Capital Budgeting
There are five strategic projects that are available for Superior Health System. The system lost money last year, but it does have a contingency fund. Whether it is worth dipping into that fund, or other avenues of financing, depends on the strength of these projects. So it is important to analyze the projects.
Partner with a major supplier who will guarantee price, delivery, and product quality
Expand the ENT, Plastic, Gynecology, and Orthopedics surgical programs
Develop a cost-reduction program.
Spend $3,000,000 to expand primary care physician membership in Corinth Health Systems, SHS's PHO
The rational for this order is as follows. Financially, the first two options are positive. Partnering with a major supplier, if it costs nothing up front and delivers that sort of value, should have been done yesterday. Expanding the ENT, gynecology and orthopedics departments has the highest up front cost, and while that might be a barrier for management to overcome, this option is expected to generate substantial revenues in subsequent years, more than enough to pay for the up-front cost, even with two years.
The third option, the cost-reduction program, is another one that should be done. There is an up-front cost, but it is believed that over the course of a few years, the cost reductions will result in savings significantly beyond the up-front investment.
From a capital budgeting perspective, neither the Henry Street School option nor the primary care option should be undertake. There is nothing in the primary care option that points out how this will generate incremental cash flows for Superior, so it is out. Running a day care is an entirely different business, so that should be entered into with caution and only if it projects to be wildly profitable. It does not -- instead it is estimated that it will not be able to generate any contribution margin, thus not cover fixed costs nor pay back on the building purchase. Both of these options, as they reduce the overall value of the organization, should be rejected.
b. The finance committee's evaluation seems reasonable on some points, silly on others. Corporate debt is usually...
So on that point, the finance committee is incorrect. Further, it should have a better sense of what causes a bond rating to drop. It is actually quite unclear from this analysis that the bond rating would drop, though such a rating might be at least somewhat dependent on the ability of the organization break even while meeting its obligations. It is understandable, however, that the finance committee would be leery of putting their credit rating at risk.
The losses from last year are definitely something that should concern the finance committee, and they are right that such losses are not sustainable. The budget should reflect that the organization wants to set a course that is financially sustainable, unless it has good reason to do otherwise. A good investment is a reasonable reason to run a budget deficit; ongoing operations are not. It will hurt the organization in the long run to set out an irresponsible budget at this point. That said, the $6 million figure is entirely arbitrary, and should be taken with a grain of salt by the finance committee, especially knowing that in capital budgeting, a project with a positive NPV should be undertaken. Arguably the most expensive proposed project, the expansion, has a much higher NPV that leaving the money in the rainy day fund where it is lucky if it actually earns a real return at all.
c. I vote to fund partnering with a major supplier as there is no stated cost. This should have been done yesterday. I support the expansion, which carries with it a $7 million price tag. Among projects, this has the highest NPV, and because we are increasing capacity, that positive cash flow is sustainable over the long run. If the market analysis shows that the revenue projections are reasonable, we should utilize some of the rainy day fund in order to facilitate this sort of organizational growth. The cost reduction program I will also support. Though there is an upfront cost, this project again has a positive net present value. Because of that, and the fact that the benefits of cost reduction are ongoing in nature,…
