"capital expenditures budget" is best described by which of the following concepts?

177

Capital Expenditure

Budgets 16 C H A P T E R

OVERVIEW

Capital expenditures involve the acquisition of assets that are long lasting, such as equipment, buildings, and land. Therefore, capital expenditure budgets are usually in- tended to plan, monitor, and control long-term financial issues. Decisions must be made about the future use of funds in order to complete these types of budgets.

Operations budgets, on the other hand, generally deal with actual short-term revenues and expenses necessary to operate the facility. For example, the Great Shores Health System’s operations budgets may usually be cre- ated to cover the next year only (a 12-month period), while Great Shores1 capital expenditure budgets may be created to cover a five-year span (a 60-month period) or even a ten-year span.

It is also important to note that the budget for capital expenditures is usually part of an overall, or compre- hensive, financial budget. Responsibility for the compre- hensive financial budget always rests with upper-level financial officers of the organization and is beyond the scope of this chapter.

CREATING THE CAPITAL EXPENDITURE BUDGET

The capital expenditure budget, which may sometimes be identified by another name, such as “capital spending plan,” usually consists of two parts. The first part of the budget represents spending for capital assets that have al- ready been acquired and are in place. This spending pro- tects an existing asset; you are essentially spending in

After completing this chapter, you should be able to

1. Recognize the reason that a capital expenditure budget is necessary.

2. Review the cash flow and the startup cost concept.

3. Understand differences between cash flow reporting methods.

4. Recognize types of capital expenditure budget proposals.

5. Understand about evaluating capital expenditure proposals.

P r o g r e s s N o t e s

order to protect that which you already have. The second part of the budget represents spending for new capital assets. In this case, you will be expending capital funds to acquire new assets such as equipment, buildings, and land.

The “existing asset” part of the budget forces planning questions about whether existing equipment and buildings should be kept in their present condition (which can involve re- pair and maintenance expenses), renovated, or replaced. Renovating equipment or build- ings implies a large expenditure that would be capitalized. (To be capitalized means the expenditure would be placed on the balance sheet as an additional capital cost that is rec- ognized as an asset.)

The “new capital asset” part of the budget forces more planning questions. In this case, the questions are about new assets. The reasons for new asset spending may involve:

• Expansion of capacity in a department or program • Creation of a new facility, department, or program • New equipment to improve productivity • New equipment or space to comply with federal or state requirements

It should also be noted that acquiring new assets results in additional capital costs that will be placed on the balance sheet as assets. For more information, refer to Chapter 3.

BUDGET CONSTRUCTION TOOLS

How the capital expenditure budget is constructed may be predetermined by requirements of the organization. Your facility or practice may have a template that must be used. This takes the decision out of your hands. Otherwise, you will have to decide which tool will be most effective to build your capital expenditure budget.

One important tool is net cash flow reporting. The concept of cash flow analysis, usually an important part of the capital expenditure budget, is described later. But how will the cash flow be reported? Four methods are discussed in this section.

Cash Flow Concept

As its title implies, a cash flow analysis illustrates how the project’s cash is expected to move over a period of time. Many analyses concentrate only on the cash expenditure for the equipment. (This is, after all, a “capital expenditure” budget.) Other analyses, however, will also take revenue earned into account.

In any case, it is always important to report the net cash flow. While most line items will usually be expenditures, called cash outflow, sometimes there will also be cash receipts, called cash inflow. For example, if a new piece of equipment will replace an old one, and the old replaced equipment will be sold for cash, the cash received from the sale will repre- sent a cash receipt.

Cash flow must also be reported as cumulative. This means the accumulated effect of cash inflows and cash outflows must be added and/or subtracted to show the overall net accumu- lated result. In our example mentioned previously: where the old equipment might be sold, the cumulative cash flow is illustrated in Table 16-1. As you can see, the initial expenditure or cash spent (outflow) is decreased by the cash received (inflow) to produce a net cumulative result.

178 CHAPTER 16 Capital Expenditure Budgets

Budget Construction Tools 179

Cash Flow Reporting Methods

Cash flow is typically reported using one of four methods. They include:

• Payback method • Accounting rate of return • Net present value • Internal rate of return

A previous chapter of this book has explained and illustrated each of the four methods. Their advantages and disadvantages, for purposes of capital expenditure budgeting, are summarized later.

Payback Method

The payback method is based on cash flow. This method recognizes the cash flows that are necessary to recover the initial cash invested. The payback method is advantageous because it is easy to understand and highlights risks. However, it does not take either profitability or the time value of money into account.

