Essay on Health Care Financial Management
Number of words: 1795
Project valuation is an important skill in healthcare financial management that helps an organization to decide whether to accept or reject an investment decision based on the rate of return on a project, for for-profit companies, and the rate of return to community, for non-profit businesses. Project valuation allows healthcare organizations to take into account the time value of money, opportunity cost and the projected rate of return on their investments. Managers should generally try to maximize value and minimize risks as part of the capital investment decision. This essay will first discuss the overall function of valuation methods and capital budgeting, followed by an analysis of the benefits and drawbacks of each valuation method. For each valuation method, a scenario will be given where the chosen method is beneficial in decision making. The essay will end with an analysis of the effects of inflation and healthcare trends, and how these should be factored into capital budgeting decisions.
Overall function of capital budgeting and its valuation methods.
Capital budgeting allows healthcare financial management teams to decide whether to accept or reject an investment decision based on the rate of return on a project, and enables managers to take into account the time value of money, opportunity cost and the projected rate of return on their investments. This essay will discuss the payback method, accounting rate of return, net present value method and internal rate of return method as project evaluation methods, and then analyse the implications of inflation and healthcare trends on capital budgeting decisions.
Evaluation of valuation method 1 and suitability for different types of organizations and scenarios
1. Foremost, the payback method allows organisations to measure the amount of time required to payback a project’s initial capital outlay on the basis of incoming cumulative cash flows.
The payback is advantageous because it is easy to understand and calculate, and provides a clear indicator of a project’s risk and liquidity. On the other hand, payback methods ignore the time value of money (in other words, the opportunity cost incurred which should be discounted for), as well as all cash flows that occur after the payback period. This can, however, be rectified by using a discounted payback period model (Fronczek-Munter, 2013).
Furthermore, the payback method typically encourages front-loading of cash flows in order to shorten the investment recovery time, and is limited because it does not take into account the financial viability of a project beyond the achievement of the payback or total value at maturity. FInally, the payback method disregards cash flows that come in toward the end of a project’s life cycle, which might outweigh cash flows at the start (Fronczek-Munter, 2013).
Generally, the payback method is suitable for healthcare organisations which have liquidity issues, take a more short-term view of their investment returns, or are primarily concerned with the ability of the project to pay back the initial outlay in a relatively short period of time. This may apply for smaller private healthcare practices or clinics which are relatively more cash strapped.
For example, the payback method would be helpful for a small clinical practice with a limited amount of funds that can only undertake one major project at a time. Hence, the management may want to set their limit at one project to be paid back within 2 years, in order to ensure that the investments do not bankrupt the organization.
Evaluation of valuation method 2 and suitability for different types of organizations and scenarios
2. Secondly, the accounting rate of return is a project valuation method that compares the cash flow returns on a project to an accounting rate of return that is composed of the cost of capital, past company data, and the project risk level. The ARR divides the average annual income by the average investment of the project, and will take the investment as the initial investment if the investment was front-loaded. The accounting rate of return is advantageous because it allows for a comprehensive consideration of the cost of capital, organisation historical performance and project risk level. However, the accounting rate of return does not take into account the time value of money.
The accounting rate of return would be more relevant for larger stakeholders such as Veteran Affairs’s (VA) hospitals and for-profit hospitals which need to take into account their historical performance, cost of capital and project risk level in conducting a thorough due diligence analysis of their projects.
Evaluation of valuation method 3 and suitability for different types of organizations and scenarios
3. Net present value (NPV) is a return on investment (ROI) analysis method that allows organisations to measure a project’s time value adjusted dollar return. The NPV method sums present values of the project’s net cash flows (inflows and outflows), and then applies a discount rate based on the project’s weighted average cost of capital (or the rate at which the project investor has to borrow to finance the level of risk for the project). The NPV serves as the excess dollar contribution of the project to the business’s equity value, and a positive NPV represents an enhancement of the business’s financial situation and a viable profitable project where the organization recovered its costs, with a higher NPV denoting a larger magnitude (Mukherjee et al, 2016).
