The not-for-profit teaching hospital is currently serving as a tertiary and a quaternary referral center. The hospital is known for providing specialty care to referred patients who in most cases requires costly clinical expertise and treatments. The specialty treatments are only available at a few selected institutions. The costly clinical expertise and procedures necessitate the need for crucial considerations of cash flows and outflows. The hospital also runs a successful specialty care program in its center for digestive disorders. The program is highly rated in diagnosis and treatment of gastrointestinal tract disorders. The extent of the research funding and the ability of the hospital to attract patients from all parts of the country serves as the best evidence to demonstrate its achievements.
The hospital benefits from its affiliation to the faculty of the university's college of medicine which provides at least twenty gastroenterologists who serve the purpose of patient clinical care, research, and teaching. The hospital offers its services through three business units which include an outpatient clinic, hospital-based motility laboratory and a hospital-based endoscopy suite. The mobility lab is estimated to generate at least five (5%) of the total net revenues. The income is attributable to an average of six hundred (600) per annum manometry tests conducted. The hospital uses two technologies namely water perfusion and solid-state involved in motility testing. Three water perfusion workstations are used to provide roughly two hundred (200) motility tests each. However, the two technologies have distinct differences with the most important one being the patient venue.
The patient is required to spend at least a day as an inpatient under the water perfusion technology. The patient can receive the services as an outpatient using the solid-state technology and therefore free at least a bed per day that can be used for other purposes. The space that is freed is referred to as backfill beds. Even though the hospital is known for the state of art technology, some manometry equipment needs to be updated. Thus, one of the medical directors had previously raised a proposal to have the technologies updated, but the inadequacy of the required capital requirement has hindered the progress. One of the workstations has been identified as unreliable a situation that has resulted in inconveniences and creation of a patients backlog. The factors mentioned have necessitated for immediate approval for the acquisition of new systems.
The capital budgeting process
The capital expenditure process would begin with the evaluation of the quotes obtained from the different manufacturers of manometry equipment. The capital budgeting processes are considered as the most effective methods of evaluating the viability of long-term projects. The Present Net Value (NPV) method and Internal Rate of Return (IRR) methods have been used to assess the potential benefits and risks associated with the implementation of the two projects (Abor, 2017). The favorite company Digestive Diagnostic Inc. was selected after careful consideration of the quality and costs. The following information about the water perfusion workstation was also presented:
- Cost $25,000
- Catheters required $4500 (9 @500)
- Test supply costs (per test)
- Medical supplies$15
- Administrative supplies$10
- The unreliable perfusion workstation is not estimated to contain any salvage value.
The solid-state technology
The solid-state technology is considered to be much more expensive than the water perfusion workstation. The following information related to solid-state technology was available:
- Cost of acquisition $25,000
- Cost of catheters $54,000 (9*6000)
Though the costs of acquisition for the two technologies are equal, the per-catheter cost for solid-state technology is higher by $5,500. The $5,500 extra costs do not include other operating costs which are considered to be higher than those of water perfusion technology.
The justifications of the solid-state technology
Though the solid-state technology is considered to be expensive, there are a few reasons that can justify the possible acquisition. One of such reasons includes the ability to reduce the patient wait time in the facility due to capacity to conduct twice as more tests as compared to those performed by the water perfusion technology. The potential to do more tests can reduce the existing patients' backlog. The second justification is based on the fact that the solid-state technology enables the tests to be conducted on an outpatient basis. The current water perfusion technology requires close observation of the patient to correct the actual data and thus needs them to remain inpatient. The solid-state technology is currently being embraced as a standard of care, and it is essential to adopt the technology for the hospital to maintain its current reputation. The solid-state technology would also enhance teaching curriculum and even research funding.
The solid-state technology seemed to raise important points, however, to make a more reliable solution; it would be important to evaluate the two technologies using the capital budgeting techniques. The following additional information is provided:
- The useful life of the two technologies is five (5) years
- The estimated increase in tests if the solid-state technology is used is 100
- Additional medical/surgical beds days freed are estimated to be 100
- Inflation rate 3%
- Cost of capital 10%
- Differential costs +/- 3%...
Discussion and recommendations
The two technologies are likely to experience similar financial risks. The NPV values for water perfusion technology and the solid-state technology are both positive. Positive NPVs are a clear indication of expected future positive net cash flows of a long-term project. The criteria behind the NPV method are to accept a project with positive NPV and reject the project if the NPV is negative. Replacing the second system would result in negative NPV and hence not a viable decision. Based on the NPV method, the hospital can undertake any of the two options. However, the solid-state technology is seen as the favorite of the two since it is likely to contribute a higher Net Present Values. The two technologies have also produced IRRs that are relatively higher than the cost of capital of the project which is set at 10%. In such a situation, the investment in the two technologies is highly recommended.
The two investment appraisal techniques have their own merits and demerits. The time value for money is put into considerations when determining the future benefits associated with the long-term projects (Finkler, Smith, Calabrese, & Purtell, 2016). However, prediction of future cash flows is difficult since the organizations are faced with different economic uncertainties. It is also complicated to come up with a correct discount rate to compute the present value of the cash flows. The internal rate of return equates the net present values of the firm to zero.
The hospital is encouraged to invest in solid-state technology to maximize the revenues and maintain the reputation in the health industry. However, the hospital had previously indicated the possibility of inadequate capital to invest in the new technology. As such the hospital must identify cheap sources of investment funds to avoid financial risks associated with the financing activities. The financial risks can also be contributed by use of inappropriate data to make forecasts of the estimated future cash flows. There are other external factors likely to influence the financial risks of the hospital. The hospital cannot have a direct influence on the external factors such as the activities of the political decision-makers within the publicly funded health care. The health sector is affected by the political decision makers especially those believed to possess a remarkable source of economic capital.
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Finkler, S. A., Smith, D. L., Calabrese, T. D., & Purtell, R. M. (2016). Financial management for public, health, and not-for-profit organizations. CQ Press.
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