MHC6305WEEK5LECTURE.docx

MHC6305 WEEK 5 LECTURE Page | 1

Capital Projects

Capital projects may be complex, but basically, the cash outlay is not recovered until the project is terminated. This cash outlay becomes equity invested in the project. This equity may be determined by a strategic value to the organization, or it may consist of some cost that cannot be recovered. In any case, investment in a strategic asset carries some expectation of a return in the form of income from that investment. It may take many years to recover a strategic investment through income from that investment. This period is termed “time to breakeven.” Many of the measures of financial health, such as return on investment and internal rate of return, hinge on this income. Net present value is a measure of various cash flows from the investment over time that really give an idea of what the investment is worth, and this may be compared to what was expended on that investment. In a large organization, there are many projects that are desirable but only so much money can be expended on capital purchase. Internal rate of return and net present value are two measures that can be used to rank alternative investment options and determine which has the greatest potential for return on the investment, making it easier to select which of the projects to go forward with. It is good for organizations to review the results of the budgeting process with the actual results achieved through investment of capital in to fine-tune their tools and assumptions in making future investments.
The social value of a project can be a major factor in a capital project and the risk associated with it. For example, the organization, say a clinic, could be considering the expense of a million-dollar radiology machine for doing rapid breast cancer screening. The machine is only used for screening and has little profit per procedure, if any. This would be a terrible project from a purely financial standpoint, but the social value of saving many in the community from a major cancer that is common and deadly is enormous. This factor must be considered. It should also be used to promote the ideals of the organization.

 Project Risk Analysis

Capital budgeting risk analysis includes three elements: defining the relevant risk, assessing that risk, and incorporating the assessment into the decision process. In capital budgeting, financial risk is related to uncertainty about a project’s profitability. If any of the forecasted cash flows are not known with certainty, the project’s forecasted profitability is uncertain and hence risk is present. As in all investments, risk is the primary determinant of a project’s required rate of return (discount rate). Different types of project risk can be defined and, at least in theory, measured: Stand-alone and Corporate. The risk that is relevant to a particular analysis depends on the situation at hand. Stand-alone risk assumes that the project will be operated in isolation and hence ignores any portfolio effects. It is measured by the amount of uncertainty in forecasted profitability—the greater the uncertainty, the greater the risk. Corporate risk concerns the risk that a project brings to the organization as a whole. The risk may be small or large, but it is best if it is within the average range of risk of all the projects undertaken by the corporation. Risk is always inherent in any project, but there are ways to limit the risk. Risk can be limited by transference to another party by way of insurance. Taking steps to reduce the risk and share it with another party, such as a community fund that guarantees a certain participation rate, can mitigate it.
It will always be unwise for a leader to enter into any project without knowing the risks and assessing them as a part of the decision-making process. Some projects have more risk than others. When choosing which projects to fund, the manager should take into account the social value of each project and the ability to limit the risk.

Risk Analysis Techniques

Risk analysis of standalone projects in HCOs can be complex. Two methods are commonly used, and they are relatively simple to use. Sensitivity analysis examines a project’s value based on things such as the change in net present value brought by given changes in an input variable such as the volume of items sold. Here is an example. You want to buy an x-ray machine and determine the sensitivity of its net present value based on the number of procedures you expect to do per day, with a low, a medium, and a high valuation. Scenario analysis is another tool and works somewhat like a spreadsheet. When you make reasonable changes to the inputs, such as income, it is easy to see the likely net value under that condition. In many situations, a low, a medium, and a high version of the input is sufficient to cover the likely circumstances. The low and high versions might also be termed least likely and most likely, respectively. An example might be returns using 4%, 6%, and 8% as scenarios. When these tools are used to determine the best case or most likely case for the profitability of projects, it is possible to estimate the value of the project and compare it to the cost of capital to the organization. It is common today to find that there are more projects than there is funding for projects, so it is important to know how to get the best bang for your buck.
Lastly, we turn our attention to capital investment decisions, or how those funds can be deployed (spent) in the most financially efficient manner. The overall process of choosing capital investments is called capital budgeting. Perhaps the most critical part of capital budgeting is cash flow estimation because the financial value of proposed projects is the cash flows they are expected to produce. The basic concepts of capital budgeting include how to estimate a project’s cash flows and how to measure its expected financial impact. Like all investment decisions, risk plays a critical role. We will learn how to assess the risk of a project as well as how to incorporate that assessment into the capital budgeting decision process