Finance

Module 12: Capital Budgeting

Skill Building

HAP395: Healthcare Finance

Time Value of Money Concepts – Part 2

Discounted Cash Flow Analysis in 8 Steps

Objectives:

1. Develop an understanding of the Discounted Cash Flow (DCF) techniques in making

capital investment and other financial decisions.

2. Practicing the DCF technique using a prepared Excel spreadsheet.

3. Practicing changing assumptions in an analysis in preparing “what it” analyses.

4. Gain experience using the Quantitative Literacy Checklist in understanding these

concepts.

I. The Eight Step Process for Preparing a DCF Analysis

A. Preparing a discounted cash flow analysis takes eight steps. As shown

here, both the Net Present Value and Internal Rate of Return are computed,

although some organizations compute only one or the other.

B. Step 1: Choose the time period involved in the investment

alternative.

1. When choosing the time period you will typically consider two

variables. The first variable is the length of time of the investment. For a

piece of equipment, it is usually the life of the equipment. After a period of

years, the equipment may be sold at which time the project is complete

and the final year will include the cash flow from the sale.

2. The second variable is to determine the number of periods in which

to divide the time. It is most common to use the number of years,

especially in analyzing projects that will last many years. One could use

months or quarters in analyzing investments, and this might be

appropriate with a financial security such as a bond. Using months or

quarters for equipment or project analysis, however, becomes unwieldy. It

is common to use timing of annual cash flows with the additional

1 DK 11/4/22 v1.0

2 DK 11/4/22 v1.0

assumption that the flow will occur at the end of the year. Flows in reality

will occur throughout the year; however the year end convention is

common and yields reasonably good results.

C. Step 2: Determine the cash flows involved.

1. Cash flows come in two general types: Inflows, or cash being

received; and outflows, or cash being expended or invested. Note that a

project that is expected to save expenses treats those savings as a cash

inflow.

2. Flows over time might be either as a single sum or as a series.

Thus, there are four typical patterns of cash flow for any investment.

a) Out In

b) Out Out Out Out . . . In

c) Out In In In . . .

d) Out Out Out Out . . . In In In . . .

3. The first out flow, if done today, in the present, is made in period

“0″. Subsequent flows will be noted in the subsequent periods.

D. Step 3: Determine the Net Cash Flow

1. This is determined by summing all of the net inflows and subtracting

the net outflows from these. To keep these amounts organized it is

common to treat all inflows as a positive number, and all outflows as a

negative number.

2. The end result is a series of net cash flow by period, starting with

period 0 and ending with the final period of the project; not one number,

but a series of numbers; one for each period.

E. Step 4: Select a discount rate in which to discount the future cash

flows to the present.

1. The discount rate is the “hurdle rate”, that is, the rate at which the

organization will place on this project so that if it “clears” this rate (as a

runner in track might clear a hurdle) the project will be deemed financially

attractive. If the project does not clear the parameters established by the

hurdle rate, the net present value of the project will be a negative number.

This will mean that the present value of all future inflows does not equal at

least the present value of the initial outflow, deeming the project financially

unattractive.

2. While a “hurdle rate” might vary by project depending on the amount of

risk involved, a common practice is to use an organization’s “cost of

3 DK 11/4/22 v1.0

capital” as the discount rate. This cost of capital rate is the hypothetical

rate that must be earned on the investment such that the overall value of

the firm will not be changed. In for-profit companies it is a blend of the

amount of money it costs, net of taxes, to borrow cash (interest expense),

blended with the amount of money it costs associated with common stock.

(In this case it is a function of the dividends and stock appreciation

expected by the owners). In not-for-profits, because there is no stock, the

cost of capital is at least the cost of the organization’s debt, or the interest

rate on the debt it has.

3. Step 4c is not to worry about the rate selected in step 4a. There are

enough estimates involved in discounted cash flow analysis that the

selection of the rate is unlikely to make a significant impact on the

deciding the attractiveness of the investment as long as a reasonable rate

is used. Reasonable means no lower than the cost of the next dollar of

debt which would be paid.

F. Step 5: using the discount rate, compute the net present value of the

investment. This can be done in one of several ways.

1. Using a financial calculator, the net cash flows can be entered by year.

This method is long and tedious and is not particularly desirable. Still it

can be done, and somewhere in the instruction manual of the calculator is

a long explanation on how to accomplish this. Try it if you want to,

however, this is not recommended.

