Palms Hospital (Traditional Project Analysis) Palms Hospital * 250 bed capacity; investor owned; Islamorada, Florida * Founded in 1946 by Rob Winslow, went back in 1967 after the war * High economic growth, population expansion Acknowledged to be one of the leading healthcare providers in the area * Currently evaluating a proposed ambulatory (outpatient) surgery centre * More than 80% o all outpatient surgery is performed by specialists * Minor procedures take about one hour or less, major procedures take two or more hours * About 60 percent of the procedures are performed under general anesthesia, 30 percent under local anesthesia, 10 percent under regional or spinal anesthesia * Operating rooms built in pairs for prep and surgery efficiency * Outpatient surgery market has experienced significant growth since the first ambulatory centre opened in 1970; 1990 – 2. million surgeries, 2009 – more than 20 million surgeries * Growth was fueled by three factors: rapid advancements in technology made it possible for inpatient surgeries to be performed as outpatient surgeries,; Medicare has been aggressive in approving new minimally invasive surgery techniques, meaning number of Medicare patients who use outpatient surgery services has grown substantially; patients prefer outpatient surgeries for convenience, and third party payers prefer them for less cost * Inpatient surgery numbers have been flat due to these factors over the last 20 years; outpatient procedures grow at 10% annually * No other outpatient surgery centre exists in Palms Hospital’s immediate environment, but rumors about physician owned facilities are surfacing * Palms Hospital owns a land adjacent to the facility that would be a perfect location for the new ambulatory surgery centre; the land was bought for $150,000, spent $25,000 to clear the land (also expensed for tax purposes) to put sewer and utility lines. If sold today, the land will ring in $200,000. * The supposed building will house four operating suites that will cost $5,000,000 plus another $5,000,000 for equipment costs for a total of $10,000,000. *Note: the building and the equipment fall into the modified accelerated cost recovery system (MACRS) five-year class for tax depreciation purposes; in reality, the building has to be depreciated over a longer period than the quipment * Although the project may have a longer life, the hospital assumes a five-year life in its capital budgeting analyses and then approximates the value of the cash flows beyond year 5 by including a terminal/salvage value in the analysis; to estimate this value, the hospital uses the market value of the building and equipment after five years, which in this case is $5M before taxes, excluding land value. *Note: taxes must be paid on the difference between an asset’s salvage value and tax book value at termination; for example, if an asset that cost $10,000 is depreciated to $5,000 and then sold for $7,000, the firm owes taxes on the $2,000 excess in salvage value over tax book value * Expected volume for this centre is 20 procedures a day, with an average charge of $1,500 but charity care, bad debts, managed care plan discounts and other allowances lower the net revenue amount to $1,000; the centre will be open 5 days a week, 50 weeks a year, 250 days out of the year.
Labor costs are expected to run at $918,000 a year excluding fringe benefits; utility costs run at $50,000 a year * If the centre is built, hospital’s cash overhead will increase by $36,000 annually, primarily for housekeeping, building and grounds maintenance; centre will be allocated $25,000 of the hospital’s current $2. 8M administrative overhead costs. On average, each procedure will require $200 in expendable medical supplies, including anesthetics. The hospital’s inventories and receivables, as well as accruals and payables will increase.
Overall change in net working capital is expected to be small, therefore not imperative to the analysis. The hospital’s tax rate is 40%. * Inflation – one of the most difficult factors to deal with in project analysis. Input costs and charges have been rising at twice the rate of overall inflation. Inflationary pressures are highly variable.
Analysis is started by assuming that both revenues and costs, except for depreciation, will increase at a constant rate – which they project will be at 3%. * Board members’ concerns – wants to make sure that a complete risk analysis including sensitivity and scenario analysis is performed before the proposal is presented (board was forced to close a daycare that appeared to be profitable but turned out to be a big money loser – 2 years ago) * Another concern would be the impact of the centre on the current volume of inpatient surgeries. Surgery department head projected that the outpatient surgery centre could siphon off up to $1,000,000 in cash revenues annually, hat could lead to a $500,000 reduction in annual cash expenses * The data developed for risk analysis were as follows: three input variables are highly uncertain – number of procedures per day, average revenue per procedure, building/equipment salvage value. If another centre was built to compete with theirs, number of procedures could be as low as 10 a day, but if acceptance to their centre is strong, they could be doing 25 procedures a day.
* Net average revenue (cost of procedure) is $1000. But if surgery severity is high, net average revenue could be $1,200. If severity is low, it could be $800. If real estate and medical equipment values stay strong, salvage value could be as high as $6M, but if it weakens, it’ll be as low as $4M – considering that the average salvage value is $5M. Another board member question why the scenario analysis only had three scenarios and suggested 5 or 7.
* Based on historical scenario analysis data that use best case, worst case, and most likely, the hospital’s average project has a coefficient of variation of NPV (net present value) in the range of 1. 0-2. 0 and the hospital typically adds or subtracts 4 percentage points to its 10 percent corporate cost of capital to adjust for differential project risk. * Note: the case asks us to conduct complete project analysis and present findings. It suggests the application of Monte Carlo simulation (but that is bullshit because that’s the simulation you need a computer software for).
