Tae-Hwan Ahn manages a Level III Trauma Center for Medical Corporation of America (MCA), a for-profit corporation that trades on the New York Stock Exchange. Ahn wants to upgrade his facility to a Level II Trauma Center but has been unable to convince top management of the value of this proposition. MCA instead has chosen to invest in other parts of the business. A competing hospital system recently built a Level II Trauma Center and Ahn’s facility now faces declining patient traffic and revenues. Headquarters has decided that MCA must either cease operations in this location or upgrade to a Level II Trauma Center to remain competitive. Ahn has gathered data about emergency medicine traffic in the area to assist top management in this decision.

MCA uses a 10-year planning horizon for major investments and assumes operating cash flows arrive at year-end. Investment/disinvestment cash flows are recognized as they occur. Inflation is expected to be 2% over MCA’s 10-year planning horizon. MCA’s nominal after-tax required return (or a weighted average cost of capital) is I (WACC) = 10% for renovations such as the Trauma Center. The real required return is not expected to change even if inflation turns out to be higher or lower than expected. MCA’s corporate income tax rate is 21% under the 2017 Tax Cut and Jobs Act. MCA’s other operations should remain profitable over the 10-year planning horizon.

The existing Level III Trauma Center (the Base Case)

• MCA renovated the Trauma Center five years ago with a $20 million investment in equipment. MCA is depreciating that investment for tax purposes using MACRS (Modified Accelerated Cost Recovery System) 5-year class life toward a salvage value of $0. Under the assumption that investment is made mid-year, assets with a 5-year depreciable life are depreciated over 6 years using annual depreciation percentages of 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%. One year of depreciable life remains on MCA’s investment from 5 years ago, so the book value of the existing equipment is 5.76% of $20 million or $1,152,000. Ahn estimates the current market value of the existing equipment is $12 million, but that the equipment is likely to have a market value of zero in 10 years.

• The census at the facility has been stable at about 15,000 patients per year since the competitor built its facility, but this is far from an acceptable utilization rate. Ahn forecasts revenues of $1,000 per patient in the coming year. Most patient visits are for less than this amount, but a few costly visits bump up the average cost. Expected first-year revenues of (15000 patients)($1000/patient) = $15 million are expected to grow with inflation over the 10-year planning horizon. For example, expected revenues in year 2 are (15000 patients)($1000/patient)(1.02) = $15.3 million.

• The average collection period of the existing facility is one-third of a year (about 120 days), so the receivables balance in the coming year of operations should be around ($15 million)/3 = $5 million. Default rates on collections are negligible at this location.

• The Level III Trauma Center is available 24-7 as a service to the community. This will require a fixed operating expense of $4 million in the coming year to assure readiness. Ahn assumes this operating expense will grow at the inflation rate. Variable operating expenses for physicians, lab techs, supplies, etc. are expected to be 70% of the average per-patient cost throughout the 10-year planning horizon.

The Proposed Level II Trauma Center (the Alternative)

• New equipment and installation would cost $60 million and would qualify for 5-year MACRS class life. The new equipment would be depreciated toward a salvage value of $0. New investment would not change the depreciable basis of the existing equipment. The market value of the new equipment in ten years is expected to be $16 million in real value (that is, in today’s dollars). The old equipment would be sold at its market value and this would generate a tax consequence on the sale of the old equipment in the amount of Tax = (Capital gain)(Tax rate) = (Market value – Book value)(21%). Although Ahn is concerned about potential downtime as the new equipment is installed and staff is trained in its use, his operations manager believes that the new equipment can replace the old equipment without significant loss of productivity or any additional costs.

• Ahn expects to serve 30,000 patients per year in the renovated facility at an average cost to the patient and revenues to MCA of $1,750 per visit. Most visits will be for less than this, but a few costly visits will increase the average cost. Expected first-year revenues are (30000 patients)($1750/patient) = $52.5 million. Although patient volume is expected to remain constant over the 10-year planning horizon, revenue per patient should grow with inflation. This means that expected revenues in Year 2 are (30000 patients)($1750/patient)(1.02) = $53.55 million.

• The average collection period should remain one-third of a year (about 120 days), so receivables in the coming year of operations should be ($52.5 million)/3 = $17.5 million. Receivables in the existing facility are $5 million, so MCA will need to make an additional $12.5 million investment in working capital (i.e., accounts receivables). Ahn assumes this working capital investment will be made at time t=0, even though the investment, in fact, would accumulate over the first year of operations. Additional small investments in working capital will be necessary over the remaining 9 years of the planning horizon as the receivables in the new facility increase more than the receivables in the old facility. Ahn assumes that these additional working capital investments will be made at the beginning of each year of operations. As an example, the $5 million receivable balance in the existing facility will grow with inflation to $5.1 million in the second year of operations. The $17.5 million receivable balance in the renovated facility will grow with inflation to $17.85 million in Year 2. Ahn assumes that the incremental investment in working capital for Year 2 would occur at time t=1 in the amount of ($17.85 million - $17.5 million) – ($5.1 million - $5 million) = ($350,000 - $100,000) = $250,000. Additional small investments in working capital also would occur for Years 3 through 10. The accumulated investment in working capital eventually would be recovered as the additional receivables in the Level II facility are collected around time t=10.

• MCA will incur a fixed operating expense of $7.5 million in the coming year to assure the Trauma Center’s readiness. This fixed expense should grow with inflation. Variable operating expenses are expected to be 65% of the average per-patient cost throughout the 10-year planning horizon.

• If the facility is renovated, MCA’s Comptroller will allocate overhead expenses of $10 million for cost accounting reasons. However, the Trauma Center’s operations are housed entirely within the facility and this allocated overhead is not tied to any incremental costs at corporate headquarters.

Questions

5. Ahn wants to investigate the impact of inflation on the proposed facility.
a. Calculate the real required return from the nominal required return of 10% and the expected inflation rate of 2%.
b. Suppose inflation rises to 5%. Recalculate the nominal required return (WACC) assuming real required returns do not change.
c. What is your new estimate of NPV under this high-inflation scenario?

Answer rating: 100% (QA)

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