The NPV is advantageous because it helps to account for the time value of a project’s rate of return, and considers the project’s weighted average cost of capital. Hence, the NPV would be more suited to larger and more complex healthcare organisations. Furthermore, the NPV allows financial managers to evaluate mutually exclusive projects at the same time, as it measures the magnitude of contribution of each project. However, the NPV may be difficult to implement given that not all organisations have a suitable discount rate or sufficient data to provide a weighted average cost of capital (Mukherjee et al, 2016).
Evaluation of valuation method 4 and suitability for different types of organizations and scenarios
4. The internal rate of return (IRR) is a return on investment (ROI) analysis method that allows organisations to measure a project’s percentage rate of return based on a rate of return where the present value of cash outflows equals the present value of cash inflows. The IRR is the discount rate at which the present value of inflows equals the project cost, where NPV=0, and thus serves as the project’s expected future rate of return. A project IRR that exceeds the cost of capital indicates an excess return that serves as a positive contribution to the business (Mukherjee et al, 2016).
The IRR is advantageous because it provides a clear decision rule based on the firm’s cost of capital, where if IRR > cost of capital, the firm should accept the project, while if IRR < cost of capital, the firm should reject the project. The disadvantage, however, is that IRR simply provides a benchmark that is highly reliant on the firm’s cost of capital, and does not offer a genuine valuation for the value-add that a project will contribute to an organization (Mukherjee et al, 2016). Furthermore, for mutually exclusive projects, the IRR does not allow a comparison or evaluation. Finally, if the cash flow structure of the project is unconventional, there may be errors on IRR calculation (Sandrick, 2008).
The IRR is beneficial in scenarios where an urgent decision is required, and where management requires a clear decision rule on whether to proceed or not, such as on the investment of necessary hospital protective equipment.
Analysis of the implications of inflation and healthcare trends on capital budgeting decisions
Inflation and healthcare trends are important factors for healthcare managers to consider in their capital budgeting and project management decisions. Foremost, inflation serves to erode the present value of cash flows for a healthcare organization, and in environments of high inflation, healthcare financial managers should apply a higher discount rate for methods such as the NPV and IRR methods.
Secondly, due to the emergence of new healthcare trends such as innovation and sustainability, healthcare managers may be required to include more qualitative and non-financial considerations in their evaluation of projects. For example, in the case of the complex, innovative telehealth project detailed in Alami et al (2018), a revised project evaluation method which included qualitative evaluation factors such as patient satisfaction and recovery rates was necessary, as telehealth provided additional benefits which may have been overlooked through conventional project evaluation methods. In this case, alternative models of project evaluation, such as the net present social value model of project evaluation which is premised on the total economic and social value of a project, could be used to measure the value of the project. Furthermore, the net present social value model of the project could also be used to measure the social and environmental impact of a project, which is increasingly important given consumer concerns over the sustainability of the healthcare industry’s resource use (AlDossary et al, 2017).
Capital budgeting and project evaluation are important tools for healthcare financial managers to decide on which projects to pursue, and managers should consider using the above methods, or even a combination of the above methods, to validate their course of action in investing in a strategic project.
AlDossary, S., Martin-Khan, M. G., Bradford, N. K., & Smith, A. C. (2017). A systematic review of the methodologies used to evaluate telemedicine service initiatives in hospital facilities. International journal of medical informatics, 97, 171-194.
Alami, H., Fortin, J. P., Gagnon, M. P., Pollender, H., Têtu, B., & Tanguay, F. (2018). The challenges of a complex and innovative telehealth project: a qualitative evaluation of the eastern Quebec Telepathology network. International journal of health policy and management, 7(5), 421.
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Mukherjee, T., Al Rahahleh, N., & Lane, W. (2016). The capital budgeting process of healthcare organizations: A review of surveys. Journal of Healthcare Management, 61(1), 58-76.
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