budget & finance decision models decision making tools hit managers will need to make decisions...

Budget & FinanceDecision Models

Decision Making Tools• HIT managers will need to make decisions about buying office

technology, EHR systems, building renovations, etc.

• There are financial tools to help

• Unsophisticated tools

Do not account for the time value of money

• Sophisticated tools

Do account for the time value of money


Unsophisticated ToolsDo not consider the Time Value of Money:

Average Rate of Return (ARR)

Average Payback Period (AvgPP)

Actual Payback Period (ActPP)


Average Rate of Return (ARR)• Rate at which the cost is recovered from an investment

• Rate is compared to the institution’s threshold (required return)

• If ARR Threshold - okay to purchase

ARR =

• Remember: Cash Flow = profit + depreciation


ARR ExampleIs it a good decision to purchase a CAC system for $250,000? Estimated cash flow due to productivity increases in coding are $100,000 per year. Hospital’s threshold rate of return is 30%.

ARR = = 40%

ARR - okay to purchase


Average Payback Period (AvgPP)• Predicts how long it should take to recover its costs

• Number of years to pay off investment based on the cash flow the purchase yields

• Compare this figure to the useful life

• If AvgPP Useful Life – okay to purchase

AvgPP =

Note: AvgPP is the flip of ARR


Average Payback Period ExampleStaying with the CAC example, recall that the CAC system costs $250,000, and the average annual cash flow is $100,000. The useful life for this system is 4 years.

AvgPP = = 2.5 years

AvgPP of 2.5 years Useful life of 4 years – okay to purchase


Actual Payback Period (ActPP)Unlike the Average Payback Period tool, this tool uses actual projected data

ActPP =

To calculate ActPP, subtract yearly actual cash flows one year at a time from the Net Investment. Count the number of years you have subtracted. Do this until the balance left is less than the next annual actual cash flow. Then divide this balance by the next annual actual cash flow and add result to the number of full years


Actual Payback Period ExampleWe stay with the CAC system that costs $250,000. Actual cash flows are predicted as follows:

Year 1 $110,000 Year 2 $97,000 Year 3 $105,000Year 1: 250,000 – 110,000 = 140,000 1 yearYear 2: 140,000 – 97,000 = 43,000 1 yearYear 3: 43,000 105,000, thereforeYear 3: = 0.41 0.41 year

ActPP = 2.41 years


Sophisticated Models• DO consider the Time Value of Money:

Net Present Value (NPV)

Benefit/Cost Ratio

Internal Rate of Return (IRR)• Considered more accurate than the unsophisticated models


Net Present ValueUses the concept of “Present Value”: PV = FV [1 + (i/m)] -nm

1. The projected future profits are each added to the annual depreciation expense.

2. Each sum is multiplied by the interest rate factor.3. Total the sums from step 24. This total is the Present Value of Cash Inflows 5. Present Value of Cash Outflows = Initial Investment

Net Present Value = Present Value of Cash Inflows minus Present Value of Cash Outflows


Net Present Value ExampleYou wish to purchase a new networked copier/fax for $30,000 for the ROI department. Cost of capital is 9%; life expectancy of the copier is 6 years; thus, annual depreciation expense is $5,000. The projected revenues from the copier are as follows:

Year 1: $7,500 Year 2: 6,300 Year 3: 4,200Year 4: 5,500Year 5: 7,000Year 6: 6,500


Projected Interest Revenues Depreciation Rate Factor

7,500 + 5,000 = 12,500 x (.9174) = $11,467.506,300 + 5,000 = 11,300 x (.8417) = 9,511.214,200 + 5,000 = 9,200 x (.7722) = 7,104.245,500 + 5,000 = 10,500 x (.7084) = 7,438.207,000 + 5,000 = 12,000 x (.6499) = 7,798.806,500 + 5,000 = 11,500 x (.5963) = 6,857.45

Present Value of Cash Inflows = $50,213.40

Present Value of Cash Outflows = $30,000.00

Net Present Value = $20,213.40


Decision Factors for NPV• If the NPV > 0, acceptable alternative

• If the NPV < 0, unacceptable alternative

• If the NPV = 0, border line acceptable alternative

Also, if NPV = 0 then:

Internal Rate of Return = cost of capital and

Benefit/Cost Ratio =1

Discussed in next slides


Benefit / Cost Ratio

B/C Ratio =

From previous example:B/C Ratio = 50,213.40/30,000 = 1.67

Decision factors:• If B/C ratio is to 1, acceptable alternative;• If B/C ratio is 1, reject the project or purchase• In this instance, we accept the copier purchase


Internal Rate of Return (IRR)Defined as: “the rate of interest at which the present value of expected cash inflows equals the present value of expected outflows”• If NPV > 0, then IRR > than the cost of capital or interest rate

accept• If NPV < 0, then IRR < than the cost of capital or interest rate

do not accept• If NPV = 0, then IRR = the cost of capital and B/C ratio = 1

Accept (marginal)


Using Excel to Calculate NPVTo calculate the NPV, use the Function Wizard. Select Formulas / Financial / NPV.

Suppose you want to calculate the NPV for the following investment: • An investment in a machine that costs $100,000 • Additional cash inflows from the machine will be $40,000, $ 50,000, and $60,000 over the

next three years (Value 1 in the Excel function). • Cost of capital is 16% (RATE in the Excel function).

Suppose you enter the data in an Excel spreadsheet as follows:Cell C1: -100,000 (note: investment is entered as a negative value)Cell C2: 40,000Cell C3: 50,000Cell C4: 60,000For Rate enter 0.16 and for VALUE 1 enter C2:C4 as 40000, 50000, 60000Run the function (click OK)Subtract the investment from the result = NPV


Extra CreditCreate one-page Excel spreadsheet that automatically calculates all 6 previous decision tools. Include formulas so that as you change the variables the values are automatically recalculated.

budget & finance decision models decision making tools hit managers will need to make decisions...

Documents

present value of cash

present value example

concept of present value

present value of cash

time value of money

marginal slide

slides slide

unsophisticated models