Capital Budgeting in Health Care

Capital Budgeting

There are five strategic projects that are available for Superior Health System. The system lost money last year, but it does have a contingency fund. Whether it is worth dipping into that fund, or other avenues of financing, depends on the strength of these projects. So it is important to analyze the projects.

Partner with a major supplier who will guarantee price, delivery, and product quality

Expand the ENT, Plastic, Gynecology, and Orthopedics surgical programs

Develop a cost-reduction program.

Spend $3,000,000 to expand primary care physician membership in Corinth Health Systems, SHS's PHO

The rational for this order is as follows. Financially, the first two options are positive. Partnering with a major supplier, if it costs nothing up front and delivers that sort of value, should have been done yesterday. Expanding the ENT, gynecology and orthopedics departments has the highest up front cost, and while that might be a barrier for management to overcome, this option is expected to generate substantial revenues in subsequent years, more than enough to pay for the up-front cost, even with two years.

The third option, the cost-reduction program, is another one that should be done. There is an up-front cost, but it is believed that over the course of a few years, the cost reductions will result in savings significantly beyond the up-front investment.

From a capital budgeting perspective, neither the Henry Street School option nor the primary care option should be undertake. There is nothing in the primary care option that points out how this will generate incremental cash flows for Superior, so it is out. Running a day care is an entirely different business, so that should be entered into with caution and only if it projects to be wildly profitable. It does not -- instead it is estimated that it will not be able to generate any contribution margin, thus not cover fixed costs nor pay back on the building purchase. Both of these options, as they reduce the overall value of the organization, should be rejected.

b. The finance committee's evaluation seems reasonable on some points, silly on others. Corporate debt is usually at a fixed interest rate, not floating, so even if Superior's credit rating declined, it would not cost the company more until it comes time to renew the debt. So on that point, the finance committee is incorrect. Further, it should have a better sense of what causes a bond rating to drop. It is actually quite unclear from this analysis that the bond rating would drop, though such a rating might be at least somewhat dependent on the ability of the organization break even while meeting its obligations. It is understandable, however, that the finance committee would be leery of putting their credit rating at risk.

The losses from last year are definitely something that should concern the finance committee, and they are right that such losses are not sustainable. The budget should reflect that the organization wants to set a course that is financially sustainable, unless it has good reason to do otherwise. A good investment is a reasonable reason to run a budget deficit; ongoing operations are not. It will hurt the organization in the long run to set out an irresponsible budget at this point. That said, the $6 million figure is entirely arbitrary, and should be taken with a grain of salt by the finance committee, especially knowing that in capital budgeting, a project with a positive NPV should be undertaken. Arguably the most expensive proposed project, the expansion, has a much higher NPV that leaving the money in the rainy day fund where it is lucky if it actually earns a real return at all.

c. I vote to fund partnering with a major supplier as there is no stated cost. This should have been done yesterday. I support the expansion, which carries with it a $7 million price tag. Among projects, this has the highest NPV, and because we are increasing capacity, that positive cash flow is sustainable over the long run. If the market analysis shows that the revenue projections are reasonable, we should utilize some of the rainy day fund in order to facilitate this sort of organizational growth. The cost reduction program I will also support. Though there is an upfront cost, this project again has a positive net present value. Because of that, and the fact that the benefits of cost reduction are ongoing in nature, I would vote for that as well.

The other two projects, according to the information provided, do not have a positive net present value. As such, I cannot recommend them.

d. To the advocates of the projects deferred, I have some advice. I am concerned about the proposal for the Henry Street School. We know nothing about running a day care. Our best projections should a competitive environment and inability to cover fixed costs, let alone pay back the purchase. The arguments that it has low risk of loss do not correspond with our data, and sound like people who want the project making up arguments to try to convince us to undertake the project. Next time, bring data. If there is a benefit to absenteeism, etc., quantify that. The finance committee cannot recommend anybody's pet projects -- we need to know we're spending our money well.

To the advocate of the primary care physician membership, again quantify the results. Right now, the proposal has a price tag on it, but revenue is not even intimated. And costs -- 5 per year? 5 what? The numbers need to be clear, logical and they need to be cited. Only then can a project be considered. You have to make a financial business case to win approval.

To Expand Funding

We should expand funding to take on any project that has a positive net present value. With $6 million, we are specifically ruling out the idea of expanding our facilities. We have the money to spare, however, for good projects that will pay back, and do so over the long run. Any project that has a positive net present value will add to the value of the organization, and therefore should be undertaken. It is understood that these projects will cost us an extra $2 million on the budget, but we have that. These projects will pay back to Superior more than whatever cash account that money is sitting in today. We have an entire year's budget in cash -- that is more than we need. Our current ratio must be through the roof -- we can easily afford to cut into that rainy day fund given the size of our overall budget.

Expanding funding need not come at the cost of the credit rating, either. As noted, with an entire year's budget in the rainy day fund, our current ratio must be very high, and that is one of the key measures for creditors. It is doubtful that we will drop below any reasonable threshold for creditors if we undertake these projects. It is true that the organization cannot run an operating deficit for any length of time without threatening our credit, but capital projects are not the operating budget. Capital projects, if they have a positive net present value, will increase the value of the organization over time, so it is important that they are undertaken when the opportunity arises to increase the value of the organization. The three projects approved do just that, and they do it in the context of our existing operations, and our existing sources of strength.