Steps for Assessment and Minimization of the Riskiness of Expected Cash Flows in Capital Budgeting Analysis
As the manager of a healthcare facility, I will assess the riskiness of expected cash flows using sensitivity analysis. Sensitivity analysis relates to the scrutiny of project investment by forecasting the predicted cash flows, expected revenues, and costs (Saini, 2018). First, I will identify all variables that influence the project's Net Present Value (NPV) or Internal Rate of Return (IRR). Secondly, I will define the relationship between the variables using a mathematical approach. Lastly, I will analyze the impact of change in the variables on the project's NPV. For variables which are most likely to change, a control measure will be put in place if the NPV is highly sensitive for any changes.
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On the other hand, I will minimize the riskiness of the expected cash flows in capital budgeting analysis in various ways. First, I can increase the discounting factor for a required rate of return for the health facility's cash flows. Consequently, the value of the expected cash flows will be reduced by this adjustment; thus, uncertainty would be increased ( Gapenski & Reiter, 2016). Besides, I can reduce the anticipated cash flows by an approximated loss percentage. This caters for risks in case expected payments are not made. If the investment is profitable in these scenarios, it is an indication that it will be successful; thus, it is considered viable to be undertaken.
Valuation Methods in Capital Budgeting and the Importance of Capital Budgeting
The valuation of capital budgets and long term investments is essential, bearing in mind the uncertainty of some factors. The expected cash flows are usually discounted against the desired rate of return. Different projects face different risk situations, which affect their performance. There are discounting and non-discounting methods for capital budgeting. Some of the methods include the Payback Period, Profitability Index, and Net Present Value. Usually, capital budgeting is essential for long term investments due to the risks and capital involved. Therefore, capital compares the risks involved in investments to choose the most viable and allocate adequate resources. Moreover, it ensures that proper decision making is done for huge investments since they are irreversible. Further, it helps the avoidance of under or over investments (EduPristine, 2018). As a result, costs are reduced while the profitability of the health facility would be increased.
Valuation Methods, Benefits, Drawbacks, and Applicability
The Net Present Value (NPV) compares project investment proposals such that cash inflows present value is compared to the original investment. It helps in choosing the most viable project. On the other hand, it is difficult to comprehend the cost of capital, which applies to this method (EduPristine, 2018). NPV is more suitable for for-profit organizations because its objective is to maximize profits for owners. It applies in a scenario where the cash outflows and expected cash inflows can be estimated to choose a viable project.
The payback period ascertains the capacity of a proposal to earn the capital invested that is, the time the project will take to recover the amount of investment. Conversely, it does not put into consideration the time value of money and profitability. It is more relevant for non-profit organizations since there is no emphasis on the time value of money and profitability (EduPristine, 2018). It is applicable in a scenario where two proposals are to be decided by choosing one with a shorter payback period. However, it also requires the PI to estimate the time value of money and profitability.
Profitability index (PI) is used to choose the most profitable project for investment; thus, vital for for-profit organizations. PI has a basis on the benefits concerning the cash outflow of investment. On the contrary, profitability may be difficult to ascertain due to uncertainties or risks like inflation and taxation, which may lead to significant variance between the gross and net profit. It can be used in a scenario where two project investments are compared to choose the most profitable.
Effects of Inflation and Healthcare Trends and Capital Budgeting Decisions
Inflation is a general increase in price levels. Consequently, it has an impact on the cost of capital, cash outflows, and cash inflows. Therefore, in capital budgeting, computations have to be adjusted to accommodate inflation when using a real rate of return. Trends in healthcare relate to the dynamic environment in which healthcare exists. When calculating the rate of return on investment (ROI) for an IT investment, it is proper to cater for the uncertain changes in technology, which may render the existing technology obsolete. This is because technology changes rapidly; thus, capital budgeting should allocate for such changes.
References
EduPristine. (2018). Capital Budgeting: Techniques and Importance. Retrieved from https://www.edupristine.com/blog/capital-budgeting-techniques
Gapenski, L. C., & Reiter, K. L. (2016). Healthcare finance: An introduction to accounting and financial management (6th ed.). Chicago, IL: Health Administration Press
Saini, R. J. (2018). Risk Analysis in Capital Budgeting. Retrieved from https://www.researchgate.net/publication/323414160_Risk_Analysis_in_Capital_Budgeting
