A tool to evaluate equipment purchases - discounted cash flow technique

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

By applying financial techniques at this level of sophistication, the laboratory manager can provide information that helps the facility implement a sound capital budgeting program. This is particularly important as greater emphasis is placed on the most effective use of limited dollars in this era of rising health care costs, competition, and consumer expectations.

The DCF method is not totally new to this field. TerHark and Diaz|2~ showed how to perform a DCF analysis using spreadsheets but failed to demonstrate the process of defining each element and the management of this technique. Chow and McNamee|3~ pointed out that considerations other than a pure DCF technique are important. Wheeler and Smith|4~ addressed the problem of setting the discount rate (part of the DCF method). A 1989 survey by Kamath and Elmer|1~ found that most hospitals do not use DCF analytical techniques. Most use less sophisticated methods such as payback or average return.

The author is administrative director of clinical laboratories, Augusta Hospital Corp., Fishersville, Va. She wishes to acknowledge the contributions to this article of Carl Weaver, Ph.D., professor of finance and director of the MBA program at James Madison University, Harrisonburg, Va.

References

1. Kamath RR, Elmer J. Capital investment decisions in hospitals: Survey results. Health Care Management Rev. Spring 1989; 14(2): 45-55.

2. TerHark D, Diaz J. A spreadsheet for capital equipment financial modeling (Computer Dialog). MLO. April 1991); 22(4): 71-73.

3. Chow CW, McNamee AH. Watch for pitfalls of discounted cash techniques. Healthcare financial Management. April 1991; 45(4): 34-43.

4. Wheeler JRC, Smith DG. The discount rate for capital expenditure analysis in health care. Health Care Management Rev. Spring 1988; 13(2): 43-51.

Figure 1

Advantages of discounted cash flow analysis

* Can be used to make a broad range of different decisions needed to manage a laboratory.

* Takes into account all initial outlays as well as operational expenses and revenues. Also accounts for the opportunity costs--costs related to using the money versus investing it in something else--of the funds associated with the life of a project.

* Has advantages over the internal rate of return method, which assumes that the cash can be reinvested at the internal rate of return rather than the opportunity cost of capital.

* Has advantages over payback analysis, which takes only the initial capital outlay and no opportunity costs into consideration.

* Helps the laboratory manager to identify the financial impact of each purchase component, which may be a basis for vendor negotiation.