- Medical technology has been identified as one of the leading causes of rising healthcare costs.
- While the traditional equation for calculating risk-return for capital expenditures yields valuable insight, it fails to explicitly identify the fundamental drivers of value and risk in a value-based payment environment.
- Conducting an extensive technology assessment helps healthcare organizations consider multiple criteria to help inform practical investment decisions.
Medical technology has led to gains in quality and quantity of life; however, it has also been identified as one of the leading causes of the rising cost of healthcare (Jessup, A., Health Care Cost Containment and Medical Innovation, Office of Science and Data Policy, Office of the Assistant Secretary for Planning and Evaluation, U.S. Department of Health and Human Services).
The acquisition of high-cost medical devices and equipment requires more extensive ROI analyses than traditional finance-based methods decision-makers use to determine if assets create value.
Ideally, the shift from fee-for-service (FSS) to value-based payment causes hospital decision-makers to blend the notion of value with a patient outcomes-based perspective of value. This will encourage a comprehensive approach to allocating capital that supports value creation.
Traditional finance-based perspective
Many hospitals have adopted a corporate finance methodology to investing in medical technology. To pursue investment opportunities, hospitals need access to capital, which often comes from external sources such as equity and/or debt investors. In exchange for supplying capital, investors expect ROI. This expected return is a function of the investment risk. It also represents a cost of capital to the organization that receives the funds.
The following equation shows the basic investment risk-return relationship and it also reveals the simplified formula for determining an organization’s cost of capital. Where E(Ri) is an investor’s expected return, Rf is the risk-free rate of return and RPi is the risk premium (Pratt, S., Cost of Capital, John Wiley & Sons, Inc., 2014, Chapter 6, iBooks).
E(Ri) = Rf + RPi
The Rf is the minimum rate of return required to compensate investors for the time value of money. It takes into consideration expected inflation and the corresponding diminishing purchasing power of the dollar (Peterson, P., Fabozzi, F., Capital Budgeting: Theory and Practice, John Wiley & Sons, Inc., 2002).
The risk-free rate is often determined based on the interest rate set for government-backed treasury bonds. The risk premium, RPi, compensates investors for the risk associated with when and how much cash flow will be received from an investment. (Pratt, Cost of Capital, Chapter 6). Thus, if an investment is deemed risky due to the uncertainty surrounding its future cash flows, investors will place a higher risk premium on the investment and in turn expect a higher rate of return.
Cost of capital and the value of an asset
Cost of capital is an important corporate finance concept. It is the hook from which the value of an asset hangs. Two of the primary measures that are used to determine if value has been created are net present value (NPV) and internal rate of return (IRR). These metrics use the cost of capital to help ascertain the return generated over the life of an asset (Nowicki, M., “Determining the Value of a Capital Expense,” Leadership newsletter, HFMA, July, 2014).
The NPV expresses an asset’s profitability in dollars and is defined as the present value of future cash flows generated by an asset minus the initial cost of the asset. Cash flows are discounted to a present value via the organization’s cost of capital. Relatedly, IRR expresses profitability as a percentage and reflects the minimum rate of return required to achieve breakeven. It is the return that makes the NPV of an investment equal to zero. Thus, from this perspective, value is created when an asset generates a positive NPV and/or its IRR exceeds the organization’s cost of capital.