# A tool to evaluate equipment purchases.

The discounted cash flow technique can help you determine whether the
purchase of specific new equipment makes sense financially.

THE DISCOUNTED cash flow (DCF) technique is a useful method for evaluating equipment purchases. It determines whether or not the lifetime cash savings from using a specific piece of equipment will cover its cash acquisition costs.

The application of the DCF technique requires five specific steps to arrive at a net present value. These include determining the following:

* expected life of the piece of equipment;

* cash inflow and savings on an annual basis over the expected life;

* acquisition costs;

* cash costs on an annual basis over the expected life; and

* cost of capital.

* Expected life. The American Hospital Association's guide on equipment defines capital investment life expectancy for different types of equipment.

* Cash inflow and savings. Estimating annual cash inflow associated with the acquisition of a piece of equipment is difficult. Revenue brought in as a result of the new equipment can be based on workload units (WLUs) or procedures. Cash savings can result from a reduction of either labor, material, or energy.

* Acquisition costs. Cash outflow associated with equipment acquisition includes more than simply the net purchase price. Also to be considered are such items as freight, installation cost, and training in the use of the equipment.

* Cash cost estimates. Reagent costs can differ substantially with different equipment, as can labor and maintenance costs. Along with these costs, the escalation of these amounts through the life of the equipment should be forecast. If the manufacturer has documented the cost savings of a particular piece of equipment, this part of the process is greatly simplified. Cash savings and cash outflows are estimates based on forecasts, and some laboratory scientists are uncomfortable using them. Risk analysis is useful for reducing this discomfort.

One risk analysis technique estimates cash flow under best-case and worst-case scenarios. The two sets of cash flows, one under optimistic and the other under pessimistic conditions, provide the analyst with additional information for evaluating the purchase decision. The actual outcome should fall somewhere between the two estimates. This technique helps define the financial risk in real dollars.

* Cost of capital. The cost of capital--the cost of the money that would be tied up in the piece of equipment--must be determined in order to convert future cash flow into an amount valued in today's dollars. Discounting the cash flow at the cost of capital determines the present value.

The cost of capital can easily be shown by the example of the purchase of a car. The interest on the money borrowed represents the cost of debt. If the interest is tax deductible, the cost of the debt is adjusted by the tax benefit received. If money is taken out of another investment and spent on the car, the cost associated with the lost return on that investment represents the cost of equity.

In for-profit hospitals, the cost of capital is calculated by combining the tax-adjusted interest rate charged on a new loan with the cost of equity--the return that would leave the current market price of the hospital's common stock unchanged.

The cost of debt, the cost of equity, and the percentage of debt financing and equity financing determine the weighted cost of capital. In not-for-profit hospitals, the cost of stock equity doesn't come into play, but the cost of equity may be a required rate set by the organization. It also may be estimated by determining the rate of return on investments in the recent past or the rate of return needed to meet organizational goals.|1~

In every case, the weighted cost of capital can be determined by taking the portion of debt times the cost of debt and the portion of equity times the cost of equity. The discount rate is this weighted average cost of capital.

If the cost of capital is not available, you can use a range of values for the discount rate, with each value applied to the estimated cash flows in order to determine a single present value. This procedure provides a range of DCFs that serves as additional information upon which to make a buy or not-buy decision.

* Net present value. The present value of the net cash flows that occur at the end of each year can be determined using the cost of capital as the discount rate. The present values can then be added up to determine the net present value (NPV). If the NPV is positive, the cash flows from using the equipment are sufficient to cover its operating costs, acquisition costs, and cost of the funds used for the acquisition. If the NPV is negative, the cash flows do not cover all the costs associated with the equipment's acquisition. In this case, the intangible benefits that are derived from ownership of the equipment must be sufficient to justify its purchase. Examples of intangible benefits include such things as life-support services or the ability to perform on-site analyses in a timely manner.

* Instrument example. Suppose we have to decide whether to buy an instrument that costs $400,000. We estimate it will generate $500,000 in revenue beginning in the year of purchase and that this revenue will continue for four additional years. We also determine that the operating expense associated with using the instrument will be $200,000 annually. The cost of debt is 10% after tax. The cost of equity has been determined to be 15%. The percent of debt is 20%, and the percent of equity is 80%.

The weighted cost of capital is thus calculated as follows:

0.2 x 0.10 + 0.8 x 0.15 = 0.14, or 14%.

