Evaluating capital investment proposals using break-even and payback analysis

¶ … medical proposals, one for a new psychiatric facility (Proposal 1), and the second for a lease of CT scan equipment (Proposal 2), it is ultimately the second proposal that provides greater incentive for an investor although it does expose investors to a higher degree of risk. While both do eventually reach a point of profitability, the higher return-on-investment of Proposal 2 (950%) versus Proposal 1 (47%) makes it a more financially lucrative investment over the total four-year period currently under analysis. This does come at a price, however, as the initial investment of $50,000 for Proposal 2 is $35,000 greater than Proposal 1 at $15,000.

Return on Investment (ROI): (Return -- Investment) / Investment

Neither proposal is fiscally solvent in the first year of operation. Proposal 1 operates at a $35,000 deficit. Total costs for the year are $95,000 ($20,000 variable costs and $75,000 in fixed costs) while revenue from fees for patient visits only raised $60,000 ($120 per visit, per patient times 500 expected patients). Considering the psychiatric facility requires a $15,000 investment for operation it puts the net profits for investors during year one of Proposal 1 at minus $50,000.

Net Profit: Gross Profit -- Total Costs -- Initial Investment

Total costs for year two are $115,000 while gross profits are $120,000 equaling a positive cash flow of $5,000 ($40,000 in variable costs, $75,000 in fixed costs, and $120,000 raised from patient fees at $120 per visit, per patient times 1000 patients). Since, however, the first year produced a $50,000 deficit for investors the net profits are still in the red at $45,000. Year three is the first year investors can expect at least a neutral return. Gross profits for year three are $180,000 while total costs equal $135,000 resulting in positive cash flow of $45,000. Proposal 1's previous deficit of $45,000 becomes negated and net profits are at zero. The fourth year of operation is the first year of net profit for Proposal 1. Gross revenue reaches $240,000 while total costs reach only $155,000 resulting in net profits of $85,000. This recoups the initial investment of $15,000 and results in a positive ROI of 467%. Internal rate of return is 72%.

Conversely, Proposal 2 operates at a $150,000 deficit for its first year of operation. Totals costs for the CT scan equipment are $1.1 million ($500,000 variable costs from $500 per patient and $600,000 fixed cost for insurance and equipment leases) while revenue for year one is only $950,000 (from per visit payments of $950 per patient). One thousand patients are expected in year one of operation. The initial cost of investment for Proposal 2 was $50,000 putting the total budget deficit for Proposal 2,-year 1 at $200,000. Total costs for year two are $1,350,000 while gross revenue reaches $1,425,000. This presents a positive cash flow of $75,000 however because of the loss of $200,000 in year one, net profits for year two are negative at $125,000 ($200,000 [year one net profit] - $75,000 [year two cash flow]).

Like Proposal 1, Proposal 2 becomes profitable over the baseline in year three. Total costs for operation are $1.6 million while profits reach $1.9 million equally a positive cash flow of $300,000. This allows the medical center to recoup it's initial investment of $50,000 for the lease of the CT scanners as well as pay off the debt for the previous two years or $125,000 equaling net profits of $175,000. Year four of operation for Proposal 2 has total costs at $1.85 million while the gross revenue for the year is $2.375 million equaling a positive cash flow of $525,000. Combined with previous year's net profit of $175,000 total net profit for four years equals $700,000.

Proposal 1

Investment

$15,000

Break Even Point

$50,000

Variable costs

$40

per patient

ROI

Fixed costs

$75,000

per year

Net Profits

$85,000

Patient fee