Part I
1. Time value analysis is the concept implemented when there is a necessity to identify future value of one unit of a currency supposed to be received in several years or the amount of money supposed to be received in future from one unit of currency invested today. The basic concept of time value of money analysis is that the value of alternative investments depends on the time when they will be exchanged. Interest rate may not cover inflation rate contributing to the differences between the present and future values of investments (Khan Academy, 2013).
Time value analysis is a tool of evaluation of costs and returns of capital assets that are extended over several years. For example, this technique can be implemented when considering acquisition of new capital assets, such as new buildings and facilities, to determine the amount of money needed to meet payments in future. Also, this technique can be implemented when calculating compounded amount of principal over time when the money was borrowed (Khan Academy, 2013).
Opportunity costs refer to making a choice of several financial opportunities offered. In this case it is important to consider the time value of money to be able to evaluate alternative projects, the risk and returns associated with them (Columbia University, 2000). For example, making deposit in a retirement account could help escape the opportunity cost of incurring losses associated with receiving inadequate funds in future; withdrawing money from salary account aiming to receive tax refund may incur the opportunity cost in the form of lost interest earned in a saving account.
2. Find the following values for a lump sum assuming annual compounding:
a. The future value of $500 invested at 8 percent for one year.
The following formula is used for compound interest future value calculations:
FV = PV*(1 + r)^n,
where FV - the future value of the investment, PV - the present value, r – interest rate, n – time of investment.
FV = $500*(1+0.8)^1 = $540.
Thus, future value of $500 invested at 8% for one year will make $540 at the end of the period. In other words, the investment of $500 today will bring $40 of profit in one year.
b. The future value of $500 invested at 8 percent for five years.
FV = $500*(1+0.8)^5 = $734.67.
Therefore, future value of $500 invested at 8% for five year will make $734.67 at the end of the period.
c. The present value of $500 to be received in one year when the opportunity cost rate is 8 percent.
The following formula will be used to calculate the present value of $500 to be received in 1 year assuming interest rate is 8%:
PV = FV/(1+r)^n,
where PV - the present value, FV - the future value of the investment, r – interest rate, n – time of investment.
PV = $500/(1+0.8)^1 = $462.96.
Thus, to receive $500 in one year assuming that the interest rate is 8%, one will have to invest $462.96 today.
d. The present value of $500 to be received in five years when the opportunity cost rate is 8 percent.
PV = $500/(1+0.8)^5 = $340.37.
Thus, to receive $500 in five years the sum of $340.37 is required to be invested on the
assumption that the interest rate is 8%.
3. Find the following values assuming a regular, or ordinary, annuity:
- The present value of $400 per year for ten years at 10 percent
PV (OA) = FV*[(1-(1+i)^-n)/i],
PV (OA) = $400*[(1-(1+0.1)^-10)/0.1] = $400*(1- 0.905)/0.1) = $380.
The present value of ordinary annuity of $400 invested for 10 years at 10% will be $380.
- The future value of $400 per year for ten years at 10 percent
FV (OA) = PV*[((1+i)^n – 1)/i],
FV (OA) = $400*[(1+0.1)^10 – 1)/0.1] = $400*[1.105 – 1)/0.1] = $420.
The future value of $400 of ordinary annuity invested for 10 years at 10% will be equal $420.
c. The present value of $200 per year for five years at 5 percent
PV (OA) = FV*[(1-(1+i)^-n)/i],
PV (OA) = $200*[(1-(1+0.05)^-5)/0.05] = $200*(1- 0.784)/0.05) = $864.
d. The future value of $200 per year for five years at 5 percent
FV (OA) = PV*[((1+i)^n – 1)/i],
FV (OA) = $200*[(1+0.05)^5 – 1)/0.05] = $200*[1.276 – 1)/0.05] = $1104.
4. Consider an uneven cash flow stream:
0 $2,000
1 2,000
2 0
3 1,500
4 2,500
5 4,000
a. What is the present (Year 0) value of the cash flow stream if the opportunity cost rate is 10 percent?
PV = R1/(1+r)^1 + R2/(1+r)^2 + R3/(1+r)^3 + R4/(1+r)^4 + R5/(1+r)^5,
PV = $2,000/1.1+$0/1.21+$1,500/1.331+$2,500/1.464+$4,000/1.611=
=$1,818.18+$0.00+$1,126.97+$1,707.65+$2,482.93=$7,135.73.
The present value of the Year 0 of given uneven cash flow stream will be equal $7,135.73 at the rate of 10%.
b. What is the value of the cash flow stream at the end of Year 5 if the cash flows are invested in an account that pays 10 percent annually?
FV = R1*(1+r)¹ + R2*(1+r)² + R3*(1+r)³ + R4*(1+r)^4 + R5*(1+r)^5,
FV=$2,000*1.1+$0*1.21+$1,500*1.331+$2,500*1.464+$4,000*1.611= =$2,420+$0.00+$1,996.5+$3,660 + $6,444= $14,520.5.