The NPV of this equipment is $774,000. Since it is positive, the acquisition of the piece of equipment is economically feasible.

The year 0 cash flow of ($100,000), as shown in Table 1, represents a net cash outflow for that year. There is a positive net cash flow of $300,000 in each subsequent year. The year 0 cash flow in the amount of ($100,000) is a present value. The present value of the $300,000 flows at the end of years 1, 2, 3, and 4 is $263,000, $231,000, $202,000, and $178,000 when discounted at 14%. When these present values are added together, they represent the net present value of the project, in this case, $774,000.

In lieu of calculating the cost of capital for a discount rate, some analysts use a range of rates to arrive at a series of present values. For example, an analyst may want to use 10%, 15%, and 20% to make the purchase decision. The resulting NPVs at these rates are $851,000, $756,000, and $677,000. The positive NPVs indicate that the equipment purchase would be economically feasible at each of these rates.

A computer can make easy work of the mathematics. (A listing of computer software for performing these calculations is available.|2~) Most financial calculators are designed to compute NPVs from a series of cash flows. Present value tables are also available for calculations.

* Hematology analyzer. A laboratory wants to replace automated hematology instrumentation. The estimated life of the instrument is 5 years. Three options are considered: 1) purchase instrument X; 2) purchase instrument Y; or 3) retain current equipment.

Hematology accounts for 40% of the total lab revenue of $6 million, or $2.4 million. Of the tests performed in hematology, the automated instrument accounts for 75% of the WLUs or $1.8 million of the hematology revenue. If option 3 is selected, there is a high probability of losing approximately $500,000 a year in outpatient revenues due to turn-around time and reliability problems.

In option 1, the purchase price includes freight costs. Two percent of the purchase price in option 2 represents freight.

Instrument X has been bid at $205,000 and instrument Y at $215,000. For both acquisition options, manufacturers provide training. No renovation or computer interface is needed.

Reagent costs for options 1 and 2 differ. Option 1 reagent costs are $55,000 a year, while option 2 costs are $47,000 a year. The annual reagent costs for option 3 are $65,000.

Maintenance costs for option 1 are $15,000 a year after warranty, with no price protection; for option 2, $15,000 a year for four years after warranty, with price protection; and for option 3, $17,000 for year 0 and no price protection for years 1 through 4.

Labor costs differ for instruments X, Y, and current. Labor cost per WLU is $0.228. Instrument X uses 124,800 WLUs at a cost of $28,434 a year; instrument Y, 162,240 WLUs at $36,991 a year; and current equipment, 324,489 WLUs at $71,637 a year.

Reagent, service, and labor costs are estimated to increase approximately 4% annually. Revenue will remain constant except that the current instrument might jeopardize the outpatient revenue.

Buying instrument X (option 1) makes the most financial sense since it has a larger positive NPV than the other options. If for some non-financial reason one of the other instruments is chosen, at least the financial impact is known. In addition, financial differences may be grounds for vendor negotiation.

* Help for the lab manager. DCF analysis is not simple, but it evaluates decisions from an objective financial perspective. Applying DCF analysis results in a more effective use of limited capital resources. Cash outflows and inflows can be determined along with the cost of capital. Risk can be addressed by analyzing "what if" or best-case/worst-case scenarios.

By applying financial techniques at this level of sophistication, the laboratory manager can provide information that helps the facility implement a sound capital budgeting program. This is particularly important as greater emphasis is placed on the most effective use of limited dollars in this era of rising health care costs, competition, and consumer expectations.

The DCF method is not totally new to this field. TerHark and Diaz|2~ showed how to perform a DCF analysis using spreadsheets but failed to demonstrate the process of defining each element and the management of this technique. Chow and McNamee|3~ pointed out that considerations other than a pure DCF technique are important. Wheeler and Smith|4~ addressed the problem of setting the discount rate (part of the DCF method). A 1989 survey by Kamath and Elmer|1~ found that most hospitals do not use DCF analytical techniques. Most use less sophisticated methods such as payback or average return.

The author is administrative director of clinical laboratories, Augusta Hospital Corp., Fishersville, Va. She wishes to acknowledge the contributions to this article of Carl Weaver, Ph.D., professor of finance and director of the MBA program at James Madison University, Harrisonburg, Va.

References

1. Kamath RR, Elmer J. Capital investment decisions in hospitals: Survey results. Health Care Management Rev. Spring 1989; 14(2): 45-55.

