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.

9/1/2014 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 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 2 Better Health, Inc., is evaluating two investment projects, each of which requires an up-front expenditure of $1.5 million. The projects are expected to produce the following net cash inflows: Year 0 1 2 3 Project A Project B -$1,500,000 -$1,500,000 $500,000 $2,000,000 $1,000,000 $1,000,000 $2,000,000 $600,000 a. What is each project's IRR? b. What is each project's NPV if the cost of capital is 10 percent? 5 percent? 15 percent? ANSWER 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 Method B 0 -$300,000 -$120,000 1 -$66,000 -$96,000 2 -$66,000 -$96,000 3 -$66,000 -$96,000 4 -$66,000 -$96,000 5 -$66,000 -$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 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 4 Great Lakes Clinic has been asked to provide exclusive healthcare services for next year's World Exposition. Although flattered by the request, the clinic's managers want to conduct a financial analysis of the project. There will be an up-front cost of $160,000 to get the clinic in operation. Then, a net cash inflow of $1 million is expected from operations in each of the two years of the exposition. However, the clinic has to pay the organizers of the exposition a fee for the marketing value of the opportunity. This fee, which must be paid at the end of the second year, is $2 million. a. What are the cash flows associated with the project? b. What is the project's IRR? c. Assuming a project cost of capital of 10 percent, what is the project's NPV? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 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 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 6 The director of capital budgeting for Big Sky Health Systems, Inc., has estimated the following cash flows in thousands of dollars for a proposed new service: Year Expected Net Cash Flow 0 -100 1 70 2 50 3 20 The project's cost of capital is 10 percent. a. What is the project's payback period? b. What is the project's NPV? c. What is the project's IRR? ANSWER 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.) Year 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 * 1 2 3 4 5 Pretax equipment salvage value MACRS equipment salvage value Difference Taxes After-tax equipment salvage value UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 8 You have been asked by the president and CEO of Kidd Pharmaceuticals to evaluate the proposed acquisition of a new labeling machine for one of the firm's production lines. The machine's price is $50,000, and it would cost another $10,000 for transportation and installation. The machine falls into the MACRS three-year class, and hence the tax depreciation allowances are 0.33, 0.45, and 0.15 in Years 1, 2, and 3, respectively. The machine would be sold after three years because the production line is being closed at that time. The best estimate of the machine's salvage value after three years of use is $20,000. The machine would have no effect on the firm's sales or revenues, but it is expected to save Kidd $20,000 per year in before-tax operating costs. The firm's tax rate is 40 percent and its corporate cost of capital is 10 percent. a. What is the project's net investment outlay at Year 0? b. What are the project's operating cash flows in Years 1, 2, and 3? c. What are the terminal cash flows at the end of Year 3? d. If the project has average risk, is it expected to be profitable? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 9 The staff of Jefferson Memorial Hospital has estimated the following net cash flows for a satellite food services operation that it may open in its outpatient clinic: Year Expected Net Cash Flow 0 -$100,000 1 $30,000 2 $30,000 3 $30,000 4 $30,000 5 $30,000 5 Salvage val $20,000 The Year 0 cash flow is the investment cost of the new food service, while the final amount is the terminal cash flow. (The clinic is expected to move to a new building in five years.) All other flows represent net operating cash flows. Jefferson's corporate cost of capital is 10 percent. a. What is the project's IRR? b. Assuming the project has average risk, what is its NPV? c. Now, assume that the operating cash flows in Years 1 through 5 can be as low as $20,000 or as high as $40,000. Furthermore, the salvage value cash flow at the end of Year 5 can be as low as $0 or as high as $30,000. What is the worst case and best case IRR? The worst case and best case NPV? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 10 A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $100 million now, and then spend $20 million in one year. In two years, it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what are the project's NPV and IRR? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 5/1/10 Chapter 12 -- Project Risk Analysis PROBLEM 1 The managers of Merton Medical Clinic are analyzing a proposed project. The project's most likely NPV is $120,000, but, as evidenced by the following NPV distribution, there is considerable risk involved: Probability NPV 0.05 -$700,000 0.2 -$250,000 0.5 $120,000 0.2 $200,000 0.05 $300,000 a. What are the project's expected NPV and standard deviation of NPV? b. Should the base case analysis use the most likely NPV or expected NPV? Explain your answer. ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 12 -- Project Risk Analysis PROBLEM 2 Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and probabilities: Year 0 1 2 3 4 5 Prob=0.2 Prob=0.6 Prob=0.2 -$100,000 -$100,000 -$100,000 $20,000 $30,000 $40,000 $20,000 $30,000 $40,000 $20,000 $30,000 $40,000 $20,000 $30,000 $40,000 $30,000 $40,000 $50,000 The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent. a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.) b. What are the project's most likely, worst, and best case NPVs? c. What is the project's expected NPV on the basis of the scenario analysis? d. What is the project's standard deviation of NPV? e. Assume that Heywood's managers judge the project to have higher-than-average risk. Furthermore, the company's policy is to adjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive? ANSWER hermore, the ts to account UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 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 of procedures. NPV divided UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 12 -- Project Risk Analysis PROBLEM 4 The managers of United Medtronics are evaluating the following four projects for the coming budget period. The firm's corporate cost of capital is 14 percent. Project A B C D Cost IRR $15,000 17% $15,000 16% $12,000 15% $20,000 13% a. What is the firm's optimal capital budget? b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.) ANSWER ting process. 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 ovider claims. UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 12 -- Project Risk Analysis PROBLEM 6 University Health System has three divisions: Real Estate, with an 8 percent cost of capital; Health Services, with a 10 percent cost of capital; and Managed Care, with a 12 percent cost of capital. The System's risk adjustment procedures call for adding 3 percentage points to adjust for high risk and subtracting 2 percentage points for low risk. Construct a diagram such as the one in Figure 12.4 that illustrates the range of project costs of capital for the system