Strategic financial decision making is key to project support. (Nuts and Bolts of Business).Imagine this scenario... You are considering purchasing a new electronic information system for your practice. There are two components to the system. The first component will cost $125,000 to install and implement. The second phase of the project will cost $375,000 to install and implement. The plan is to install the second phase in two years. The new system will bring greater accuracy to documentation and billing. A consultant has performed an analysis of this investment. The net present value of the investment (NPV NPV See: Net present value ) over a five-year projection projection, in psychology: see defense mechanism. See rear-projection TV, front-projection TV and LCD panel. (theory) projection - In domain theory, a function, f, which is (a) idempotent, i.e. is $5,000. (see Table 1) Your gut gut (gut) 1. intestine. 2. the primordial digestive tube, consisting of the fore-, mid-, and hindgut. 3. surgical g. blind gut cecum. instinct instinct, term used generally to indicate an innate tendency to action, or pattern of behavior, elicited by specific stimuli and fulfilling vital needs of an organism. is that the investment is a good one. However, you must make a recommendation to your board of directors on whether to proceed with the investment. If you have been faced with this situation you are not alone. A major component of any capital budgeting decision is the financial analysis. This is because every resource allocation resource allocation Managed care The constellation of activities and decisions which form the basis for prioritizing health care needs decision a business considers requires an estimate of the value of that decision. The problem is that physician executives may not have the training or background in either accounting or finance to estimate the value of these decisions. Likewise, accountants and financial analysts often lack the background to understand the clinical practice implications of their financial analyses. Even when physician executives possess formal training in financial analysis, many fail to link the analysis to overall corporate strategy. The result is that major decisions may be made based on the "numbers" without regard to strategic evaluation or the value of the options surrounding sur·round tr.v. sur·round·ed, sur·round·ing, sur·rounds 1. To extend on all sides of simultaneously; encircle. 2. To enclose or confine on all sides so as to bar escape or outside communication. n. the decision. Strategic financial evaluation is more than making a "yes" or "no" investment decision. It requires examining the strategic fit of the investment decision, particularly as it relates to the overall corporate vision, the financial analysis, as well as a valuation of any options surrounding the investment decision. Positive financial return? The first question the physician executive must ask when deciding whether to proceed with the investment is not whether it will produce a positive financial return for the organization. Rather, it is whether the investment proposal fits the overall corporate strategy and vision for the organization. To answer this question there must be an understanding of the vision of the organization, as well as a vision for the investment proposal. If the strategic vision of the organization is to move to paperless documentation and billing, then from a strategic standpoint The Standpoint is a newspaper published in the British Virgin Islands. It was originally published under the name Pennysaver, largely as a shopping-coupon promotional newspaper, but since emerged as one of the most influential sources of journalism in the , the investment in the new system should make sense. The decision to move to a paperless environment should be discussed and agreed upon Adj. 1. agreed upon - constituted or contracted by stipulation or agreement; "stipulatory obligations" stipulatory noncontroversial, uncontroversial - not likely to arouse controversy as a strategic vision of the organization long before vendors are contacted and systems examined. The second step in strategic financial decision-making decision-making, n the process of coming to a conclusion or making a judgment. decision-making, evidence-based, n a type of informal decision-making that combines clinical expertise, patient concerns, and evidence gathered from is breaking down and analyzing the components of the financial analysis. This is represented by the analysis performed by the consultant. Based on the projection of cash flows over a five-year period, the investment reveals a positive net present value of $5,000. This analysis, when taken alone, suggests that while investment in the system produces a positive value, it is not overwhelmingly so. While the project makes sense strategically, the financial analysis is equivocal EQUIVOCAL. What has a double sense. 