HCM 565 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT PAPERS

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 11 — Capital Budgeting PROBLEM 1
Winston Clinic is evaluating a project that costs $52,125 and has expected net cash flows of $12,000 per
year for eight years. The first inflow occurs one year after the cost outflow, and the project has a cost of
capital of 12 percent.
a. What is the project’s payback?
b. What is the project’s NPV? Its IRR?
c. Is the project financially acceptable? Explain your answer.
ANSWER Data
Project Cost
Net Cash Flows
Years
Cost of Capital ($52,125)
$12,000
8
12% 0
Net Cash
Flows
Cumulative
Cash Flow $ (52,125.00)
$ (52,125.00) $ 1
$12,000
(40,125.00) Years to
Payback
Answer A Year
0
1
2
3
4
5
6
7
8 4.34375 Annual Cash Cumulative Cash
Flow
Flow
($52,125)
($52,125)
12,000
($40,125)
12,000
($28,125)
12,000
($16,125)
12,000
($4,125)
12,000
12,000
12,000
12,000 $7,875
$19,875
$31,875
$43,875 $ Year
4 2 3 $12,000 $12,000 $12,000 (28,125.00) $ (16,125.00) $ (4,125.00) $ NPV
Answer B Break Even
Point
-0.34 5 6 $12,000 $12,000 7,875.00 $ 19,875.00 IRR
$7,486.68 16% Answer C $ 7 8 $12,000 $12,000 31,875.00 $ 43,875.00 A positive NPV indicates the investment is potentially lucrative. From a financial perspective, a the greater
the NPV, the more beneficial the investment/project. $7000 is not too great a number, but still positive. An
IRR of 16% is greater than the capital cost of 12%. This is a good project investment and financially
acceptable. UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 11 — Capital Budgeting
PROBLEM 3
Capitol Health Plans, Inc., is evaluating two different methods for providing home health services to its
members. Both methods involve contracting out for services, and the health outcomes and revenues are
not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows.
Here are the projected flows:
Year Method A
0
1
2
3
4
5 Method B
-$300,000
-$66,000
-$66,000
-$66,000
-$66,000
-$66,000 -$120,000
-$96,000
-$96,000
-$96,000
-$96,000
-$96,000 a. What is each alternative’s IRR?
b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why?
ANSWER Data
Method A
0
$ (300,000.00) $
Method B
0
$ (120,000.00) $ 1
(66,000.00) $ 2
(66,000.00) 1
(96,000.00) $ 2
(96,000.00) Cash Outflows
3
$ (66,000.00) $
Cash Outflows
3
$ (96,000.00) $ 4
(66,000.00)
4
(96,000.00) Capital
9% Method A
0
$ (300,000.00) $
Method B
0 1
66,000.00 $
1 Net Cash Outflows
2
3
66,000.00 $
66,000.00 $
Net Cash Outflows
2
3 4
66,000.00
4 $ (120,000.00) $ 96,000.00 $ 96,000.00 $ 96,000.00 $ 96,000.00 h services to its
d revenues are
are all outflows. Answer
IRR for A
$ 5
(66,000.00) Answer
NPV A
3% IRR for B
$ 5
(96,000.00) NPV B
75% IRR must be calculated
using positive or net cash
outflows. If negative cash
outflows are used, IRR
cannot be calculated. $ 5
66,000.00
5 ($556,716.98) ($493,406.52)
To calculate NPV, the net
cash outflows are
summed.The most positive
NPV would be chosen. That
would be method B. $ 96,000.00 HCM 565 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT PAPERS
Chapter 11 — Capital Budgeting
PROBLEM 5
Assume that you are the CFO at Porter Memorial Hospital. The CEO has asked you to
analyze two proposed capital investments: Project X and Project Y. Each project requires a net
investment outlay of $10,000, and the cost of capital for each project is 12 percent. The project’s expected
net cash flows are as follows:
Year
0
1
2
3
4 Project X Project Y
-$10,000 -$10,000
$6,500
$3,000
$3,000
$3,000
$3,000
$3,000
$1,000
$3,000 a. Calculate each project’s payback period, net present value (NPV), and internal rate of return (IRR).
b. Which project (or projects) is financially acceptable? Explain your answer.
