Literature week 5 – Financial Management
Young, D. (2008) Management accounting in healthcare
organizations.
Chapter 8 – Programming
In the programming phase of the management control process, senior management’s
decisions frequently involve investments in fixed assets that will be used over several years
and result in a sort of financial ‘payback’. Programming decisions = capital budgeting
decisions, involve an analytical technique that recognizes the multiyear period over which
the fixed assets will be used.
In the programming phase, a variety of long-term decisions concerning the organization’s
product lines/programs/resources are made. This is made in accordance with the
organization’s context (competition, legislation, opportunities etc).
The financial benefits one gets from a product in the future are not nearly as much worth as
the amount received today from it. Purchasing a product can lead in the long-term to annual
debt service outlays rather than the large outlay of cash that otherwise would be necessary.
It will always have some positive cash flow effects, coming about from decreased operating
expenses or increased contribution. The period over which cash flows will be received is the
asset’s economic life (its physical life is usually longer).
An important aspect of all capital investment decisions is financial feasibility. Determining
this consists of comparing the purchase price of the asset with the estimated future cash
inflows that can be attributed to it. Three most common techniques for this: payback
period, net present value and internal rate of return.
- Payback period: dividing the net investment by the estimated annual cash inflows it
generates. The quotient is the number of years of cash inflows needed to recover
the investment. The net investment is the cost of the new asset plus installation
costs, plus disposal costs for the asset being replaced, minus any revenue received
from selling that asset. Annual cash flows are the reduced expense or increased
contribution attributable to the new asset. Main advantage: simplicity, frequently
used to gain rough estimate of the feasibility of an investment opportunity.
Disadvantages: does not facilitate a comparison of the financial feasibility of two or
more competing projects, and does not consider the time value of money.
- Net present value: this avoids the payback period limitation by including the time
value of money into the analysis. It calculates the present value of a proposal’s
future cash inflows. Five steps:
1
, Things to consider: a project that yields a net present value of zero or greater should
be acceptable. Also, this method might be quite imprecise, especially estimates that
lay further in the future and with a high rate of technological change. Third, inflation
is a factor. By excluding the inflation effect from the cash flow calculations and
required rate of return, the effect is neutralized without having to do complex
calculations. Finally, the financial analysis is only one aspect of the decision-making
process (others are e.g. political or strategic). A manager’s judgment or feel of the
situation is also important. Also if a project is mandatory its net present value is
irrelevant. The use of net present value (or a related technique) only formalizes the
quantitative part of the analysis. As a result, when we calculate net present value,
we should be satisfied if it is fairly close to zero. If it is greater than zero, the project
has a higher financial return than we require; if it is close to zero or even slightly
negative, we should recognize that it is probably financially feasible and should turn
to nonquantitative considerations to evaluate it further.
- Internal rate of return (IRR): similar to net present value approach. Instead of using
the required rate of return, the net present value is set to zero and the effective rate
of return for the investment is calculated. Gives an exact RR. IRR can assist a
company in determining its financial priorities.
Once the present value factor has been determined, it can be located in a table in
the row corresponding to the economic life of the project.
For-profit organizations must consider tax effects of a proposed project. That means,
anytime an organization realize some cost savings, the increase in income before taxes is
not all that they get to keep because taxes go off it still. Depreciation serves as a tax shield,
reducing the amount of taxes that would otherwise be paid. It does so by increasing the
organization’s expenses.
The approach used to determine the discount rate begins with a calculation of the entity’s
weighted cost of capital (WCC), which is then incorporated into a computation of the
2
Young, D. (2008) Management accounting in healthcare
organizations.
Chapter 8 – Programming
In the programming phase of the management control process, senior management’s
decisions frequently involve investments in fixed assets that will be used over several years
and result in a sort of financial ‘payback’. Programming decisions = capital budgeting
decisions, involve an analytical technique that recognizes the multiyear period over which
the fixed assets will be used.
In the programming phase, a variety of long-term decisions concerning the organization’s
product lines/programs/resources are made. This is made in accordance with the
organization’s context (competition, legislation, opportunities etc).
The financial benefits one gets from a product in the future are not nearly as much worth as
the amount received today from it. Purchasing a product can lead in the long-term to annual
debt service outlays rather than the large outlay of cash that otherwise would be necessary.
It will always have some positive cash flow effects, coming about from decreased operating
expenses or increased contribution. The period over which cash flows will be received is the
asset’s economic life (its physical life is usually longer).
An important aspect of all capital investment decisions is financial feasibility. Determining
this consists of comparing the purchase price of the asset with the estimated future cash
inflows that can be attributed to it. Three most common techniques for this: payback
period, net present value and internal rate of return.
- Payback period: dividing the net investment by the estimated annual cash inflows it
generates. The quotient is the number of years of cash inflows needed to recover
the investment. The net investment is the cost of the new asset plus installation
costs, plus disposal costs for the asset being replaced, minus any revenue received
from selling that asset. Annual cash flows are the reduced expense or increased
contribution attributable to the new asset. Main advantage: simplicity, frequently
used to gain rough estimate of the feasibility of an investment opportunity.
Disadvantages: does not facilitate a comparison of the financial feasibility of two or
more competing projects, and does not consider the time value of money.
- Net present value: this avoids the payback period limitation by including the time
value of money into the analysis. It calculates the present value of a proposal’s
future cash inflows. Five steps:
1
, Things to consider: a project that yields a net present value of zero or greater should
be acceptable. Also, this method might be quite imprecise, especially estimates that
lay further in the future and with a high rate of technological change. Third, inflation
is a factor. By excluding the inflation effect from the cash flow calculations and
required rate of return, the effect is neutralized without having to do complex
calculations. Finally, the financial analysis is only one aspect of the decision-making
process (others are e.g. political or strategic). A manager’s judgment or feel of the
situation is also important. Also if a project is mandatory its net present value is
irrelevant. The use of net present value (or a related technique) only formalizes the
quantitative part of the analysis. As a result, when we calculate net present value,
we should be satisfied if it is fairly close to zero. If it is greater than zero, the project
has a higher financial return than we require; if it is close to zero or even slightly
negative, we should recognize that it is probably financially feasible and should turn
to nonquantitative considerations to evaluate it further.
- Internal rate of return (IRR): similar to net present value approach. Instead of using
the required rate of return, the net present value is set to zero and the effective rate
of return for the investment is calculated. Gives an exact RR. IRR can assist a
company in determining its financial priorities.
Once the present value factor has been determined, it can be located in a table in
the row corresponding to the economic life of the project.
For-profit organizations must consider tax effects of a proposed project. That means,
anytime an organization realize some cost savings, the increase in income before taxes is
not all that they get to keep because taxes go off it still. Depreciation serves as a tax shield,
reducing the amount of taxes that would otherwise be paid. It does so by increasing the
organization’s expenses.
The approach used to determine the discount rate begins with a calculation of the entity’s
weighted cost of capital (WCC), which is then incorporated into a computation of the
2
