A tool to evaluate equipment purchases - discounted cash flow technique

Medical Laboratory Observer, March, 1993 by Neysa R. Simmers

The discounted cash flow technique can help you determine whether the purchase of specific new equipment makes sense financially.

THE DISCOUNTED cash flow (DCF) technique is a useful method for evaluating equipment purchases. It determines whether or not the lifetime cash savings from using a specific piece of equipment will cover its cash acquisition costs.

The application of the DCF technique requires five specific steps to arrive at a net present value. These include determining the following:

* expected life of the piece of equipment;

* cash inflow and savings on an annual basis over the expected life;

* acquisition costs;

* cash costs on an annual basis over the expected life; and

* cost of capital.

* Expected life. The American Hospital Association's guide on equipment defines capital investment life expectancy for different types of equipment.

* Cash inflow and savings. Estimating annual cash inflow associated with the acquisition of a piece of equipment is difficult. Revenue brought in as a result of the new equipment can be based on workload units (WLUs) or procedures. Cash savings can result from a reduction of either labor, material, or energy.

* Acquisition costs. Cash outflow associated with equipment acquisition includes more than simply the net purchase price. Also to be considered are such items as freight, installation cost, and training in the use of the equipment.

* Cash cost estimates. Reagent costs can differ substantially with different equipment, as can labor and maintenance costs. Along with these costs, the escalation of these amounts through the life of the equipment should be forecast. If the manufacturer has documented the cost savings of a particular piece of equipment, this part of the process is greatly simplified. Cash savings and cash outflows are estimates based on forecasts, and some laboratory scientists are uncomfortable using them. Risk analysis is useful for reducing this discomfort.

One risk analysis technique estimates cash flow under best-case and worst-case scenarios. The two sets of cash flows, one under optimistic and the other under pessimistic conditions, provide the analyst with additional information for evaluating the purchase decision. The actual outcome should fall somewhere between the two estimates. This technique helps define the financial risk in real dollars.

* Cost of capital. The cost of capital--the cost of the money that would be tied up in the piece of equipment--must be determined in order to convert future cash flow into an amount valued in today's dollars. Discounting the cash flow at the cost of capital determines the present value.

The cost of capital can easily be shown by the example of the purchase of a car. The interest on the money borrowed represents the cost of debt. If the interest is tax deductible, the cost of the debt is adjusted by the tax benefit received. If money is taken out of another investment and spent on the car, the cost associated with the lost return on that investment represents the cost of equity.

Table 1
Example of net present value calculation
($000)
Year               0        1        2        3        4
Capital          (400)      0        0        0        0
outlay
Revenue           500      500      500      500      500
Operating        (200)    (200)    (200)    (200)    (200)
expenses
Cash flow        (100)     300      300      300      300
Present value    (100)     263      231      202      178
@ 14%.
NPV
@ 14% = $774,000

In for-profit hospitals, the cost of capital is calculated by combining the tax-adjusted interest rate charged on a new loan with the cost of equity--the return that would leave the current market price of the hospital's common stock unchanged.

The cost of debt, the cost of equity, and the percentage of debt financing and equity financing determine the weighted cost of capital. In not-for-profit hospitals, the cost of stock equity doesn't come into play, but the cost of equity may be a required rate set by the organization. It also may be estimated by determining the rate of return on investments in the recent past or the rate of return needed to meet organizational goals.|1~

In every case, the weighted cost of capital can be determined by taking the portion of debt times the cost of debt and the portion of equity times the cost of equity. The discount rate is this weighted average cost of capital.

If the cost of capital is not available, you can use a range of values for the discount rate, with each value applied to the estimated cash flows in order to determine a single present value. This procedure provides a range of DCFs that serves as additional information upon which to make a buy or not-buy decision.

* Net present value. The present value of the net cash flows that occur at the end of each year can be determined using the cost of capital as the discount rate. The present values can then be added up to determine the net present value (NPV). If the NPV is positive, the cash flows from using the equipment are sufficient to cover its operating costs, acquisition costs, and cost of the funds used for the acquisition. If the NPV is negative, the cash flows do not cover all the costs associated with the equipment's acquisition. In this case, the intangible benefits that are derived from ownership of the equipment must be sufficient to justify its purchase. Examples of intangible benefits include such things as life-support services or the ability to perform on-site analyses in a timely manner.