.
Cleverley,
Song, & Cleverley state that “the profitability index method of capital
project evaluation is of primary importance in cases when the benefits of the
projects are mostly financial” (2011, p. 430).
This method of assessment attempts to compare the rates of return in
projects that are competing for capital budget expenditure. An interesting research study that looked at
the capital budgeting practices of emerging economies found that the most
frequently used technique for assessing investments was the profitability
index. The researchers of this study saw
that this was an effective method but that the a more rounded approach to
capital budgeting with an emphasis in information technology would prove very
beneficial (Khamees, Al-Fayoumi, & Al-Thuneibat, 2010, p 49). This applies to the field of healthcare in
the sense that it is an emerging economical system that is on the cusp of going
through drastic changes. Changes that
will cause fluctuations in the volume of service that individual hospital get
causing slowdowns in collection and decreases in revenue. It would be wise for hospital systems to
adapt new technological methods of determining profitability levels as the
financial realm they exist in changes.
Additionally
Cleverley, Song, & Cleverley state that “Equivalent annual cost is of
primary value when selecting capital project for which alternatives exist…
equivalent annual cost is the expected average cost, considering both capital
and operating cost over the life of the project” (2011, p. 431). This assessment tool takes into consideration
the present value of operating cost and the present value of investment cost
and divides that value against the present value of annuity. The interesting piece of information that
this method brings to light is the factor of time. In comparing different projects or equipment
costs the equivalent annual cost can aid in determining the better option for
the long run.
The
tools and methods for using and implementing capital budgeting mentioned in
this paper are merely attempts to forecast the financial weather of the
future. In truth no action plan or
statistical measure can every guarantee that a project or piece of new
equipment will rake in a heavy return on investment. With that said, it is within the best
interests of any healthcare facility to understand to the best of their ability
what the possible outcomes may be for their financial future. In order for healthcare institution to arm
themselves with information they should use all the tools available to them to
predict financial outcomes in the event that there is a slowdown in collections
or a decrease in revenue as a result of decreases in service volume.
References
Cleverley, W.O., Song, P.H., & Cleverley,
J.O. (2011). Essentials of HealthCare Finance, Seventh Edition. Jones &
Bartlett Learning, LLC. United States of America.
Khamees, B., Al-Fayoumi, N., &
Al0Thuneibat, A.A. (2010). Capital budgeting practices in the Jordanian
industrial corporations. International
Journal of Commerce & Management, 20(1), 49-63 doi:10.1108/10569211011025952
Mehta, P. M. (2008). Effective Implementation
of a Project Control System. Cost engineering 50(1), 34-37.
Williams, D.R., & Hammes, P.H. (2007).
Real Options Reasoning in Healthcare: An Integrative Approach and Synopsis.
Journal of Healthcare Management, 52(3), 170-186.