Accounting Rate of Return

The accounting rate of return is based on profitability. However, it does not take the time value of money into account.

Net Present Value

Net present value, or NPV, is a discounted cash flow method. It is based on cash flows in that it takes all the cash (incoming and outgoing) into account over the life of the equipment (or, if applicable, over the life of the relevant project). Although the NPV is based on cash flows, it also takes profitability and the time value of money into account.

Internal Rate of Return

Internal rate of return, or IRR, is also a discounted cash flow method that takes all incom- ing and outgoing cash into account over the life of the equipment (or the project). It also takes profitability and the time value of money into account.

The use of net present value, the internal rate of return, and so forth, is the vocabulary of capital budgeting. It is also an important part of the language of finance. Therefore, it is

Table 16–1 lllustration of Cumulative Cash Flow

Line XCash Spent Cash Received Cumulative Number (Outflow) (Inflow) Cash Flow

1 Buy new equipment (50,000) — (50,000) 2 Sell old equipment that is being

replaced — + 6,000 (44,000)

180 CHAPTER 16 Capital Expenditure Budgets

important to understand the differences between the four methods. Review Chapter 12 for more detail. Appendix 16-A presents a step-by-step method for net present value computa- tion that assists in this understanding.

Budget Inputs

Capital expenditure budget inputs may have to be taken into consideration if the operat- ing budget requires additional capital equipment or space renovations. Figure 16-1 illus- trates these potential inputs.

Startup Cost Concept

If the proposal for capital expenditures incorporates operational expenses, the concept of startup costs must also be taken into consideration. In these cases, management believes the cost of starting up a new service line or a new program should be included as part of the original investment. Although such operational costs do not fall into a strict definition of capital expenditure budgeting, the requirement is common enough to warrant discussion.

FUNDING REQUESTS

This section discusses the process of requesting capital expenditure funds and the types of proposals that might be submitted for consideration.

The Process of Requesting Capital Expenditure Funds

Different departments or divisions often have to compete for capital expenditure funding. The hospital’s radiology department director may want new equipment, but so does the

Additional Equipment Required

Additional Space or

Renovation of Existing Space

Required

Operating Revenue Forecast &

Staffing Plan &

Capacity Level Checkpoint

No Estimated Capital $$ Required

Capital Expenditures

Plan

Preliminary Capital

Expenditures Budget

Estimated Capital $$ Required

Yes

No Yes

Figure 16–1 Capital Expenditures Budget Inputs.

surgery department director, and so on. The various requests for funding are often col- lected and subjected to a review process in order to make decisions about where, and to whom, the available capital expenditure funds will go. While the upper levels of manage- ment make overall decisions about future use of funds, the departmental funding requests represent the first step in the overall process.

The process involved for capital expenditure funding requests varies according to the or- ganization. Size plays a part. Due to its sheer size, we would expect a giant hospital to have a more complex process than, say, a two-physician practice. The corporate culture of the or- ganization plays a part, too. Some organizations are extremely structured, while others are more flexible in their management principles. And in some facilities, politics may also play a part in the process of making and reviewing funding requests.

Types of Capital Expenditure Proposals

The type of proposal affects its size and scope. Proposal types commonly include the follow- ing types of requests:

• Acquiring new equipment • Upgrading existing equipment • Replacing existing equipment with new equipment • Funding new programs • Funding expansion of existing programs • Acquiring capital assets for future use

Certain of these types may sometimes be paired as either/or choices in capital expendi- ture proposals. All six types of proposals are discussed in this section.

Acquiring New Equipment

The reason why new equipment is needed must be clearly stated. The acquisition cost must be a reasonable figure that contains all appropriate specifications. The number of years of useful life that can be reasonably expected from the equipment is also an important assumption.

Upgrading Existing Equipment

The reason why an upgrade is necessary must be clearly stated. What is the impact? What will the outcomes be from the upgrade? The upgrade costs must be a reasonable figure that also contains all appropriate specifications. Will the upgrade extend the useful life of the equipment? If so, by how long?

Replacing Existing Equipment with New Equipment

The rationale for replacing existing equipment with new equipment must be clearly stated. Often a comparison may be made between upgrading and replacement in order to make a more compelling argument. The usual arguments in these comparisons revolve around im- provements in technology in the new equipment that are more advanced than available up- grades to the old equipment. A favorite argument in favor of the new equipment is increased productivity and/or outcomes.