The value of the cash flow stream at the end of the Year 5 will be $10,843.5 assuming the interest rate on the level of 10%.
- What cash flow today (Year 0), in lieu of the $2,000 cash flow, would be needed to accumulate $20,000 at the end of Year 5? (Assume that the cash flows for Years 1 through 5 remain the same.)
Assuming that the present value of the cash flow is $20,000 and the cash flows remain the same for all years (Year 1 to Year 5), the following formula should be used:
PV = R1/(1+r)^1 + R2/(1+r)^2 + R3/(1+r)^3 + R4/(1+r)^4 + R5/(1+r)^5,
$20,000 = x/1.1+x/1.21+x/1.331+x/1.464+x/1.611;
$20,000*1.611=1.464x+1.331x+1.21x+1.1x+x;
X=$5,273.32.
An investor will need $5,273.32 in order to receive $20,000 at the end of the Year 5 under the assumptions made.
5. Define stated, periodic, and effective annual interest rates. Explain when each type of calculation might be used.
Stated annual interest rate is an investment that is expressed as annual percentage without being compounded. The stated annual interest rate brings lower returns than compound interest rate (Neumann, Clement and Cooper, 1999).
Periodic interest rate is charged over a specific period of time. It is usually quoted on an annual basis. It is used when there is a necessity to compound an interest rate more frequent than on an annual basis. It is calculated by dividing an annual interest rate by the number of period that are compounding (Neumann, Clement and Cooper, 1999).
The effective annual interest rate is investor’s earnings after accounting for the compounding effects. The effective annual interest rate is calculated using the following formula:
EAIR = (1+i/n)^n – 1,
where i – stated annual interest rate, n – number of compounding periods.
Part II
- Define financial risk and required return. How might a health care organization’s philosophy on risk and return differ in a for-profit and not-for-profit organization?
Financial risk is the possibility of losing money when investing in a company that cannot meet its obligations. The required return refers to investment earnings in a form of minimum annual percentage earned. The concept of the required return is used in corporate finance and equity evaluation.
It is known that higher returns associated with higher risk level. For-profit organizations could allow taking higher risks than not-for-profit organizations because the mission of a for-profit organization is to generate profits for shareholders while the mission of a non-profit organization is to serve humanity and generating profits is not the primary goal.
- a. When considering stand-alone risk, the return distribution of a less risky investment is more peaked (“tighter”) than that of a riskier investment. What shape would the return distribution have for an investment with (a) completely certain returns and (b) completely uncertain returns?
Stand-alone risk is a risk associate with a specific operating unit in a healthcare organization. When considering stand-alone risk, the return distribution will have the shape of a straight vertical line with variability equal zero in the case of completely certain returns. Completely uncertain returns are characterized with infinitely large variance and the probability distribution curve will be a horizontal line in the extreme case.
b. What are the two types of portfolio risk? How is each type defined? How is each type measured?
There are two types of portfolio risks, namely: systematic risk and unsystematic risk. Systematic risk is the risk that influences several types of assets in a portfolio. An example of systematic risk is political or economic event. Unsystematic risk is a kind of risk that affects a small number of assets, such as an employees’ strike. Portfolio diversification can protect investors from unsystematic risks only. Systematic risk is also referred as stock volatility and is measured by beta coefficient. Beta is used in CAPM (the capital asset pricing model) to calculate the expected return of an asset or a portfolio. Regression analysis is used when calculating beta. Beta shows the tendencies in security returns affected by market changes. Unsystematic risk is measured through systematic risk mitigation by diversifying investment portfolio.
3. Interview a health care facility’s Administrator or Risk Manager. What type of insurance coverage does the facility need? What are the yearly premiums for these coverages? How, and by whom, is the decision reached concerning deductibles, coverage limits, and the acceptable level of risk to assume?
Healthcare facility administrator of the non-profit healthcare organization was interviewed for the purposes of the current assignment. He required the name of the organization remain anonymous.
He suggested that general liability insurance, professional liability insurance, and service liability insurance is needed. A general liability insures a healthcare organization against harm caused to the patients and visitors on the organization’s property. The insurance will cover for damages ought to pay someone who is injured on the property. Professional liability insurance protects against liabilities resulted from poor organizational management and covers directors, officers, staff, volunteers, and non-profit organization itself. Service liability insurance covers sizable portion of the damages and the legal defense resulted from providing poor services to the patients. The organization will be protected from lawsuits by clients claiming they were hurt by the services of poor quality provided to them. He considers that as for a community-based non-profit organization, $1 million of coverage for general liability insurance. Professional liability insurance should apply for $5 million of coverage, and service liability insurance should apply for $2 million of coverage. However, this is a subjective opinion since there is no proper answer to this question. No one can assume how many accidents that should be insured may occur in the healthcare organization. The premiums paid by the organization can vary from $1,500 to $5,000 per year depending on insurance plans chosen, insurers, breadth of coverage, quality of employment practices at the organization, and prior claims.
