Answer To: You have been hired in the finance department at a large, metropolitan for-profit hospital. Your...
David answered on Nov 30 2019
Capital Budgeting Issues- Mutually Exclusive Projects
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Being appointed as a financial manager of a hospital, he has been given the task of developing the financial analysis for the two mutually exclusive projects which are to build a Rehabilitation Centre or building a Neonatal Wing. These projects are required to appraise in light of the capital budgeting tools of NPV, returns, profitability etc.
Accordingly, the concepts of such project evaluation measures have been discussed and best estimate is being carved out.
CAPITAL BUDGETING TOOLS 2
A. NET PRESENT VALUE: 3
B. RETURN ON INVESTMENT 4
C. PROFITABILITY INDEX 5
D. CASE MIX 6
CAPITAL BUDGETING TOOLS
In capital planning choices, totally unrelated activities allude to a faction of ventures out of which just a single task can be chosen for investment. A choice to attempt one proposal from totally unrelated ventures limits every single other task from thought. (Jan, O. 2016)
Not at all like autonomous activities, in which a choice to put resources into one anticipate makes little difference to the choice to make interest in another, investment choice in case of an occurrence of totally unrelated ventures is subject to the merits of the tasks in relative terms.
The capital budgeting approaches takes into consideration various tools such as NPV, profitability index etc as discussed below.
A. NET PRESENT VALUE:
This method is widely used for capital budgeting decisions. It takes into account the time value of money. The most significant advantage of this method is that it explicitly recognizes the time value of money and considers the total benefits arising out of the proposal over its lifetime.
This concept is instrumental in achieving the objective of financial management, which is the maximization of shareholders’ wealth. For example, assuming a firm has $1 million of cash, it has two options either to pay it as dividend to its shareholders who can invest it to earn a return equivalent to cost of equity or to invest it in a project which generates cash flow. Shareholders would prefer the project if and only if it generates a return equivalent to or more than cost of equity. It will be possible only if the present value of cash inflow discounted at cost of equity is more than the present value of cash i.e., $ 1 million . This is called net present value.
Limitations of this method include its difficulty to calculate. The discount rate is the most important element used in the calculation of the present values, but calculation of this is very complicated as there is a difference of opinion even regarding the exact method of calculating it. Another shortcoming is that it is an absolute measure. Prima facie between two projects this method will favour the project, which has higher present value without considering initial outlay. Thus, in case projects involving different outlays, this method may not give dependable results. This method also does not give satisfactory result when two projects have different effective lives.
In case of mutually exclusive projects, the project with higher NPV is selected and if both the NPVs are negative, both the projects are not taken for investment purposes. (Peavler, R. 2017)
B. RETURN ON INVESTMENT
Degree of profitability (ROI) measures the pick up or misfortune produced on a project investment with respect to the measure of cash contributed. Return for money invested is generally communicated as a rate and is ordinarily utilized for individual budgetary choices, to contrast an organization's productivity or with analyze the effectiveness of various ventures.
Return for money invested = (Net Profit/Cost of Investment) x 100
The ROI figuring is adaptable and can be controlled for various employments. An organization may utilize the computation to think about the ROI on various potential speculations, while a speculator could utilize it to ascertain an arrival on a stock.
For instance, a financial specialist purchases $1,000 worth of stocks and offers the offers two years after the fact for $1,200. The net benefit from the venture would be $200 and the ROI would be 20%.The count can be modified by deducting duties and expenses to get a more precise photo of the aggregate ROI.
A similar figuring can be utilized to compute a project analysis by an organization. For instance, to make sense of the net benefit of a speculation, an organization would need to track precisely how much money went into the undertaking and the time spent by representatives chipping away at it.