2. In the construction of contracts, it is a general rule that when an expression may be taken in two senses, that shall be preferred which gives it effect. Vide Ambiguity; Construction; Interpretation; and Dig. . But, should the analysis end here? The answer is no, because one final question remains in the overall strategic financial analysis. The project consists of two phases. The practice may or may not choose to make the additional and much larger investment of $375,000 at the end of two years. This "option" is not reflected in the discounted cash flow analysis performed by the financial consultant. This is an important component to consider since there is value in the option. It has been argued that financial business strategy is more like a series of options rather than mere cash flows. As such, strategic corporate investment options can resemble European European emanating from or pertaining to Europe. European bat lyssavirus see lyssavirus. European beech tree fagussylvaticus. European blastomycosis see cryptococcosis. call options and may be analyzed an·a·lyze tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es 1. To examine methodically by separating into parts and studying their interrelations. 2. Chemistry To make a chemical analysis of. 3. using a Black-Scholes Model of Option valuation. (1,2) The Black-Scholes Model looks at five variables in valuing an option. These include the: * Exercise price * Stock price * Time to expiration EXPIRATION. Cessation; end. As, the expiration of, a lease, of a contract, or statute. 2. In general, the expiration of a contract puts an end to all the engagements of the parties, except to those which arise from the non- fulfillment of obligations created * Variance The discrepancy between what a party to a lawsuit alleges will be proved in pleadings and what the party actually proves at trial. In Zoning law, an official permit to use property in a manner that departs from the way in which other property in the same locality of the returns on the stock * Risk-free rate of return Risk-Free Rate of Return The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. In a similar way you can analyze an·a·lyze v. 1. To examine methodically by separating into parts and studying their interrelations. 2. To separate a chemical substance into its constituent elements to determine their nature or proportions. 3. an investment project by substituting the expenditures required for the investment for the exercise price, the value of the assets that will be acquired in making the investment for the stock price, the length of time the investment may be deferred as the time to expiration for the option, the risk of the investment as the variance of returns on stock, and the time value of money for the risk free rate of return. Putting these variables together results in two components to determine. 1. First you must determine a measure of the Net Present Value as a quotient quotient - The number obtained by dividing one number (the "numerator") by another (the "denominator"). If both numbers are rational then the result will also be rational. ([NPV.sub.q]) or Value to Cost ratio. 2. The second measure is of the Cumulative Volatility Volatility 1. A statistical measure of the tendency of a market or security to rise or fall sharply within a period of time. 2. A variable in option pricing formulas that denotes the extent to which the return of the underlying asset will fluctuate between now and the (O[square root of] t), or measure of uncertainty, examining variance ([O.sup.2]) per period of time. Taken together, you then use a Black-Scholes Table (Figure 3) to determine the value of the investment option as a percent of the underlying asset. (1,2,3) The first step in the option analysis is to separate the project into its two phases and perform a discounted cash flow analysis for each phase. (Tables 2,3). As you can see, the NPV of the first phase alone is $16,000. This is better than the combined NPV of $5,000, which may further support a recommendation to proceed with the first phase of the project. The second step is to assign values to the variables to determine the value to cost ratio and cumulative volatility to calculate the value of the option. NPVq equals "S", the present value of the phase 2 assets, divided by "PV(X)", the present value of the investment in phase 2. PV(X) equals the investment (X) divided by the sum of one plus a "risk free rate" to the power of time until expiration Time until expiration The time remaining until a financial contract expires. Also called time to maturity. of the option. (Figure 1). For our example, the time to expiration is two years. Assume the risk-free rate Risk-free rate The rate earned on a riskless asset. is the current rate of return on two-year Treasury Bills (1.6 percent). The investment (X) is the investment in phase 2 or $375,000. The present value of the phase 2 assets is $256,000 (sum of the present values of the investment of phase 2). Calculation reveals an NPVq equal to 0.70. (Figure 2) Next, we calculate the cumulative volatility. There is no standard method to measure the variance. You may use a computer model and a Monte