Watch for pitfalls of discounted cash flow techniques

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

how they will affect other areas of

the organization as a whole; and * If they sometimes feel that if a

project ends there will be no tomorrow.

Answering yes to one or more of these questions may indicate overcommitment to a project.(l)

Rotating administrators is one way to reduce commitment to a losing course of action. This approach, however, must be weighed against the costs of removing committed decision makers from a project, which may outweigh long-term benefits by demoralizing staff members and discouraging managers from trying again.

A less dramatic technique is to separate initial from ensuing decisions on a project. In the banking industry, for example, a "workout group" sometimes handles problem loans, rather than the individuals who had originally approved them.

A financial manager aware of psychological biases in capital budgeting decisions may be able to step back and look at a proposed or ongoing project from a fresh perspective. And awareness of potential analytical pitfalls in capital budgeting techniques may help a financial manager to more effectively apply an organization's resources.

Table : EXHIBIT 1: Short-term project bias [Tabular Data Ommitted]

Table : EXHIBIT 2: Poor capital budgeting decisions [Tabular Data Omitted]

Table : EXHIBIT 3: Present value factors [Tabular Data Omitted] (a.) Carroll, J. and Newbould, G., "NPV vs. IRR: With capital budgeting, which do you choose?" Healthcare Financial Management, November 1986, pp. 62-68. (b.) Kim, S.; Crick, T.; and Farragher, E., "Foreign Capital Budgeting Practices Used by the U.S. and Non-U.S. Multinational Companies," The Engineering Economist, Spring 1984, pp. 207-215. (c.) Ross, S. and Westerfield, R., Corporate Finance, St. Louis, Times Mirror/Mosby College Publishing, 1988.

Van Horne, J., Financial Management and Policy, eighth edition, Englewood Cliffs, N.J., Prentice Hall, 1989. (d.) Kaplan, R., "Must CIM be justified by faith alone?" Harvard Business Review, March-April, 1986, pp. 87-95. (e.) Kaplan, p. 92. (f.) Horngren, C. and Foster, G., Cost Accounting; A Managerial Emphasis, sixth edition, Englewood Cliffs, N.J., Prentice Hall, 1987.

Van Horne. (g.) Kim, Crick, and Farragher.

Stanley, M. and Block, S., "A Survey of Multinational Capital Budgeting," The Financial Review, March 1984, pp. 36-51. (h.) Healthcare organizations apparently have a long way to go in considering risk factors. A recent survey of the capital budgeting practices of hospitals since start-up of Medicare's prospective payment system found that nearly 70 percent do not account for risk in their analyses. Under-adjusting for risk is no more correct than over-adjusting for it, and healthcare financial managers should adopt a more balanced treatment of risk considerations. For further detail, see: Kamath, R. and Elmer, J., "Capital Investment Decisions in Hospitals: Survey Results," Health Care Management Review, Spring 1989, pp. 45-56. (i.) Hodder, J. and Riggs, H., "Pitfalls in Evaluating Risky Projects," Harvard Business Review, March-April, 1986, p. 137. (j.) Bowen, M., "The Escalation Phenomenon Reconsidered: Decision Dilemmas or Decision Errors?" Academy of Management Review, 1987, pp. 52-66. (k.) Lichtenstein, S. and Fischhoff, B., "Do Those Who Know More Also Know More About How Much They Know?" Journal of Experimental Psychology: Human Learning and Memory, 1978, pp. 551-578. (l.) Staw, B. and Ross, J., "Knowing When to Pull the Plug," Harvard Business Review, March-April 1987, pp. 68-74.