Capital Finance and Investment Decision Making
This domain tests how healthcare organizations decide which capital projects to fund, how they estimate cash flows, and how they pay for assets. Questions commonly combine discounted cash flow analysis with capital structure and leasing considerations.
Estimating cash flows
Use incremental after-tax cash flows: the initial outlay (equipment, installation, and working capital), annual operating cash flows, and terminal value (salvage plus release of working capital). Exclude sunk costs and financing flows, since the cost of financing belongs in the discount rate.
Decision rules
Accept projects with positive NPV discounted at the weighted average cost of capital. IRR is the discount rate at which NPV equals zero; the profitability index supports capital rationing; payback screens liquidity only. WACC = wd times kd times (1 minus t) plus we times ke. Not-for-profits have no tax shield and often estimate the cost of equity with CAPM or a build-up method. Lease-versus-buy compares after-tax lease payments with debt-financed ownership, applying ASC 842 classification tests.
Worked example
Equipment costs $5 million plus $200,000 of working capital, has a five-year life, and produces $1.4 million of net annual cash flow. The cost of capital is 9%. The five-year annuity factor at 9% is 3.8897, so PV of operating flows = 1.4 times 3.8897 = $5.4456 million. PV of the working capital release = 0.2 divided by 1.5386 = $0.1300 million. Total PV = $5.5756 million against a $5.2 million outlay, so NPV is about +$0.376 million and the project should be accepted. IRR solves 5.2 = 1.4 times factor + 0.13, giving a factor of 3.62 and an IRR near 11.8%, above the 9% hurdle. The profitability index is 5.5756 divided by 5.2 = 1.07.
Traps that cost marks
- Discounting accounting income instead of cash flow.
- Omitting working capital and terminal value.
- Subtracting interest expense in the cash flows while also discounting at WACC.
- Choosing the higher IRR between projects of different size or duration.
- Ignoring debt covenants, rating impact, and debt capacity.