Any healthcare organization should consider several sources of risk including corporate compliance, malpractice, legal liability, and human resources. Healthcare facility administrator or risk manager is responsible for assessment of acceptable level of risk. The decisions regarding deductibles, acceptable level of risk, and coverage limits are made by senior management (paid executives) or of a healthcare organization or by volunteer trustees. However, the acceptable risk level is not obvious and often depends on personal perception of the healthcare administrator or risk manager. The acceptable level of risk in the nonprofit organization can be regulated by government. It can be also influenced by the life cycle stage and the age of the facility. The healthcare organization that was considered is quite large. Hence, being an organization having substantial resources it has to approach risk in a conservative fashion in comparison to small organizations that could take greater risks aiming to establish themselves.
Part III
- What is the primary difference between financial statement analysis and operating indicator analysis?
Financial statement analysis is the process of review and evaluation of financial statements of a company. The primary goal of financial statement analysis is gain understanding of overall financial health of a company aiming to enable effective decision making process. The information receive during financial statement analysis can be used by shareholders, investors, and company managers. On the contrary, operating indicator analysis involves using operational data aiming to explain financial condition of a business. Operating indicator analysis is primary used for internal needs aiming to resolve internal financial problems. This is the primary difference between financial statement analysis and operating indicator analysis.
- Why are both types of analyses useful to health services managers and investors?
Both types of analyses are useful to health services managers and investors because they help assess and evaluate the financial health of a healthcare organization. They offer vast information for analysis of a company financials.
- Should financial statement and operating indicator analyses be conducted only on historical data? Explain your answer.
Financial statements and operating indicator analyses are conducted based on historical data. Thus, the information derived from them is not effective in planning process because the situations that occurred in the past may not repeat in future. Also, comparative analysis of financial statements and operating indicator analysis based on historical data only cannot fully reflect financial data because of inflation. Inflation should be taken into account when conducting financial statement analysis or operating indicator analysis.
2. Define Key Performance Indicators (KPI) and dashboards. What is their value? How are KPIs and dashboards used in financial condition analysis?
Key Performance Indicators (KPI) represent a set of measures used for evaluation of a company performance in terms of meeting operational goals. KPI can vary across the industries depending on their performance criteria. Dashboards consolidate all KPI so decisions can be made on the basement of the facts.
Financial dashboards provide gauges in the form of measurable numbers of a healthcare organization performance. For example, company profitability can be traced by examining revenue forecasts during financial year. Dashboards help customize their components to meet the individual needs of a specific organization. KPI and dashboards are utilized to help making organizational strategy and plan organizational activities. In healthcare industry, dashboards are used for monitoring of trends aiming to prevent negative consequences of events that may influence financial condition of a specific organization.
3.
- What is Economic Value Added (EVA), and how is it measured?
Economic Value Added (EVA) is a measure of a company’s performance calculated on the basement of the residual wealth when deducting cost of capital from tax adjusted operating profit of a company. Basically, EVA traces shareholder value created. EVA is measuring real economic profit of a company. It is a complex management system that focuses on value creation rather than just a financial metric. The formula for EVA is
as follows:
EVA =Net Operating Profit After Taxes (NOPAT) - (Capital*Cost of Capital).
b. Why is EVA a better measure of financial performance than are accounting measures such as earnings per share and return on equity?
In comparison to EPS, EVA is a more meaningful goal because EVA can be used not only as a financial tool, but also as a way of structuring performance of healthcare organizations. EPS measures the portion of a company’s profit allocated to an outstanding share of common stock. Thus, earnings per share stand for an indicator of a company’s profitability. EPS is not currently seen as an effective performance measure in the conditions of demanding capital markets. EPS did not prove a reliable measure of an organizational performance as the experience of Enron showed. ROE is the amount of net income returned on shareholder equity expressed as a percentage. ROE shows how much profit was generated by a company on each invested unit of currency. In comparison to ROE, EVA is a more accurate measure of profitability because it evaluates an opportunity costs to the investments yielding better returns. In other words, EVA allows comparing an investment to an alternative investment.
c. What does EVA tell managers about how to achieve good financial performance?
EVA can be used as an effective financial management system allowing managers focusing on the effectiveness of using capital and control cash flow generating. The benefits of using EVA for measuring financial performance are as follows: attention of managers is focused on primary responsibility, i.e. increasing wealth of investors and it helps reduce distortion caused by using historical data analysis. EVA is referred as an increased awareness of the efficient use of capital producing additional shareholder value.
References
Columbia University. (2000). Risk and return: introduction. Columbia University. Retrieved from http://ci.columbia.edu/ci/premba_test/c0332/s6/index.html
Gapenski, L. C. (1998). Healthcare Finance: an introduction to accounting and financial management. Chicago, IL: Health Administration Press.
Khan Academy. (2013). Time value of money. Khan Academy. Retrieved from http://www.khanacademy.org/science/core-finance/interest-tutorial/present-value/v/time-value-of-money
Neumann, B. R., Clement, J. P., and Cooper, J. C. (1999). Financial Management: concepts and applications for health care organizations. Dubuque, IA: Kendall/Hunt Publishing Company.
