\'Concept Four\' discusses approaches to allocating capital issues. The financia
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Question
'Concept Four' discusses approaches to allocating capital issues. The financial elements of calculating Net Present Value (NPV) and Weighted Average Cost of Capital (WACC) are strategic tools used to evaluate capital projects. Strategic planning involves solid quantitative and qualitative application that should guide a company toward reaching its desired financial goals that align with its corporate mission. Read and study 'Concept Four: Allocating Capital' of Best Practice Financial Management. After reading Concept Four, write a 2-4-page paper discussing the issues and outcomes of Alpha Health Systems (AHS), giving a brief overview of its initial implementation of a corporate finance-based capital allocation process. The paper should discuss the various approaches the organization used to deliver successful means to allocating its capital
Explanation / Answer
An organisation ahs sufficeint resources, the next step is to decide how to distribute those resources.
This step determines wheather any or all of many potential capital projects generated during the organsiation's value.Due to the political nature of capital allocation , teh process must result ina dding to the organisatiion's value.Due to the political nature of capital allocation, the process must be led and supported by the CEO.
Traditional Approaches to Capital Allocation: Often done on a subjective basis, ignoring quantitative methods.
Political Allocation Approach – The department that demands the most gets the most.
Historical Benchmark Approach – Allocate capital according to what was allocated the previous year.
First Come–First Served Approach – Specific projects are evaluated in a serial fashion as they arise throughout the calendar year.
Balanced Scorecard Approach – Attempts to include the evaluation of both quantitative and qualitative management issues.
Go-With-The-Flow Approach – involves no methodology and no articulated policy. The organization tries to fund whatever comes along, without the benefit of evaluative process.
Characteristics of a Best Practice Process: A healthcare organization should use an approach similar to that of many Fortune 500 companies. These approaches use many of the following key elements.Link to a sound strategic plan – capital allocation must be based on good ideas worthy of investment along with clear objectives and principles.A Solid business plan for each investment opportunity – facilitates informed decision making. Plan must describe its financial effect in significant detail.
Standardized, one-batch project review – helps to ensure true comparability. Rational and consistent evaluative guidelines and inform decision criteria ensure unbiased decision making.Quantitative analysis using corporate finance-based techniques – Must include consideration of risk, calculation of net cash available for capital, incremental cash flow projections and discounted cash flow or NPV. Data-driven and team-based decision making – should be done without the involvement of key stakeholders. Multiple team members ensures unbiased decisions.
Coordinated calendar and planning cycles – The timing and structure for these processes should reflect there interdependent nature and must be rigorously observed for optimal effectiveness.Clear definition of available capital – To make informed and timely decisions, this limit must be well understood.High level of governance, education, and communication – ensuring that organizational constituencies have a strong knowledge base about the principles of corporate finance and understand the capital allocation process also helps to build commitment to the system of governance. Process integrity through project monitoring and measurement – provides credibility, enabling specific comparison of actual results to projected results.
Net Present Value Analysis: Estimate of the up-front investment – Looks only at incremental costs, ignoring outlays already made. Includes opportunity costs and working capital requirements.Projection of free cash flows – determines how much cash is generated in a particular year – cash that could b available to distribute to an investor.
Cost of capital estimate – determines the rate at which the cash flows should be discounted.Terminal value estimate – the estimate of an investment’s value after the original projection period.Project Selection – Often involves ranking projects in order of their NPV. The projects with the highest NPV values are selected first.
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