Funding Requests 181

182 CHAPTER 16 Capital Expenditure Budgets

Funding New Programs

A proposal for new program capital expenditures must take startup costs into account. This type of proposal will generally be more extensive than a straightforward equipment re- placement proposal because it involves a new venture without a previous history or proven outcomes.

Funding Expansion of Existing Programs

A proposal for expansion of an existing program is generally easier to prepare than a pro- posal for a new program. You will have statistics available from the existing program with which to make your arguments. In addition, any startup costs should be negligible for the existing program. The most difficult selling point may be comparison with other depart- ments’ funding requests.

Acquiring Capital Assets for Future Use

This type of proposal may be the most difficult to accomplish. Capital expenditures for fu- ture long-term use are often postponed by decision makers in cash-strapped organizations who must first fulfill immediate demands for funding. Consider, for example, a metropoli- tan hospital that is hemmed in on all sides by privately owned property. The hospital will clearly need expansion space in the future. An adjacent privately owned property comes on the market at a price less than its appraised value. Even though the expansion is not sched- uled until several years in the future, it would be wise to seriously consider this acquisition of a capital asset for future use.

EVALUATING CAPITAL EXPENDITURE PROPOSALS

Management planning must involve the allocation of available financial resources for proj- ects that promise to reap returns in the future. This applies to both for-profit and not-for- profit organizations.

Hard Choices: Rationing Available Capital

Most businesses, including those providing healthcare services and products, have only a limited amount of capital available for purposes of capital expenditure. It usually becomes necessary, then, to ration the available capital funds. Different organizations approach the rationing process in different ways. However, most organizations will consider the following factors in some fashion or other:

• Necessity for the request • Cost of capital to the organization • Return that could be realized on alternative investments

These three factors will probably be considered in a descending sequence of decision making. The overriding question is necessity. Necessity for the request pertains to the criti- cality of the need. What are the basic reasons for contemplating the capital expenditure? Are these reasons necessary? If so, how necessary?

Information Checkpoint 183

While necessity is an overarching consideration, the cost of capital to the organization for the proposed capital expenditure is a computation of the sort we have previously dis- cussed in this section. Although the answer to “what is the cost of capital” is provided in the form of a computation, the amount of the answer depends on the method selected to illus- trate this cost.

The third element in management’s decision-making sequence is what return could be realized on alternative investments of the available capital. This concept is known as “op- portunity cost.” The term is appropriate. Assume a rationing situation where unlimited funds are not available. Thus, when a choice is made to expend funds on capital project A, an opportunity is lost to expend those same funds on project B or project C. The choice of A thus costs the opportunity to gain benefits from B or C.

To summarize, the decision makers must apply judgment in making all these choices. Thus, the rationing of available capital becomes somewhat of a management art as well as a science.

The Review and Evaluation Process

The degree of attention paid to evaluation and the level of management responsible for making the decisions may be dictated by the overall availability of capital funding and by the amount of funds requested. Evaluation of capital expenditure budget proposals may be objective or subjective. An impartial review process is most desirable.

An objective method usually involves scoring and/or ranking the competing proposals. In scoring, the basic approach generally focuses on a single proposal and evaluates it on a fixed set of criteria. In ranking, the proposal is compared with other proposals and ranked in accordance with a looser set of criteria.

The objective review and evaluation may actually first involve scoring to eliminate the very low-scoring proposals. The remaining higher scoring proposals may then be ranked in accordance with still another set of criteria.

The criteria may, in turn, contain quantitative items such as outcomes and/or productiv- ity and may also contain qualitative items such as whether the proposal is in accordance with the organization’s core mission.

Finally, some authorities believe the source of financing the project (whether it is inter- nal or external, for example) should not be relevant to the investment decision. Real-world management, however, has a different view. How the project will be financed may be their first question in the review and evaluation process.

INFORMATION CHECKPOINT

What Is Needed? An example of an entire capital expenditure budget or a capital expenditure proposal for a particular project or a specific piece of equipment.

Where Is It Found? Probably with your manager or the director of your depart- ment or, depending on the dollar amount proposed, per- haps with someone in the finance department.

How Is It Used? The use would probably be one time. Can you tell if this is so?

