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.