Does practice ownership pay?

Does practice ownership pay?

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Sep 07, 2007

To determine whether ownership is a good investment, substitute your numbers into the following formulas. For this example, we're assuming:

• You're an associate making $60,000 per year.
• As an owner, you estimate making $140,000 per year.
• During your career, whether you're an owner or an associate, your future earnings increase with inflation.
• You can borrow money for prime plus 2 percent (8.25 percent + 2 percent = 10.25 percent).
• You want to pay off any note over 10 years.
• You want to buy an existing practice for $500,000.
• You put 20 percent down (0.2 X $500,000 = $100,000) and finance 80 percent (0.8 X $500,000 = $400,000).
• You want to practice for 20 years, at which time you'll sell the practice for $2 million (assuming a realistic growth rate of slightly more than 7 percent per year).

1. Calculate your debt-service payments
Using Microsoft Excel, click on Insert, then function, and a box appears. Under category, choose Financial; and under function, choose PMT. Enter the monthly interest rate where it says "rate." In this case, you'd enter 0.008542, as in 0.8542 percent (10.25 percent divided by 12 months = 0.8542 percent per month). Now enter the number of months for the loan (120) where it says "Nper." Enter the face amount of the loan ($400,000) where it says "Pv." Your monthly payment is $5,341.65, or $64,100 a year.

2. Determine cash flow and rate of return
For our case study, we estimate annual cash flow as follows:

Year 1
• Down payment                    ($100,000)
• Debt-service payments           ($64,100)
• Incremental compensation       $80,000
      (= $140,000 - $60,000)                     
• Year 1 cash flow                    ($84,100)

Year 2
• Debt-service payments         ($64,100)
• Incremental compensation     $80,000
      (= $140,000 - $60,000)                    
• Year 2 cash flow                   $15,900
Cash flow is the same through year 10.

Year 11
• Incremental compensation     $80,000
      (= $140,000 - $60,000)                   
• Year 11 cash flow                 $80,000
Cash flow is the same through year 20.

Next, list the annual cash flows in column C. Click on Insert, then Function, then choose IRR. These assumptions produce a 30.2 percent rate of return. The formula is: =IRR(C1:C20). Compare this rate of return with other investments. For example, since 1925, large company stocks have produced an average of 10.4 percent annual rate of return, while small company stocks have logged 12.7 percent.

While owning a practice is riskier than owning the entire U.S. stock market, the veterinary practice rate of return estimated here compares favorably to those competing investments. Ideally, you'd figure the cash flows after tax. However, if the IRR is handsome before tax, it likely will be so after tax as well, and using pretax dollars is much simpler. Because the IRR function requires that you estimate future cash flows, run at least three scenarios: best case, most-likely case, and worst case.

3. Consider your alternatives
List your total estimated compensation under both scenarios in columns D and E. Click on Insert, then Function, then NPV. Choose a rate of return you'd realize on competing investments. For this case, I plugged 10.4 percent (the long-term return of large U.S. companies) into the formula: =NPV(0.104,D1:D20). Next, calculate = NPV (0.104,E1:E20). The results? Financially, our case study shows you'd be better off as an owner, but ownership still may not be for you. And if your estimates favor associateship, you still might consider ownership, because nonfinancial considerations are often more important than financial issues alone.

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