Return for capital invested is a standout amongst the most utilized benefit proportions as a result of its adaptability. That being stated, one of the drawbacks of the ROI computation is that it can be controlled, so results may fluctuate between clients. When utilizing ROI to look at speculations, it's critical to utilize similar contributions to get an exact examination. (Myaccountingcourse,2017)
C. PROFITABILITY INDEX
This method is similar to NPV approach. It measures the present value of returns per rupee invested. A major shortcoming of the NPV method is that being an absolute measure, it is not reliable method to evaluate projects requiring different initial investments. This method in particular removes this shortcoming. It is used mainly in issues of capital rationing.
In other words, it is a relative measure. Profitability index is also known as “Desirability Factor”.
Profitability Index = Present value of cash inflows / Present value of cash outflows
Suppose a firm has only $ 10,000 to invest and has two alternatives to invest, each yielding PV of $ 15000 with investment of $7000 and $ 19000 with investment of $9000 over a period of 3 years on Ke of 12%. In such case, the profitability index will help by judging the best alternative. The PI of option 1 will be 2.14 against PI of 2.11 for option B and thus option A will be considered.
A project will qualify for an acceptance if its PI exceeds one. When the index equals 1, the firm becomes indifferent to project. This approach satisfies almost all the requirements of a sound investment criterion. It considers all the elements of capital budgeting, such as time value of money, totality of benefits and so on. This method is superior to NPV method as it evaluates the worth of project in terms of their relative rerun than absolute magnitudes.
However, in cases of mutually exclusive nature of projects, the NO method is superior to the PI method. In such cases, the projects with higher index are accepted and other is rejected. (Financial Management Pro, 2015)
D. CASE MIX
Case Mix Index (CMI) is a relative esteem appointed to an analysis related gathering (DRG/MSDRG) of patients in a restorative care condition. The CMI esteem is utilized as a part of deciding the distribution of assets to look after or potentially treat the patients in the gathering.
Patients are characterized into bunches having a similar condition, many-sided quality and necessities. These bunches are known as Diagnosis Related Groups (DRGs), or Medicare Severity-Diagnosis Related Groups (MS-DRGs).
Each DRG/MS-DRG has a relative value appointed to it that demonstrates the measure of assets required to treat patients in the unit, when contrasted with the various diagnosis related units within the framework. (Mandva, S. 2017)
The CMI estimation of a hospital facility can be utilized to modify the normal cost per persistent (or per day) for a given healing centre in respect to the balanced normal cost for different clinics by partitioning the normal cost per patient (or day) by the centre’s computed CMI.
The average cost per patient would mirror the charges announced for the sorts of cases treated in that year.
If a hospital has a CMI more than 1.00, their balanced cost per patient or every day will be lower and alternately if a doctor's facility has a CMI under 1.00, their balanced cost will be higher.
For instance, if Hospital A has a normal cost for every patient of $1,000 and a CMI of 0.80 for a given year, their balanced cost per tolerant is $1,000/0.80 = $1,250. In like manner, if Hospital B has a normal cost for each patient of $1,500 and a CMI of 1.25, their balanced cost per tolerant is $1,500/1.25 = $1,200.
This index helps in judging the finance of the hospital and determining where to perform.
1. Jan, O. (2016). Mutually Exclusive Projects. Retrieved October 31, 2017, from https://accountingexplained.com/managerial/capital-budgeting/mutually-exclusive-projects
2. Peavler, R. (2017, April 7). What Is Net Present Value (NPV) in Capital Budgeting? Retrieved November 01, 2017, from https://www.thebalance.com/net-present-value-npv-as-a-capital-budgeting-method-392915
3. A. (2016, May 27). Profitability Index, PI. Retrieved November 01, 2017, from http://financialmanagementpro.com/profitability-index-pi/
4. Return on Investment (ROI) Calculator | Formula | Example. (2017, October). Retrieved November 01, 2017, from https://www.myaccountingcourse.com/financial-ratios/return-on-investment
5. Mandva, S. (2017, May 10). Why Case Mix Index Matters To Your Hospital And How To Maximize It. Retrieved November 01, 2017, from https://www.mobileaspects.com/why-case-mix-index-matters-to-your-hospital-and-how-to-maximize-it/