ANSWER Data
Year
Project X
Project Y
Cost of Capital 0
-10000
-10000
12% 1
6500
3000 2
3000
3000 3
3000
3000 4
1000
3000 Answer A
NPV of X
NPV of Y
IRR of X
IRR of Y Answer B
$966.01
($887.95)
18.03%
7.71% A project with a positive NPV should be considered. This is
the case with project X. An IRR that is greater than the
cost of capital is also considered the better choice. Again,
project X has an IRR of 18%>12 (cost of capital). Project X
should be selected. UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 11 — Capital Budgeting
PROBLEM 7
California Health Center, a for-profit hospital, is evaluating the purchase of new diagnostic equipment.
The equipment, which costs $600,000, has an expected life of five years and an estimated pretax salvage
value of $200,000 at that time. The equipment is expected to be used 15 times a day for 250 days a year
for each year of the project’s life. On average, each procedure is expected to generate $80 in collections,
which is net of bad debt losses and contractual allowances, in its first year of use. Thus, net revenues for
Year 1 are estimated at 15 X 250 X $80 = $300,000.
Labor and maintenance costs are expected to be $100,000 during the first year of operation, while utilities
will cost another $10,000 and cash overhead will increase by $5,000 in Year 1. The cost for expendable
supplies is expected to average $5 per procedure during the first year. All costs and revenues, except
depreciation, are expected to increase at a 5 percent inflation rate after the first year.
The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to the
following depreciation allowances:
Year
1
2
3
4
5
6 Allowance
0.2
0.32
0.19
0.12
0.11
0.06 The hospital’s tax rate is 40 percent, and its corporate cost of capital is 10 percent.
a. Estimate the project’s net cash flows over its five-year estimated life.
b. What are the project’s NPV and IRR? (Assume that the project has average risk.)
(Hint: Use the following format as a guide.)
0
Equipment cost
Net revenues
Less: Labor/maintenance costs
Utilities costs
Supplies
Incremental overhead
Depreciation Operating income
Taxes
Net operating income
Plus: Depreciation
Plus: After-tax equipment salvage value*
Net cash flow
*
Pretax equipment salvage value
MACRS equipment salvage value 1 Difference
Taxes
After-tax equipment salvage value Year
2 3 4 5 HCM 565 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT PAPERS
Chapter 12 — Project Risk Analysis
PROBLEM 3
Consider the project contained in Problem 7 in Chapter 11 (California Health Center).
a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per
day, average collection amount, and salvage value. Remember supplies vary with number of procedures.
b. Conduct a scenario analysis. Suppose that the hospital’s staff concluded that the three most uncertain
variables were number of procedures per day, average collection amount, and the equipment’s salvage
value. Furthermore, the following data were developed:
Equipment
Number of
Average
Salvage
Scenario
Probability
Procedures
Collection
Value
Worst
0.25
10
$60
$100,000
Most likely
0.50
15
$80
$200,000
Best
0.25
20
$100
$300,000
c. Finally, assume that California Health Center’s average project has a coefficient of variation of NPV in
the range of 1.0 – 2.0. (Hint: Coefficient of variation is defined as the standard deviation of NPV divided
by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its
10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?
d. What type of risk was measured and accounted for in Parts b. and c.? Should this be of concern to the
hospital’s managers?
ANSWER Volume
NPV 3750
$214,220.07
Net Present Value Volume Changes
-30%
-20%
-10%
0%
10%
20%
30% 2625.00
3000.00
3375.00
3750.00
4125.00
4500.00
4875.00 $214,220.07
?
?
?
3750.00
?
?
