• Determining the Value of a Capital Expense

    Michael Nowicki Jul 30, 2014

    To make a convincing business argument for investing in new equipment or other innovations, clinical and finance leaders can start with two financial metrics that shed light on the investment’s ROI.

    Clinical leaders at ABC Day Surgery Center want to purchase a $10,000 ventilator for patients who are having difficulty coming out of anesthesia in the recovery room. But the CFO wants evidence that the purchase is worthwhile.

    In the 1980s and early 1990s, when capital expenditures were a “pass-through” based on cost in the DRG formula, few not-for-profit healthcare organizations calculated ROI to evaluate capital expenditures. However, now that capital costs are part of the costs recognized in the DRG formula—and DRG reimbursement can be at risk because of insufficient volumes of DRGs—decision makers must analyze the financial viability of staff wish lists for new equipment.

    How can ABC Day Surgery determine the long-term ROI of the ventilator? The CFO helped the clinical leaders by calculating two useful metrics:

    • Net present value (NPV) 
    • Internal rate of return (IRR)

    Both these calculations tell decision makers how much income the capital expenditure will earn over its useful life. But the two metrics tell the story in different ways: NPV gives a dollar answer, while IRR provides the answer as a percentage.

    Calculating NPV and IRR

    Both NPV and IRR rely on discounted cash flows, which consider the time value of an investment. Cash flows are typically projected net revenues minus projected operating expenses for the requested equipment. However, decision makers can calculate NPVs for non-revenue producing equipment by using cost savings to act like a cash flow. For instance, newer air handling systems should be more energy efficient than older air handling systems, so the energy savings between newer and older could be used as the cash flow.

    Most theorists agree that NPV is superior to IRR (Brigham, E., Fundamentals of Financial Management, Dryden Press, 1992). However, because IRR is a common method of evaluating capital expenditures, decision makers should be prepared to calculate both NPV and IRR.

    By comparing the NPVs and IRRs for similar types of capital expenditures (e.g., medical equipment), decision makers can determine which equipment has a better return in both dollars and percent. These financial criteria can then be used in a table with other criteria (see the exhibit below) to determine which equipment to fund.

    Exhibit 1 Determing ROI

    Determining NPV
    . A healthcare finance leader can calculate NPV fairly easily, using this equation:

    Present Value of Cash Flows – Original Investment = NPV

    Let's say that ABC Day Surgery Center wants to purchase the ventilator equipment for $10,000 with projected cash flows (net revenues minus expenses) of $3,000 per year during the equipment's five-year useful life. The CFO of the surgery center would then be able to calculate NPV at 10 percent (see the exhibit below).

    Exhibit 2 Determining ROI

    Because an NPV of 10 is above zero, it is positive, meaning that the capital expenditure would generate discounted cash flows in excess of the amount necessary to repay the surgery center’s original investment. 

    In contrast, an NPV of zero means that the capital expenditure is generating discounted cash flows just sufficient to repay the original investment. And, if the NPV is negative (below zero), the capital expenditure is generating discounted cash flows insufficient to repay the original investment.

    Determining IRR. While NPV gave leaders at ABC Day Surgery a dollar value for the equipment purchase, they could also assess financial viability based on a percentage using IRR. An IRR is basically the discount rate that would be derived if the NPV is held at zero.

    Typically, organizations have a hurdle rate, meaning a rate the capital expenditure must surpass in order to be funded. For example, if the surgery center had capital invested at 3 percent in a relatively safe investment, it would make little financial sense to take the money out of a safe investment at 3 percent to buy equipment that might, depending on volumes and the reimbursement environment, earn a 3 percent ROI. Instead, the surgery center might set the hurdle rate at 7 percent, reflecting the "risk" that accompanies most capital investments.

    While the NPV is relatively easy to calculate, the IRR formula requires a calculator or Excel: 

     Exhibit 3 Determining ROI 400

    Using this complex formula, the CFO at the ABC Day Surgery determined that the IRR for the $10,000 ventilator is 15.71 percent. 

    Speaking the Language of Finance

    Healthcare leaders can make a convincing argument for investing in new equipment if they can express to the finance team and the C-suite the benefit of the capital expenditure in terms of financial viability over the life of the equipment. With NPV and IRR, healthcare leaders can demonstrate in dollar amount and percentages the income new equipment will generate for the facility.

    Michael Nowicki, FACHE, FHFMA, is professor of health administration, Texas State University, San Marcos, Texas, and is a member of HFMA’s South Texas Chapter.

    Article adapted with permission from Introduction to the Financial Management of Healthcare Organizations, Sixth Edition, by Michael Nowicki, EdD, FACHE, FHFMA. (Chicago: Health Administration Press, 2014).