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BECKMAN COULTER CORPORATE

Michael S. Gannon - Director, BCI-Clinicon Consulting Group, Beckman Coulter, Inc.

Most laboratory investment projects involve expenditures and savings made over a period of years. To equate the value of cash flows with different time periods, it is prudent to employ a cash flow analysis method that takes into account the time value of money. This concept is linked to the impact of inflation on the value of money. In an inflationary environment, money collected in the future is worth less than the same amount of money collected today.

Many traditional financial analysis techniques employed by laboratory managers such as payback period and return on investment fail to take the time value of money into consideration. Although useful tools in the financial analysis of investment decisions, their exclusive use can result in faulty decisions such as the acceptance of projects that lose money and the rejection of projects that may represent significant financial advantages. Analytical techniques used in finance to take the time value of money into account are called discounted cash flow methods.

The net present value (NPV) is the most useful of these discounted cash flow methods. NPV analysis yields a result, expressed in after-tax dollars (important for profit-based operations), that takes into consideration the difference in the value of future cash flows and the cost of raising the capital required for the investment. NPV helps make sound decisions about whether to accept or reject potential investment projects based on an objective financial criterion. Projects associated with positive NPVs represent net savings for the organization. Projects associated with an NPV of zero will recuperate only the cost of the capital required to make the investment. Projects associated with negative NPVs represent a financial loss for the organization.

The baseline year is when the initial investment is made. All cash flows occurring in future years are reduced in purchasing power compared to this baseline year. The amount that the cash flows associated with a given year are reduced, or discounted, in value is a function of time and the "hurdle rate". The hurdle rate can be the cost of the invested capital if the project is to be funded with borrowed capital or the required minimum return the project must generate in order to justify the investment of internally available funds. This allows for direct comparison of cash flows. A positive NPV of $1.00 for a project initiated in 1999 with a hurdle rate of 10% means that the project will return the full cost of the invested capital (10%) plus $1.00 in 1999-equivalent value dollars.

An Example Of NPV Analysis

The following table illustrates a simple NPV analysis for a core lab reengineering project at a non-profit hospital utilizing internally available funds to finance the project. To simplify matters, the entire investment is made at the beginning of the project. If the client had been a taxable, for-profit operation, the calculation would be more complex because IRS credits for capital cost allowances must be taken into consideration. The economic life of the project is set at five years. This is equivalent to the estimated amount of time that the potential labor savings can be maintained without investing additional capital to replace assets required to initiate the project as they age. It is important to base the estimate of the economic life of a project on this criterion rather than on a set criterion like the payback period. Use of the payback period for the economic life does not account for positive cash flows that may accrue to the hospital after the payback period and may result in the rejection of a financially sound investment.

Because the hospital will use internally available funds to finance this project, we have assumed that the hospital can pick from two mutually-exclusive investment projects:

(1) invest $1.4 million of its capital resources in the core lab project, or
(2) invest the same amount in a 10% security for 5 years.

The return the hospital would make from the security represents the "opportunity cost" of the core lab project because the hospital is foregoing the opportunity to earn the accrued interest on the security in order to mobilize the capital to implement the core lab project. The core lab project must replace this opportunity cost before it can return a positive NPV.

The use of a security as a "challenger" to the core lab project is prudent since it requires objective financial proof that the project has the potential to provide a higher return than simply saving the money. The "null hypothesis" (H0) states that the core lab project will not outperform the return on the security. This null hypothesis must be disproved in order to accept the laboratory management's hypothesis (H1) that investing the money in the core lab project will outperform the return on the security . Since the projects are mutually exclusive, if the core lab project cannot outperform the return made on the security, the analysis will return a negative NPV, H0 would not be rejected and the core lab project would not be accepted. Conversely, if the analysis returns a positive NPV, H0 would be rejected and the core lab project would be accepted.

The 10% security would pay $700,000 in accrued interest at its maturity date [($1.4 million X 10%) X 5 years]. This explains $700,000 of the $941,747 opportunity cost of the core lab project. What about the $241,747 difference? This is caused by the negative impact of inflation on the earnings of the security which, if "left" in the investment for 5 years, would endure a $241,747 decrease in their purchasing power. Therefore, to match a return equivalent to $700,000 in "today dollars", the core lab project must return $941,747 at the end of five years.

The interpretation of the NPV analysis is as follows:

H0:	The core lab project will not outperform the security
H1:	The core lab project will outperform the security

Criteria for rejection of H₀: Core lab project returns a positive NPV

Result:	Core lab project shows an NPV of +$1,297,466
Decision:	Reject H0, Accept H1

A positive NPV of $1,297,466 indicates that the core lab project would outperform the security by $1,297,466 after compensating for the negative impact of inflation and recovery of the $1.4 million initial investment.

It's important to note that the project is expected to return $3,639,213 in total labor cost savings to the hospital over five years. According to our analysis this amount can now be broken down as follows:

1. $1.4 million in labor cost savings to replace the capital resources used-up to make the initial investment. This represents the only "real" cost of the project

2. $941,747 in labor cost savings to compensate for the opportunity cost of the project. This is an artificial cost.

3. $1,297,466 in savings over and above (A) and (B).

Finally, at the beginning of an NPV analysis it is important to identify the strategic intent of the project. If part of the strategic intent is to reduce operating costs and decrease prices. In order to increase laboratory revenues, the projected increase in revenues needs to be evaluated and included as a positive cash flow in the calculation. If the intent of the project is survival then a negative NPV might be acceptable if the negative financial impact of the investment is outweighed by the potential financial losses that may be associated with rejection of the project. In this case, the analysis led to the conclusion that mobilizing the capital required to implement the core lab project is in keeping with a strategy to maximize potential returns.