184 CHAPTER 16 Capital Expenditure Budgets

KEY TERMS

Accounting Rate of Return Capital Budget Capitalized Asset Cash Flow Analysis Cumulative Cash Flow Internal Rate of Return Net Present Value Operations Budget Opportunity Cost Payback Method Unadjusted Rate of Return

DISCUSSION QUESTIONS

1. Have you ever been involved in helping to create any part of a capital expenditure budget?

2. If so, which type of proposal was it? Was the proposal successful? 3. Do you recall whether any of the four cash flow reporting methods were used? If so,

which one? Do you now think that was the best choice for the particular proposal? 4. If you were assigned to prepare a capital expenditure budget request, what two peo-

ple would you most want to have on your team? Why? How would you expect to use them?

185

This appendix presents a further discussion of the four methods of capital budgeting com- putations presented in Chapter 16.

ASSUMPTIONS

Item: Assume the purchase of a new piece of laboratory equipment is proposed.

Cost: The laboratory equipment will cost $70,000.

Useful life: It will last five years.

Remaining value (salvage value): The lab equipment will be sold for $10,000 (its salvage value) at the end of the five years.

Cost of capital: The estimated cost of capital for the hospital is 10 percent.

Cash flow: The addition of this new piece of equipment is expected to generate additional revenue. In fact, the increase of revenue over expenses is expected to amount to $20,000 per year for the five years. The cash flow is therefore expected to be as follows: Year 0 � ($70,000); year 1 � $20,000; year 2 � $20,000; year 3 � $20,000; year 4 � $20,000; year 5 � $20,000. Note that year 0 is a negative figure and years 1 through 5 are positive figures.

PAYBACK METHOD

The payback method calculates how many periods are needed to recover the equip- ment’s initial investment of $70,000. In this case, the periods to be counted are years; thus, there are five years, or five periods as shown in Table 16-A-1.

The investment of $70,000 is recovered half-way between year 3 and year 4, when the remaining balance to be recovered equals zero. Therefore, the payback period is three and one half years, expressed as 3.5 years.

Table 16–A-1 Payback Method Input

Year Cash Flow Balance

0 (70,000) (70,000) 1 20,000 (50,000) 2 20,000 (30,000) 3 20,000 (10,000) 4 20,000 10,000 5 20,000 30,000

A Further Discussion of

Capital Budgeting Methods

16-A A P P E N D I X

186 CHAPTER 16 Capital Expenditure Budgets

Commentary: The payback method recognizes the cash flows that are necessary to recover the initial cash invested. The payback method is advantageous because it is easy to under- stand and highlights risks. However, it does not take either profitability or the time value of money into account.

UNADJUSTED RATE OF RETURN (AKA ACCOUNTANT’S RATE OF RETURN)

The unadjusted, or accountant’s, rate of return is based on averages. The average accounting income is divided by the average level of investment to arrive at the account- ing rate of return. Step 1 computes the average accounting income; step 2 computes the average level of investment, and step 3 then calculates the accounting rate of return.

Step 1: In this example, the average accounting income is calculated by deducting depreci- ation (a non-cash amount) from the annual cash flow.

Step 1.1 First, we must calculate the annual depreciation amount. In this example the de- preciation is computed on a straight-line basis, which means the total amount of deprecia- tion will equal the equipment’s cost minus its salvage value.

The equipment’s cost is $70,000 and its salvage value at the end of its five-year life is esti- mated to be $10,000. Therefore, the total amount to be depreciated is the difference, or $60,000. To arrive at annual depreciation, the $60,000 is divided by the number of years of useful life, which is five years in this example. Therefore, the annual amount of deprecia- tion is $60,000 divided by five years, or $12,000 per year.

Step 1.2 Next, we must use the depreciation amount to calculate the accounting income per year. In this example, the accounting income represents the cash flow per year of $20,000 as previously computed less the depreciation expense per year of $12,000. The re- maining balance net of depreciation is $8,000 as shown in Table 16-A-2.

Step 2: In this example, the average level of investment is determined by calculating the av- erage investment represented by the equipment. We determine the average investment by computing its mid-point as follows:

Step 2.1 Determine the total investment by adding the initial investment of $70,000 and the salvage value of $10,000, for a total of $80,000.

Step 2.2 Now divide the total investment of $80,000 by 2. The answer of $40,000 indi- cates the mid-point of the investment and is considered the average investment over the five-year period of its useful life.

Step 3: The unadjusted or accounting rate of return is now calculated by dividing the aver- age income (step 1) by the average invest- ment (step 2). In this example, the unadjusted or accounting rate of return

Table 16–A-2 Accounting Income Input

Less Balance Net of Year Cash Flow Depreciation Depreciation

1 20,000 12,000 8,000 2 20,000 12,000 8,000 3 20,000 12,000 8,000 4 20,000 12,000 8,000 5 20,000 12,000 8,000

amounts to $80,000 average income divided by $40,000 average investment, or a 20% rate of return.

