medical proposals, one for a new psychiatric facility (Proposal 1), and the second for a lease of CT scan equipment (Proposal 2), it is ultimately the second proposal that provides greater incentive for an investor although it does expose investors to a higher degree of risk. While both do eventually reach a point of profitability, the higher return-on-investment of Proposal 2 (950%) versus Proposal 1 (47%) makes it a more financially lucrative investment over the total four-year period currently under analysis. This does come at a price, however, as the initial investment of $50,000 for Proposal 2 is $35,000 greater than Proposal 1 at $15,000.
Return on Investment (ROI): (Return — Investment) / Investment
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Neither proposal is fiscally solvent in the first year of operation. Proposal 1 operates at a $35,000 deficit. Total costs for the year are $95,000 ($20,000 variable costs and $75,000 in fixed costs) while revenue from fees for patient visits only raised $60,000 ($120 per visit, per patient times 500 expected patients). Considering the psychiatric facility requires a $15,000 investment for operation it puts the net profits for investors during year one of Proposal 1 at minus $50,000.
Net Profit: Gross Profit — Total Costs — Initial Investment
Total costs for year two are $115,000 while gross profits are $120,000 equaling a positive cash flow of $5,000 ($40,000 in variable costs, $75,000 in fixed costs, and $120,000 raised from patient fees at $120 per visit, per patient times 1000 patients). Since, however, the first year produced a $50,000 deficit for investors the net profits are still in the red at $45,000. Year three is the first year investors can expect at least a neutral return. Gross profits for year three are $180,000 while total costs equal $135,000 resulting in positive cash flow of $45,000. Proposal 1’s previous deficit of $45,000 becomes negated and net profits are at zero. The fourth year of operation is the first year of net profit for Proposal 1. Gross revenue reaches $240,000 while total costs reach only $155,000 resulting in net profits of $85,000. This recoups the initial investment of $15,000 and results in a positive ROI of 467%. Internal rate of return is 72%.
Conversely, Proposal 2 operates at a $150,000 deficit for its first year of operation. Totals costs for the CT scan equipment are $1.1 million ($500,000 variable costs from $500 per patient and $600,000 fixed cost for insurance and equipment leases) while revenue for year one is only $950,000 (from per visit payments of $950 per patient). One thousand patients are expected in year one of operation. The initial cost of investment for Proposal 2 was $50,000 putting the total budget deficit for Proposal 2,-year 1 at $200,000. Total costs for year two are $1,350,000 while gross revenue reaches $1,425,000. This presents a positive cash flow of $75,000 however because of the loss of $200,000 in year one, net profits for year two are negative at $125,000 ($200,000 [year one net profit] – $75,000 [year two cash flow]).
Like Proposal 1, Proposal 2 becomes profitable over the baseline in year three. Total costs for operation are $1.6 million while profits reach $1.9 million equally a positive cash flow of $300,000. This allows the medical center to recoup it’s initial investment of $50,000 for the lease of the CT scanners as well as pay off the debt for the previous two years or $125,000 equaling net profits of $175,000. Year four of operation for Proposal 2 has total costs at $1.85 million while the gross revenue for the year is $2.375 million equaling a positive cash flow of $525,000. Combined with previous year’s net profit of $175,000 total net profit for four years equals $700,000.
Proposal 1
Investment
$15,000
Break Even Point
$50,000
Variable costs
$40
per patient
ROI
Fixed costs
$75,000
per year
Net Profits
$85,000
Patient fee
$120
per visit
IRR
72%
Patients
year one
Growth
per yr
Year 1
Year 2
Year 3
Year 4
Investment
$15,000
Prev Balance
($35,000)
$5,000
$45,000
Variable Costs
$20,000
$40,000
$60,000
$80,000
Fixed Costs
$75,000
$75,000
$75,000
$75,000
Total Costs
$95,000
$115,000
$135,000
$155,000
Gross Profit
$60,000
$120,000
$180,000
$240,000
Cash Flow
($35,000)
$5,000
$45,000
$85,000
Net Profit
($50,000)
($45,000)
$0
$85,000
Proposal 2
Investment
$50,000
Break Even Point
$200,000
Variable costs
$500
per patient
Net Profits
$700,000
Fixed costs
$50,000
per month
IRR
Patient fee
$950
per visit
Patients
1,000
year one
Growth
per yr
Year 1
Year 2
Year 3
Year 4
Investment
$50,000
Prev. Balance ($150,000)
$75,000
$300,000
Variable Costs
$500,000
$750,000
$1,000,000
$1,250,000
Fixed Costs
$600,000
$600,000
$600,000
$600,000
Total Costs
$1,100,000
$1,350,000
$1,600,000
$1,850,000
Gross Rev.
$950,000
$1,425,000
$1,900,000
$2,375,000
Cash Flow
($150,000)
$75,000
$300,000
$525,000
Net Profit
($200,000)
($125,000)
$175,000
$700,000
Sources
Fridson, Martin S., and Fernando Alvarez. Financial Statement Analysis: a Practitioner’s Guide. New York: John Wiley & Sons, 2002. Print.
Friedlob, G. Thomas., and Franklin James Plewa. Understanding Return on Investment. New York: Wiley, 1996. Print.
Hofstrand, Don. “Understanding Cash Flow Analysis – File C3-14 December 2009.” Iowa State University Extension. Web. 15 Mar. 2011.
.
Ko, P.h.D., James. “Online IRR NPV Calculator.” DataDynamica Software Home Page. Web. 15 Mar. 2011. .