2. TerHark D, Diaz J. A spreadsheet for capital equipment financial modeling (Computer Dialog). MLO. April 1991); 22(4): 71-73.

3. Chow CW, McNamee AH. Watch for pitfalls of discounted cash techniques. Healthcare financial Management. April 1991; 45(4): 34-43.

4. Wheeler JRC, Smith DG. The discount rate for capital expenditure analysis in health care. Health Care Management Rev. Spring 1988; 13(2): 43-51.

Figure 1

Advantages of discounted cash flow analysis

* Can be used to make a broad range of different decisions needed to manage a laboratory.

* Takes into account all initial outlays as well as operational expenses and revenues. Also accounts for the opportunity costs--costs related to using the money versus investing it in something else--of the funds associated with the life of a project.

* Has advantages over the internal rate of return method, which assumes that the cash can be reinvested at the internal rate of return rather than the opportunity cost of capital.

* Has advantages over payback analysis, which takes only the initial capital outlay and no opportunity costs into consideration.

* Helps the laboratory manager to identify the financial impact of each purchase component, which may be a basis for vendor negotiation.

THE DISCOUNTED cash flow (DCF) technique is a useful method for evaluating equipment purchases. It determines whether or not the lifetime cash savings from using a specific piece of equipment will cover its cash acquisition costs.

The application of the DCF technique requires five specific steps to arrive at a net present value. These include determining the following:

* expected life of the piece of equipment;

* cash inflow and savings on an annual basis over the expected life;

* acquisition costs;

* cash costs on an annual basis over the expected life; and

* cost of capital.

* Expected life. The American Hospital Association's guide on equipment defines capital investment life expectancy for different types of equipment.

* Cash inflow and savings. Estimating annual cash inflow associated with the acquisition of a piece of equipment is difficult. Revenue brought in as a result of the new equipment can be based on workload units (WLUs) or procedures. Cash savings can result from a reduction of either labor, material, or energy.

* Acquisition costs. Cash outflow associated with equipment acquisition includes more than simply the net purchase price. Also to be considered are such items as freight, installation cost, and training in the use of the equipment.

* Cash cost estimates. Reagent costs can differ substantially with different equipment, as can labor and maintenance costs. Along with these costs, the escalation of these amounts through the life of the equipment should be forecast. If the manufacturer has documented the cost savings of a particular piece of equipment, this part of the process is greatly simplified. Cash savings and cash outflows are estimates based on forecasts, and some laboratory scientists are uncomfortable using them. Risk analysis is useful for reducing this discomfort.

One risk analysis technique estimates cash flow under best-case and worst-case scenarios. The two sets of cash flows, one under optimistic and the other under pessimistic conditions, provide the analyst with additional information for evaluating the purchase decision. The actual outcome should fall somewhere between the two estimates. This technique helps define the financial risk in real dollars.

* Cost of capital. The cost of capital--the cost of the money that would be tied up in the piece of equipment--must be determined in order to convert future cash flow into an amount valued in today's dollars. Discounting the cash flow at the cost of capital determines the present value.

The cost of capital can easily be shown by the example of the purchase of a car. The interest on the money borrowed represents the cost of debt. If the interest is tax deductible, the cost of the debt is adjusted by the tax benefit received. If money is taken out of another investment and spent on the car, the cost associated with the lost return on that investment represents the cost of equity.

Table 1 Example of net present value calculation ($000) Year 0 1 2 3 4 Capital (400) 0 0 0 0 outlay Revenue 500 500 500 500 500 Operating (200) (200) (200) (200) (200) expenses Cash flow (100) 300 300 300 300 Present value (100) 263 231 202 178 @ 14%. NPV @ 14% = $774,000

In for-profit hospitals, the cost of capital is calculated by combining the tax-adjusted interest rate charged on a new loan with the cost of equity--the return that would leave the current market price of the hospital's common stock unchanged.

The cost of debt, the cost of equity, and the percentage of debt financing and equity financing determine the weighted cost of capital. In not-for-profit hospitals, the cost of stock equity doesn't come into play, but the cost of equity may be a required rate set by the organization. It also may be estimated by determining the rate of return on investments in the recent past or the rate of return needed to meet organizational goals.|1~

In every case, the weighted cost of capital can be determined by taking the portion of debt times the cost of debt and the portion of equity times the cost of equity. The discount rate is this weighted average cost of capital.