2. Using a financial present value table, the net present value of $1 can

be determined for each year. (You can also determine this using the

appropriate mathematical formula found in the text). Simply multiply this

factor by the net cash flow to get the discounted cash flow or that year.

Sum all of the years, including year 0 and the total will be the Net Present

Value.

3. Using a financial spreadsheet, both methods one and two can easily

be done. This is likely the most efficient way to do this task.

a) A spreadsheet such as Excel has NPV formulas which will

automatically compute the present value of a stream of cash flows

at a given discount rate.

b) The spreadsheet can also compute the appropriate discount

factors by year, multiply them by each year’s net cash flow, and

sum them to arrive at the net present value. If the spreadsheet is

4 DK 11/4/22 v1.0

done appropriately, both methods can be done with the longer

manual calculations being done as a check.

G. Step 6: Determine if the sum of each year’s discounted present

value.

1. If the Net Present Value is greater or less than 0, then the project

adds value to the organization. If less than 0, the project reduces the

value of the organization.

H. Step 7: Using the cash flows identified, determine what discount rate

would be appropriate in order to make the net present value equal to zero.

1. This value by definition is the Internal Rate of Return (IRR) of the

project or investment. “Internal” because it typically will be a project that

an organization might undertake by purchasing equipment and doing

something inside of the organization to produce a product for sale, or to

save costs; “Rate of Return” because it is an expression of an interest

rate which can equate the flows of the investment with that of an external

investment such a bond or bank account.

a) If the internal rate of return of the project is greater than the

hurdle rate, then you have a “winner”. If less, the project is a

“loser”. The spread between the IRR and the hurdle rate is the

“Computational Risk” associated with the selection of the discount

rate. The larger the spread, the less the discount rate selected has

to do with the generation of a positive NPV.

A great advantage of using spreadsheets, in addition to their accuracy,

speed, and ease of use once you know the basics, is the ability to perform

“what if” analysis. If one changes assumptions, what will be the new

results? This type of exercise is termed “sensitivity analysis” and is

valuable in gaining insight as to the level of impact of changes made.

I. Step 8: Reflect on your answers, assumptions, and process.

1. Using concepts introduced in the Quantitative Literacy

Rubric/Checklist used in this course, think about the various results you

have calculated. Do they appear reasonable? What assumptions went

into this analysis that may give you some concern? What conclusions can

you make from this analysis? How will you communicate these results to

others?

II. Other analytical values determined by DCF analysis

A. The DCF analysis yields two are values that are sometimes uses in

analyzing investments.

1. The first is the “Profitability Index”. This is an index used to

compare one investment alternative with others. Values above one are

5 DK 11/4/22 v1.0

desirable, with the higher the value, the financially better the alternative.

a) The computation for the Profitability Index is to take the NPV

for all future cash flows and divide that by the value of the initial

investment.

b) The second is the “Payback Period”. This value measures

the time it takes to recoup the investment inflows to a level to equal

the initial investment. This time is normally measured in years, with

shorter payback period being better than longer ones. For this

analysis, traditional payback calculations use undiscounted cash

flows, which is a drawback as it does not take into account the time

value of money. An alternative is to use discounted cash flows to

determine a discounted payback period.

III. Discounted cash flow analysis is often used in two types of

analysis.

A. The analysis of a capital investment. An investment might be a financial

investment, such as a bond, or it might be a piece of equipment, project, or new

service line which includes a combination of equipment and operating expenses.

B. The analysis of financing options, particularly when confronted with the

decision of purchasing a piece of equipment or leasing it.

C. In both cases, the fundamental seven-step process can be used.

IV. An example of using the DCF Eight Step Process

A. Using the accompanying spreadsheet as a template, compute the net

present value (NPV), the internal rate of return (IRR), the Profitability Index, and

the Payback Period using discounted cash flows, for a project with these

assumptions:

1. The initial price of a piece of equipment we’ll call “Project A” will be

for $100,000.

2. Gross revenues associated with the program using this equipment

will be $60,000 each year for 5 years.

3. Net revenues associated with a program using this equipment will

be $40,000 each year for 5 years, thus the deductions from revenue year

will be $20,000.

4. Expenses will be $10,000 each year for 5 years.

5. The equipment will be sold for $10,000 after the end of the five

years.

6 DK 11/4/22 v1.0

6. The discount rate to be used will be 10%.

B. Change these variables and note the new results:

1. Changing the purchase price from $100,000 to $110,000 yields

these values.

