Budget & Finance Decision 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
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Budget & Finance Decision Models Decision Making Tools HIT managers will need to make decisions about buying office technology, EHR systems, building renovations,
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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
Budget & FinanceDecision Models
Unsophisticated ToolsDo not consider the Time Value of Money:
Average Rate of Return (ARR)
Average Payback Period (AvgPP)
Actual Payback Period (ActPP)
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision 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
Budget & FinanceDecision Models
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
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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)
Budget & FinanceDecision Models
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
Budget & FinanceDecision Models
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.