If the cost of capital is not available, you can use a range of values for the discount rate, with each value applied to the estimated cash flows in order to determine a single present value. This procedure provides a range of DCFs that serves as additional information upon which to make a buy or not-buy decision.

* Net present value. The present value of the net cash flows that occur at the end of each year can be determined using the cost of capital as the discount rate. The present values can then be added up to determine the net present value (NPV). If the NPV is positive, the cash flows from using the equipment are sufficient to cover its operating costs, acquisition costs, and cost of the funds used for the acquisition. If the NPV is negative, the cash flows do not cover all the costs associated with the equipment's acquisition. In this case, the intangible benefits that are derived from ownership of the equipment must be sufficient to justify its purchase. Examples of intangible benefits include such things as life-support services or the ability to perform on-site analyses in a timely manner.

* Instrument example. Suppose we have to decide whether to buy an instrument that costs $400,000. We estimate it will generate $500,000 in revenue beginning in the year of purchase and that this revenue will continue for four additional years. We also determine that the operating expense associated with using the instrument will be $200,000 annually. The cost of debt is 10% after tax. The cost of equity has been determined to be 15%. The percent of debt is 20%, and the percent of equity is 80%.

The weighted cost of capital is thus calculated as follows:

0.2 x 0.10 + 0.8 x 0.15 = 0.14, or 14%.

The NPV of this equipment is $774,000. Since it is positive, the acquisition of the piece of equipment is economically feasible.

The year 0 cash flow of ($100,000), as shown in Table 1, represents a net cash outflow for that year. There is a positive net cash flow of $300,000 in each subsequent year. The year 0 cash flow in the amount of ($100,000) is a present value. The present value of the $300,000 flows at the end of years 1, 2, 3, and 4 is $263,000, $231,000, $202,000, and $178,000 when discounted at 14%. When these present values are added together, they represent the net present value of the project, in this case, $774,000.

In lieu of calculating the cost of capital for a discount rate, some analysts use a range of rates to arrive at a series of present values. For example, an analyst may want to use 10%, 15%, and 20% to make the purchase decision. The resulting NPVs at these rates are $851,000, $756,000, and $677,000. The positive NPVs indicate that the equipment purchase would be economically feasible at each of these rates.

A computer can make easy work of the mathematics. (A listing of computer software for performing these calculations is available.|2~) Most financial calculators are designed to compute NPVs from a series of cash flows. Present value tables are also available for calculations.

* Hematology analyzer. A laboratory wants to replace automated hematology instrumentation. The estimated life of the instrument is 5 years. Three options are considered: 1) purchase instrument X; 2) purchase instrument Y; or 3) retain current equipment.

Hematology accounts for 40% of the total lab revenue of $6 million, or $2.4 million. Of the tests performed in hematology, the automated instrument accounts for 75% of the WLUs or $1.8 million of the hematology revenue. If option 3 is selected, there is a high probability of losing approximately $500,000 a year in outpatient revenues due to turn-around time and reliability problems.

Table 2 Cash flow analysis Option 1: Buy instrument X ($000) Year 0 1 2 3 4 Cash outlay Capital (205) - - - - Freight 0 - - - - Maintenanc - (15) (15) (16) (16) Reagents (55) (57) (59) (62) (64) Labor (28) (30) (31) (32) (33) Cash inflow Revenue 1,800 1,800 1,800 1,800 1,800 Cash flow 1,512 1,699 1,695 1,690 1,686 Cost of capital: at 10% Net present value = $6,878,000 at 12% Net present value = $6,654,000 at 15% Net present value = $6,345,000

In option 1, the purchase price includes freight costs. Two percent of the purchase price in option 2 represents freight.

Instrument X has been bid at $205,000 and instrument Y at $215,000. For both acquisition options, manufacturers provide training. No renovation or computer interface is needed.

Table 3 Cash flow analysis Option 2: Buy instrument Y ($000) Year 0 1 2 3 4 Cash outlay Capital (215) - - - - Freight 4 - - - - Maintenance - (15) (15) (15) (15) Reagents (47) (49) (51) (53) (55) Labor (37) (38) (40) (42) (43) Cash inflow Revenue 1,800 1,800 1,800 1,800 1,800 Cash flow 1,497 1,698 1,694 1,690 1,687 Cost of capital: at 10% Net present value = $6,863,000 at 12% Net present value = $6,638,000 at 15% Net present value = $6,330,000

Reagent costs for options 1 and 2 differ. Option 1 reagent costs are $55,000 a year, while option 2 costs are $47,000 a year. The annual reagent costs for option 3 are $65,000.