2. Keeping the $100,000 purchase price, and decreasing the discount

rate from 10% to 8% yields these values.

The answers are noted below as well as on separate tabs of the

accompanying Excel Spreadsheet.

7 DK 11/4/22 v1.0

Answers to Project A Base Problem:

Net Present Value (NPV) = $19,933

Internal Rate of Return (IRR) = 17.23%

Profitability Index = 1.20

Payback Period using discounted cash flows = 4.20 years

Answers to change 1 — Increasing purchase price by $10,000:

Net Present Value (NPV) = $9,933

Internal Rate of Return (IRR) = 13.34%

Profitability Index = 1.09

Payback Period using discounted cash flows = 4.60 years

Observation: Increasing the purchase price lowers the NPV; lowers the

IRR; decreases the Profitability Index; and lengthens the Payback Period.

Answers to change 2 — keeping original purchase price and decreasing

discount rate from 10% to 8%:

Net Present Value (NPV) = $26,587

Internal Rate of Return (IRR) = 17.23%

Profitability Index = 1.27

Payback Period using discounted cash flows = 4.02 years

Assumptions:

For your analysis assume that the Center uses a 7% discount rate for projects

of this risk level, and that they will initially use a five-year time horizon. This is a

tax-exempt not-for-profit organization so there will not be any income tax effects

to consider in the calculations.

The business after buying the equipment is expected to generate gross revenues

of $140,000 each year in the first two years and is expected to be $190,000 each

year in the next two years, followed by $240,000 in the fifth year. The services

will be paid for by third parties and there is a demand for this new service. Since

the third-party payers will pay less than the full charge, assume that deductions

from revenue to average 20% of gross revenues in each of the five years. The

equipment cost is $425,000 and will cost $45,000 to install. After five years the

equipment will be retired, and it is expected that it could be sold for $60,000.

The costs for the service include part-time staffing costs of $13,000 and supply

costs of $10,000 in each of the first two years. For the following two years,

salaries are expected to be $15,000 and supplies are estimated to be $13,000;

and in the last year five, salaries are expected to be $22,000 and supplies are

expected to be $18,000. The equipment is under warranty in the first year so

there is no extra fee paid. A maintenance contract costing $6,500 per year will

be paid in years 2 through 5.

1. Use the template spreadsheet and 8-step process to enter the above

assumptions in the appropriate cells.

2. Compute the Net Present Value of Future Cash Flows, and the Internal

Rate of Return. Highlight in yellow those two answers on your

spreadsheet. Note those answers in the table below so that they are

in both places.

3. Note at the bottom of the schedule whether this is an attractive project

from a purely financial point of view based upon the numbers that you

calculated on the spreadsheet. Why did you make that decision? Note

your answers in the table below so that they are in both places.

Optional Additional Point Opportunity:

Copy your spreadsheet tab with your answer and label the new tab “Six

Years”. Add a Year 6 column and assume that year six cash inflows and

outflows will be the same as year 5, with the exception that the equipment

will be sold for $40,000 at the end of year 6 instead of $60,000 at the end

of year 5. Adjust any formulas in the cells as appropriate caused by

the addition of a year 6. Compute the new Net Present value and

Internal Rate of Return for this six-year project. Highlight those answers in

yellow on your spreadsheet. Note those answers in the table below so

that they are in both places

Custompaper.help is an academic writing platform that provides students and professionals with quality services to ease their assignment challenges. With a wide range of services, the platform has become one of the leading academic writing service providers in the market due to its reliability and affordability. Below, we shall discuss some of the services which Custompaper.help provides:

Essay Writing Service

The essay writing service provides customers with quality essays on any subject or topic they requested within a given deadline. The writers at custompaper are experts in their respective fields, and they ensure customer satisfaction by producing original content with thorough research involved backed up with strong evidence from reliable sources available online or offline. All essays come with free plagiarism reports as well as revisions if needed so that customers can trust that they are getting high-quality work for their money’s worth.

Research Paper Writing Service

This is another popular service offered by custom paper help wherein customers are assisted in conducting research papers according to their needs and requirements within specified deadlines. Writers at custom paper help have vast knowledge about various topics belonging to different disciplines such as Management, Arts & Humanities, History etc., allowing them to craft impeccable research papers every time regardless of the complexity or urgency level requested by customers. Additionally, all our research papers come along with proper citation formats which ensures customer’s safety when it comes to plagiarism issues while also helping them save time on formatting procedures thus improving overall efficiency even further!