? Answer A
The sensitivity analysis reveals the project is much more
sensitive to salvage changes versus volume changes. Salvage Changes
-30%
-20%
-10%
0%
10%
20%
30% $140,000.00
$160,000.00
$180,000.00
$200,000.00
$220,000.00
$240,000.00
$260,000.00 Sensitivity Analysis
300000.00
250000.00
200000.00
150000.00
100000.00
50000.00
0.00
-30% -20% -10% On Volume 0% On Salvage 10% 20% Answer B Scenario Probability
Worst
0.25
Most likely
0.50
Best
0.25 Number of
Procedures Average
Collection
10
$60
15
$80
20
$100 Equipment
Salvage
Value
$100,000
$200,000
$300,000 NPV
($335,905)
74,904
610,230 30% Perform a sensitivity analysis to see how NPV is affected by
changes in the number of procedures per day, average
collection amount, and salvage value. Remember supplies
vary with number of procedures. Net Present Value
$214,220.07
?
?
?
$200,000.00
?
?
? Data for Graphing
Percentage
Change
-30%
-20%
-10%
0%
10%
20%
30% On Volume On Salvage 2625.00
3000.00
3375.00
3750.00
4125.00
4500.00
4875.00 $140,000.00
$160,000.00
$180,000.00
$200,000.00
$220,000.00
$240,000.00
$260,000.00 20% 30% UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 — Project Risk Analysis
PROBLEM 5
Allied Managed Care Company is evaluating two different computer systems for handling provider claims.
There are no incremental revenues attached to the projects, so the decision will be made on the basis of
the present value of costs. Allied’s corporate cost of capital is 10 percent. Here are the net cash flow
estimates in thousands of dollars:
Year
0
1
2
3 System X System Y
-$500
-$1,000
-$500
-$300
-$500
-$300
-$500
-$300 a. Assume initially that the systems both have average risk. Which one should be chosen?
b. Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its
corporate cost of capital up or down by 2 percentage points. Which system should be chosen?
ANSWER Year
System X
System Y
Corporate
Cost of
Capital
Corporate
Cost of
Capital
Corporate
Cost of
Capital 0
1
2
3
NPV
-$500.00 -$500.00 -$500.00 -$500.00 ($1,743.43)
-$1,000.00 -$300.00 -$300.00 -$300.00 ($1,746.06) 10% 12% 8% Answer A
The NPV with the most
positive value should be
chosen – System X. The NPV with the most
positive value should be
chosen – System X. Answer B Answer B
System Y
System X with
with NPV @
NPV @ 12% ($1,700.92)
12%
System Y
System X with
with NPV @
NPV @ 8% ($1,788.55)
8%
At 12%
system X
would be
chosen ($1,720.55) ($1,773.13)
At 8%
sytem Y
would be
chosen UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 — Project Risk Analysis
PROBLEM 10
Michigan Home Health is considering opening an office in a new market. The organization has
identified the number of home visits, revenue per home visit, and the level of fixed costs of
the new office as being the major sources of uncertainty in the investment decision. To get a
better understanding of the sensitivity of the new office NPV to these variables, the following
data have been assembled:
Change
NPV
from
Number Revenue Level of
base
of home
per home fixed
case
visits
visit
costs
-30%
-$814
-$57
$82
-20%
-$515
-$11
$82
-10%
-$216
$36
$82
0%
$82
$82
$82
10%
$381
$129
$82
20%
$680
$176
$82
30%
$979
$222
$82
Construct a graph to show the sensitivity of the new office NPV to each variable.
ANSWER $1,500
The sharpest rise in slope is number of home visits. The sensitivity analysis
shows that the project is most sensitive to numer of home visits. $1,000
$500
$0
-30%
-$500
-$1,000 Num Sensitivity Analysis
$1,500
$1,000
$500
$0
-30% -20% -10% 0% 10% 20% -$500
-$1,000
Number of home visits Revenue per home visit Level of fixed costs 30% HCM 565 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT PAPERS