Table 4 Cash flow analysis Option 3: Keep current equipment ($000) Year 0 1 2 3 4 Cash outlay Capital - - - - - Freight - - - - - Maintenance (17) (18) (18) (19) (20) Reagents (65) (68) (70) (73) (76) Labor (72) (75) (77) (81) (84) Cash inflow Revenue 1,300 1,300 1,300 1,300 1,300 Cash flow 1,146 1,140 1,134 1,127 1,120 Cost of capital: at 10% Net present value = $4,732,000 at 12% Net present value = $4,583,000 at 15% Net present value = $4,337,000

Maintenance costs for option 1 are $15,000 a year after warranty, with no price protection; for option 2, $15,000 a year for four years after warranty, with price protection; and for option 3, $17,000 for year 0 and no price protection for years 1 through 4.

Labor costs differ for instruments X, Y, and current. Labor cost per WLU is $0.228. Instrument X uses 124,800 WLUs at a cost of $28,434 a year; instrument Y, 162,240 WLUs at $36,991 a year; and current equipment, 324,489 WLUs at $71,637 a year.

Reagent, service, and labor costs are estimated to increase approximately 4% annually. Revenue will remain constant except that the current instrument might jeopardize the outpatient revenue.

Buying instrument X (option 1) makes the most financial sense since it has a larger positive NPV than the other options. If for some non-financial reason one of the other instruments is chosen, at least the financial impact is known. In addition, financial differences may be grounds for vendor negotiation.

* Help for the lab manager. DCF analysis is not simple, but it evaluates decisions from an objective financial perspective. Applying DCF analysis results in a more effective use of limited capital resources. Cash outflows and inflows can be determined along with the cost of capital. Risk can be addressed by analyzing "what if" or best-case/worst-case scenarios.

By applying financial techniques at this level of sophistication, the laboratory manager can provide information that helps the facility implement a sound capital budgeting program. This is particularly important as greater emphasis is placed on the most effective use of limited dollars in this era of rising health care costs, competition, and consumer expectations.

The DCF method is not totally new to this field. TerHark and Diaz|2~ showed how to perform a DCF analysis using spreadsheets but failed to demonstrate the process of defining each element and the management of this technique. Chow and McNamee|3~ pointed out that considerations other than a pure DCF technique are important. Wheeler and Smith|4~ addressed the problem of setting the discount rate (part of the DCF method). A 1989 survey by Kamath and Elmer|1~ found that most hospitals do not use DCF analytical techniques. Most use less sophisticated methods such as payback or average return.

The author is administrative director of clinical laboratories, Augusta Hospital Corp., Fishersville, Va. She wishes to acknowledge the contributions to this article of Carl Weaver, Ph.D., professor of finance and director of the MBA program at James Madison University, Harrisonburg, Va.

References

1. Kamath RR, Elmer J. Capital investment decisions in hospitals: Survey results. Health Care Management Rev. Spring 1989; 14(2): 45-55.

2. TerHark D, Diaz J. A spreadsheet for capital equipment financial modeling (Computer Dialog). MLO. April 1991); 22(4): 71-73.

3. Chow CW, McNamee AH. Watch for pitfalls of discounted cash techniques. Healthcare financial Management. April 1991; 45(4): 34-43.

4. Wheeler JRC, Smith DG. The discount rate for capital expenditure analysis in health care. Health Care Management Rev. Spring 1988; 13(2): 43-51.

Figure 1

Advantages of discounted cash flow analysis

* Can be used to make a broad range of different decisions needed to manage a laboratory.

* Takes into account all initial outlays as well as operational expenses and revenues. Also accounts for the opportunity costs--costs related to using the money versus investing it in something else--of the funds associated with the life of a project.

* Has advantages over the internal rate of return method, which assumes that the cash can be reinvested at the internal rate of return rather than the opportunity cost of capital.

* Has advantages over payback analysis, which takes only the initial capital outlay and no opportunity costs into consideration.

* Helps the laboratory manager to identify the financial impact of each purchase component, which may be a basis for vendor negotiation.

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Title Annotation: | discounted cash flow technique |
---|---|

Author: | Simmers, Neysa R. |

Publication: | Medical Laboratory Observer |

Date: | Mar 1, 1993 |

Words: | 2353 |

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