Dissertation Writing Service

CustomPaperHelp also offers dissertation writing assistance for those who need it most – students preparing for graduation or professionals wanting to further refine their skills through higher education levels such as Master/PhD degrees etc, Our team of writers consists of experienced individuals having Master’s/PhD degrees themselves so you can rest assured that your dissertation will be handled expertly from the start till the end! Furthermore, we offer unlimited revisions until your complete satisfaction is achieved, along with regular checkups being done throughout the process just so everything goes according to course without any hiccups!

Editing And Proofreading Services

If you already have written an essay but want professional feedback before submitting it, then CustomPaperHelp also offers editing & proofreading services which helps in identifying & rectifying errors present in assignments like grammar mistakes, spelling mistakes, punctuation problems etc., thereby ensuring top-notch quality work, before submission takes place! We understand how important accuracy & consistency are when it comes to grading systems used at universities nowadays, so taking extra care during this phase becomes absolutely essential if good grades are desired afterward!

Coursework Help

For those who find coursework difficult due to complications of being quite technical in nature; CustomPaperHelp extends its support here too, by providing quality solutions every single time – starting from understanding concepts properly up until composing flawless answers following university guidelines closely enough making sure no loopholes remain whatsoever! Whether it’s related math problem-solving algorithms or lengthy home assignments – our expert panel has got you covered from head-to-toe leaving no stone unturned during this very crucial stage since final grades depend largely upon the success rate achieved here successfully!

Assignment Help

Assignments form an integral part of getting better scores & ultimately, a degree itself (in case pursuing a masters/PhD) – something only possible if precision is made a priority right away; otherwise, chances of failure increase exponentially over a time period detrimentally affecting performance evaluation systems later down road drastically hence stressing timely importance completion prior commencement other operations associated same project altogether consistently meeting high standards expected each situation respectively! Here too, CustomPaperHelp presents comprehensive solution package exceeding expectations beyond point offering optimal values therein ensuring maximum satisfaction reached under circumstances prevailing accordingly without fail…proving once more why people trust us implicitly without second thought whatsoever!!

Why Choose Us

Quality Papers

We value our clients. For this reason, we ensure that each paper is written carefully as per the instructions provided by the client. Our editing team also checks all the papers to ensure that they have been completed as per the expectations.

Professional Academic Writers

Over the years, our Acme Homework has managed to secure the most qualified, reliable and experienced team of writers. The company has also ensured continued training and development of the team members to ensure that it keep up with the rising Academic Trends.

Affordable Prices

Our prices are fairly priced in such a way that ensures affordability. Additionally, you can get a free price quotation by clicking on the "Place Order" button.

On-Time delivery

We pay strict attention on deadlines. For this reason, we ensure that all papers are submitted earlier, even before the deadline indicated by the customer. For this reason, the client can go through the work and review everything.

100% Originality

At Custom Paper Help, all papers are plagiarism-free as they are written from scratch. We have taken strict measures to ensure that there is no similarity on all papers and that citations are included as per the standards set.

Customer Support 24/7

Our support team is readily available to provide any guidance/help on our platform at any time of the day/night. Feel free to contact us via the Chat window or support email: support@acmehomework.com.

Try it now!

How it works?

Follow these simple steps to get your paper done

Place your order

Fill in the order form and provide all details of your assignment.

Proceed with the payment

Choose the payment system that suits you most.

Receive the final file

Once your paper is ready, we will email it to you.

Our Services

Custom Paper Help has stood as the world’s leading custom essay writing services providers. Once you enter all the details in the order form under the place order button, the rest is up to us.

Essays

At Custom Paper Help, we prioritize on all aspects that bring about a good grade such as impeccable grammar, proper structure, zero-plagiarism and conformance to guidelines. Our experienced team of writers will help you completed your essays and other assignments.

Admissions

Admission and Business Papers

Be assured that you’ll definitely get accepted to the Master’s level program at any university once you enter all the details in the order form. We won’t leave you here; we will also help you secure a good position in your aspired workplace by creating an outstanding resume or portfolio once you place an order.

Editing

Editing and Proofreading

Our skilled editing and writing team will help you restructure you paper, paraphrase, correct grammar and replace plagiarized sections on your paper just on time. The service is geared toward eliminating any mistakes and rather enhancing better quality.

Coursework

Technical papers

We have writers in almost all fields including the most technical fields. You don’t have to worry about the complexity of your paper. Simply enter as much details as possible in the place order section.