Watch for pitfalls of discounted cash flow techniques

Healthcare Financial Management, April, 1991 by Chee W. Chow, Alan H. McNamee

Watch for pitfalls of discounted cash flow techniques

In recent years, rising costs, tightened reimbursement formulas, and increased competition have financially strained healthcare organizations. To remain afloat in this environment requires more than short-term measures to contain costs and increase revenues. Each healthcare organization also must ensure that its amount and mix of resources - facilities, personnel, and equipment - are appropriately adjusted for long-term shifts in demographic and competitive conditions.

Long-term resource allocation decisions, commonly called capital budgeting, involve trading off current resources for future resources. While discounted cash flow (DCF) techniques to improve capital budgeting decisions already may be familiar to healthcare financial managers,(a) even the best analytical technique can produce erroneous results if incorrectly applied. Studies in manufacturing, which has faced competitive pressures for much longer than health care, have found frequent misapplications of the DCF approach.

Hidden properties

Two DCF methods are generally well-known: net present value (NPV) and internal rate of return (IRR). The NPV method involves converting each project's future cash flows into present value equivalents, then comparing each project's present value of inflows minus the present value of outflows.

A difficulty in applying NPV is that it requires a manager to specify a discount rate for future cash flows. Theoretically, this discount rate should be the expected return forgone because of a particular project. In practice, however, it is commonly operationalized as an organization's weighted cost of capital.

In contrast, the IRR method does not require a manager to specify a future discount rate. Instead, it calculates a rate of return entirely from a project's predicted cash flows. Surveys of manufacturing firms have shown that IRR is by far the most common capital budgeting approach.(b) This popularity is due, at least in part, to the IRR approach's convenience. IRR not only removes the need to specify (or justify) a cost of capital but also helps financial managers rank options by rate of return while still allowing them to compare these rates to a minimum hurdle rate.

Despite these benefits, IRR can mislead capital budgeting decisions because of several hidden properties. Two of these, assumed reinvestment rate and accounting for the scale of investment, are particularly worthy of attention.(c)

ASSUMED RATE. The IRR approach has a built-in assumption that all future cash inflows from a project can be reinvested at the project's IRR. This assumption is unlikely to prove correct, because projects with higher returns tend to be adopted first, and their cash inflows will not necessarily have equally profitable reinvestment opportunities.

On the other hand, an NPV analysis makes the more realistic assumption that reinvestments will be made at an organization's discount rate or cost of capital. If the IRR method's reinvestment assumption is untenable, it can introduce an unintended bias in favor of short-term projects or projects with proportionally more short-term cash inflow.

For a healthcare organization that typically can attain a 10 percent return on its investments and is evaluating two mutually exclusive projects with the cash flows predicted in Exhibit 1, an IRR analysis would show projects A and B to be equally profitable.

But when the net present values of these projects are calculated using a 10 percent rate, project B is shown to be superior to project A:

Project A: $1,082 =

(10,000 x .9091) +

(10,000 x .7513) -

15,522

Project B: $1,755 =

(22.996 x .7513) -

15,522

As a result, while an IRR analysis would suggest similar results from the two projects, the NPV method would favor adoption of project B.

Because both calculations take into account the time pattern of cash flows and the time value of money, their conflicting conclusions are not caused by either method omitting one of these factors. The conflicting conclusions are caused by the two DCF methods' different reinvestment rate assumptions.

This is clarified by the amount of cash on hand at the end of year three - the two projects' terminal values.

Using a 10 percent reinvestment rate, project A's $10,000 inflow at the end of year one would grow to $12,100 by the end of year three ($10,000 x 1.1 x 1.1). Together with year three's $10,000 cash inflow, project A would have a $22,100 terminal value, below project B's $22,996. But with a 14 percent reinvestment rate, project A's year one $10,000 inflow would grow to $12,996 by the end of year three ($10,000 x 1.14 x 1.14), and the projects' terminal values would be equal.

A comparison of the calculations using the 10 percent and 14 percent rates makes this point apparent. Because proportionally more of project A's future cash inflows occur early, applying the IRR method's higher assumed reinvestment rate to these early inflows increases project A's assessed profitability in comparison to project B's. For this reason, IRR tends to make shorter-term projects appear more attractive because they have earlier cash inflows. To avoid this bias, managers should directly estimate the cost of capital rather than abdicate this decision to a quantitative technique.