Carlo simulation Monte Carlo Simulation A problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables. technique to create a probability distribution Probability distribution A function that describes all the values a random variable can take and the probability associated with each. Also called a probability function. probability distribution for the investment returns and then calculate the corresponding standard deviation In statistics, the average amount a number varies from the average number in a series of numbers. (statistics) standard deviation - (SD) A measure of the range of values in a set of numbers. . Or, you can make an educated guess. Examining a range of variances and producing a sensitivity analysis can accomplish this. For the sake of this example, let us assume that there is a 50 percent chance of proceeding with the second phase of the investment. The cumulative volatility equals 0.5 x [square root of (2)] or 0.70. (Figure 2) (7) Using a Black-Scholes Table (Figure 3), we can determine the underlying value of the option, which is approximately ap·prox·i·mate adj. 1. Almost exact or correct: the approximate time of the accident. 2. 15.8 percent of the present value of $256,000 or $40,448. So, the NPV of the project is $56,448 (phase 1 NPV of $16,000 + value of the phase 2 option of $40,448). This makes a greater financial, as well as strategic argument to proceed with the phase 1 investment, with a valuable option of proceeding to phase 2 at the end of two years. Looking to the future This example and analysis illustrates the importance of looking beyond traditional financial investment decisions based on analysis of discounted cash flows (DCF DCF See: Discounted Cash Flows ) only. Strategic financial evaluation builds upon the principles of DCF analysis to examine the overall corporate strategy and vision, as well as options surrounding the investment decision. Table 1 Net Present Value of the Investment Proposal ($ Values in Thousands and Rounded) Year 0 1 2 3 4 5 6 Cash Flow (125) 9 10 (364) 35 38 40 Terminal 610 Value * Discount Factor at 1.0 0.893 0.797 0.712 0.636 0.567 0.507 12% Present (125) 8 8 (259) 22 22 329 Value Net Present Value = 5 * Terminal Value equals perpetuity value with 5% growth per year Table 2 Net Present Value of Phase I Investment ($ Values in Thousands and Rounded) Year 0 1 2 3 4 5 6 Cash Flow 0 9 10 11 12 12 13 Terminal 191 Value * Investment (125) Discount Factor at 1.0 0.893 0.797 0.712 0.636 0.567 0.507 12% Present (125) 8 8 8 8 7 102 Value Net Present Value = 16 * Terminal Value equals perpetuity value with 5% growth per year Table 3 Net Present Value of Phase 2 Investment ($ Values in Thousands and Rounded) Year 0 1 2 3 4 5 6 Cash Flow 0 23 26 27 Terminal Value * 419 Investment (375) Discount Factor at 12% 0.712 0.636 0.567 0.507 Present Value (267) 15 15 226 Net Present Value = (11) * Terminal Value equals perpetuity value with 5% growth per year Figure I: Determining Option Metrics metrics Managed care A popular term for standards by which the quality of a product, service, or outcome of a particular form of Pt management is evaluated. See TQM. ** [NPV.sub.q] = S/PV(X) = S/[(1+rf).sup.t] Cumulative Volatility = **[square root (t)] [NPV.sub.q] = Value/Cost "S" = values of the phase 2 investment "X" = Capital expenditure for phase 2 "rf" = the risk free rate on an investment with a similar time as the expiration of the option "**" = standard deviation of returns (measure of uncertainty) "t" = time of expiration of the option ** From Timothy Leuhrman: Capital Projects as Real Options: An Introduction: Harvard Business School Harvard Business School, officially named the Harvard Business School: George F. Baker Foundation, and also known as HBS, is one of the graduate schools of Harvard University. Publication 9-295-072, March 1995 Figure 2: Calculating the Net Present Value of the Investment [NPV.sub.q] = S/PV(X) = S/ X/[(1+rf ).sup.t] [NPV.sub.q] = $256,000/$375,000 / [(1 + 1.6%).sup.2] = 0.7 Cumulative Volatility = *[square root (t)] = 0.5[square root (2)] = 0.7 Underlying Value of the Option = 15.8% of "S" = 15.8% x $256,000 = $40,448 (see Figure 3) NPV = NPV of phase 1 + Value of the Option = $16,000 + $40,448 = $56,448
Figure 3
Black-Scholes Values of a Call Option (expressed as a percentage of the
underlying asset value) ***
[NPV.sub.q]
0.3 0.4 0.5 0.6
0.3 0.0 0.0 0.1 0.7
0.4 0.0 0.1 0.9 2.4
0.5 0.2 1.0 2.6 5.1
0.6 0.9 2.5 5.1 8.3
**[square 0.7 2.1 4.7 8.1 11.9
root of (t)] 0.8 4.0 7.5 11.5 15.7
0.9 6.4 10.7 15.2 19.6
1.0 9.3 14.3 19.1 23.6
[NPV.sub.q]
0.7 0.8 0.9 1.0
2.0 4.4 7.8 11.9
4.8 8.0 11.7 15.9
8.2 11.8 15.7 19.7
11.9 15.8 19.7 23.6
**[square 15.8 19.8 23.6 27.4
root of (t)] 19.8 23.7 27.5 31.1
23.8 27.7 31.3 34.7
27.7 31.6 35.1 38.3
*** Adopted From Timothy Leuhrman: Capital Projects as Real Options: An
Introduction: Harvard Business School Publication 9-295-072, March 1995
*[Unreadable in original source]
*[Text unreadable in original source] |
|
||||||||||||||||
Printer friendly
Cite/link
Email
Feedback
Reader Opinion