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Determining which of two investment proposals is better in the short-term or long-run, identifying when break even for either proposal is achieved, or determining when payback is received requires an analysis of the two propsals’ cash flows.

In order forn an investment to be profitable, total inflows must increase outflows, i.e. the sum of all cash flows in a time series must be positive.  Early on, a new business or facility is expected to incur losses, but is expected to recover those losses in the future (otherwise, the business should not have been started at all). The point were the business recovers all prior losses is the break-even point.

II. Problem

You are the chair of the budgeting team at Health Care Medical Center and are in the process of approving the budget for the next few years. The following proposals have been made by department/unit heads.

Proposal #1

A psychiatric facility to operate in the medical center. The facility will provide services to patients on an outpatient basis. The facility will operate Saturday and Sunday 8:00 am to 6:00 pm. The labor requirements will be one salaried physician per day; two nurses for each day and one medical assistant/front office staff member per day.

The goal is to provide needed mental health services within the community. The proposal will require an initial outlay of $15,000 plus $75,000 per year fixed costs and an additional $40 in variable costs per patient seen at the clinic.

Net cash flow is the balance of the cash being received and paid by the firm during a time period. When net cash flow is negative during a one-year period, it means that the amounts disbursed by the firm exceeded total cash received during the same period. Assuming that all revenues are paid on a cash and prompt basis, the firm is expected to be incurring losses if its cash flow is negative.

A firm may be able to recover in the following year by increasing revenues, or decreasing losses. When the cumulative cash flow, or sum of all cash flows exceeds zero, this means that the firm is already generating cash that would pay off its prior investments.

Break-even is reached when total cash receipts by the firm equals its total disbursements since day 1, or in other words when cumulative cash flows is zero. A higher cumulative cash flow means that the firm is receiving more money from its investment.

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