Read Me First - University of Phoenix



Weekly Overview

Week Two

Overview

Understanding time value of money concepts is critical to business managers making financial and investment decisions. The two key components of time value of money are present value and future value valuation methods. The present valuation (also known as PV) of money allows business managers to calculate the value of future cash flows in today’s dollars based on current interest rates or expected returns on an investment. The use of future value calculations (also known as FV) involves determining the amount of money earned in a future timer period from a current investment or investments made in today or in a series of payments over time. A key concept of time value of money is that a dollar today is worth more than a dollar in the future based on the premise that the dollar can be invested now and earn a return.

One key that is critical to the success of health care facilities is making good choices with investment capital decisions. Capital is any large dollar asset that is not an expense based on the total amount of the spend. Also, the fact that the asset is used for multiple years by the organization. Capital assets come in the form of land, buildings, medical equipment, and machines for services, as well furniture and fixtures that are in the health care facilities. Because acquiring these assets requires making decisions about large sums of money, they must derive value and efficiency in the process of delivery products and services. Some capital investments are made in order to reduce costs as well, although most are made based on driving increased revenue.

There are various methods used to evaluate capital investment decisions. One is called the payback method. This method measures the feasibility of an investment based on the duration of time it takes to recover the amount of the initial investment. The payback method does not apply time value of money principles, so it is deemed deficient compared with two other options, net present value (NPV) and internal rate of return (IRR). The net present value method calculates the difference of the present value of future cash flows generated by a capital project netted against the initial investment. If the NPV is a positive value, generally the projected value is regarded as one the business should move forward with because it is adding derived value to the organization. As for the internal rate of return method, it determines the rate of return on the investment if the net present value (NPV) is equal to zero. If this rate exceeds the required rate the business expects or the cost to finance the project, then the project is deemed to be one that the business should do. This is based on the premise that the return exceeds the required return or cost to borrow.

What you will cover

1. Time Value of Money and Investment Decisions

a. Calculate results using present and future valuation methods

1) Present Value (PV)—the value or amount today of a future payment, or the value today of a series of payments made over time.

PV = FV x 1 / (1+i)^n

Where:

FV = Future Value

PV = Present Value

i = Interest Rate (usually expressed on an annual basis)

n = Number of periods invested (usually expressed in number of years)

2) Future Value (FV)—the value in a future time period of an amount invested today, or the value in the future of a series of payments made over time.

FV = PV x (1+i)^n

Where:

FV = Future Value

PV = Present Value

i = Interest Rate (usually expressed on an annual basis)

n = Number of periods invested (usually expressed in number of years)

3) A dollar today is worth more than a dollar in the future based on the premise that the dollar today can be invested now and earn a return

a) Methods of interest used in calculating future returns

(1) Simple interest—interest is calculated only on the principal invested

(2) Compounding interest—interest is calculated on the principal invested and interest earned in prior periods

b. Explain the objectives of capital investment decisions.

1) Capital investments are large monetary decisions that health care organizations make with regard to assets needed to deliver products and services. Given the sizeable investments made for capital purchases, it is imperative that the due diligence is done to ensure returns are strong enough to justify the purchase.

2) Capital investment decisions have two components that need to be addressed. The first is determining if the investment will yield a sufficient return. After it is determined that a capital project is worthwhile, figuring out how to finance the investment is the next decision. The ideal scenario would be that capital purchases are cash funded, but this is not always feasible. Thus, the most appropriate financing option must be determined because it will be funding long-term assets like equipment, buildings/facilities, land, furniture, and technology initiatives.

3) Key factors to consider with capital investments projects.

a) Financial return—as noted above, the capital investment must pay for itself and yield a return on the investment to sustain successful operational and financial performance.

b) Nonfinancial benefit—the financial benefit is critical, but capital spends must also support the organization’s missions, goals, and objectives

c) Future funding—projects need to be profitable to attract debt (borrowing) and equity financing in the future by external investors. If capital investments are not achieving desired results, attracting external investors and those willing to offer debt will be challenging.

4) Capital investments in health care facilities typically fall under these categories:

a) Strategic decisions—selection of a capital project that is intended to increase the health care organization’s long-term strategic position.

b) Expansion decisions—choosing a capital project that increases the health care facility’s capacity or operation capability. This could be for assets for the creation of a new product or service or a new addition to the facility itself.

c) Replacement decisions—this includes capital purchases designed to replace outdated or obsolete assets with new, cost-saving assets.

d) Although the three categories include different reasons for making purchases of capital assets, sustainability of the success of the business is a common thread. Capital purchases are sizeable investments upfront that can not only increase revenue, but also have cost savings benefits.

c. Calculate and interpret results using net present value (NPV) and internal rate of return (IRR).

1) Payback method—measuring the feasibility of investment based on how long it takes to recover the amount of the initial investment.

a) This method is simple to use; however, it completely disregards the time value of money

b) The payback method is easy to understand

c) The result is based in years not a dollar figure

d) Determining the appropriate criteria for the desired payback period is arbitrary. In addition, by not considering the time value of money, this method is usually only used as a general rule of thumb, not for final decisions.

2) Net Present Value Method (NPV)—the NPV method is another approach to determining the feasibility of capital investments. The NPV calculates the difference of the present of future cash flows generated by a capital project netted against the initial investment.

a) The method is preferred over the payback method because it takes the time value of money into consideration. The downside to this method is that the cash flow may be difficult to estimate as well as an appropriate required rate of return (also known as the discount rate).

b) The decision rule is that if a project has a Net Present Value greater than or equal to zero, the project should be accepted. If the NPV is less than zero, the project should be rejected. If multiple projects are being considered, the project with the highest Net Present Value should be selected.

3) Internal Rate of Return Method (IRR)—this valuation method determines the rate of return on an investment in which the Net Present Value is equal to zero.

a) Decision rules for the IRR method

(1) If the IRR is greater than the required rate of return, the project should be accepted

(2) If the IRR is less than the required rate of return, the project should be rejected

(3) If the IRR is equal to the required rate of return, the health care facility should be indifferent on accepting or rejecting the project.

b) The IRR is widely used because it is easy to understand and it takes a time value of money approach into account. However, the method sometimes may generate multiple rates of return, which can make coming to a decision difficult. In addition, the cash flow estimate may be difficult to quantify.

Discussion PROMPTS

1. WHY IS $1 WORTH MORE TODAY THAN IT IS IN A FUTURE PERIOD?

2. How does an organization select from multiple projects that have positive NPVs if there is only a fixed amount of capital it can spend?

3. How can a required rate of return that is too high or too low affect the decision making process in NPV or IRR valuations?

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download