Commentary: While the accounting rate of return is based on profitability, it does not take the time value of money into account. That is why it is known as the “unadjusted” rate of return. This method is used by many capital expenditure budget decision makers.

NET PRESENT VALUE

Net present value, or NPV, is a discounted cash flow method. It is based on cash flows in that it takes all the cash (incoming and outgoing) into account over the life of the equipment. Table 16-A-3 shows the individual steps involved in the computation as follows:

Step 1: Enter the net cash flow on the table. (For this example, the net cash flow has already been calculated; see the middle column of Table 16-A-1. Also enter the salvage value.)

Step 2: Determine the cost of capital (which is 10% in this example). Look up the present value factor for 10% for each period. Also, include the present value factor for the salvage value.

Step 3: Multiply the present value factor for each period times the period’s net cash flow.

Step 4: Compute the net present value by first adding the present value answers for each op- erating period (Years 1 through 5 plus the salvage value) and then by subtracting the initial cash expenditure of $70,000 in Year 0 from the sum of the present value computations. In this example, 70,000 is subtracted from a total of 81,980 to arrive at the net present value of $11,980 as shown in Table 16-A-3.

Commentary: Net present value takes all the cash (incoming and outgoing) into account over the life of the equipment. Even though the net present value is based on cash flow, it also takes profitability and the time value of money into account.

INTERNAL RATE OF RETURN

Internal rate of return, or IRR, computes the actual rate of return that is expected, or as- sumed, from an investment. The internal rate of return reflects the discount rate at which the investment’s net present value equals zero.

Internal Rate of Return 187

Table 16–A-3 Net Present Value Computations

Salvage Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Value

Net Cash Flow (70,000) 20,000 20,000 20,000 20,000 20,000 10,000 Present value factor (10% cost of capital) n/a 0.909 0.826 0.751 0.683 0.620 0.620 Present value answers (70,000) 18,180 16,520 15,020 13,660 12,400 6,200 Net present value = 11,980

188 CHAPTER 16 Capital Expenditure Budgets

The IRR computation will be compared against the cost of capital. In our example the cost of capital is 10%, as set out in our initial assumptions.

The internal rate of return, or IRR, seeks the rate of return that allows the net present value of the project to equal zero. The IRR expresses the rate of return that the organization can expect to earn when investing in the equipment (or the project, as the case may be).

The actual rate of return is determined by trial and error. The authorities say to “guess” and work forward from your initial guess. An easier method to arrive at IRR is to use a busi- ness calculator or a computer program and let it perform the computation for you. It is cumbersome, but possible, to arrive at the appropriate IRR by hand. An example follows.

This example solves for an initial investment of 70,000 and a positive cash flow of 20,000 per year for five years. Because the annual amount of 20,000 is the same for each of the five years, we can use the “Present Value of an Annuity of $1” presented in Appendix 12-C for this purpose.

The computation is approached in two steps as follows:

Step 1: Initial investment (70,000) divided by the annual net cash inflow (20,000) equals the annuity present value (PV) factor for five periods. We compute 70,000 divided by 20,000 and arrive at a PV factor of 3.5.

Step 2: Now we refer to Appendix 12-C, the “Present Value of an Annuity of $1.” We look across the “5” row (because that is the number of periods in our example). We are looking for the column that most closely resembles our PV factor of 3.5. On our table we find 3.605 in the 12% column and 3.433 in the 14% column. Obviously 3.5 will fall somewhere be- tween these amounts. To find what 15% would be, we add the 3.605 to the 3.433 and divide by 2. The answer is 3.519 (3.605 � 3.433 � 7.038; 7.038 divided by 2 � 3.519). Thus we have found, by trial and error, that the rate of return in our example is approximately 15%.

As we have previously stated, an easier method to arrive at IRR is to use a business calcu- lator or a computer program and let it perform the computation for you. The business cal- culator or computer program will quickly give you a precise answer.

Many capital expenditure budget proposals also compare the rate of return to the orga- nization’s cost of capital. In our example, the cost of capital is 10%, so the 15% IRR is clearly greater.

Commentary: Internal rate of return, or IRR, is also a discounted cash flow method that takes all incoming and outgoing cash into account over the life of the equipment (or the project). It, too, takes profitability and the time value of money into account.

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