## 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.

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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

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