Consider the project contained in Problem 7 in Chapter 11 (California Health Center). I have uploaded the excel file for Problem 7 Ch 11. Also upload the excel file for this problem so it may be easier to read.

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?

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 ProbabilityProceduresCollection 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 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 System X System Y 0 -$500 -$1,000 1 -$500 -$300 2 -$500 -$300 3 -$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 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 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 year a) 0 1 2 3 Payback $ $ $ $ annual CF (52,125) 12,000 12,000 12,000 4 $ 12,000 5 6 7 8 12,000 12,000 12,000 12,000 $ $ $ $ cummulative CF ### $ (40,125) $ (28,125) $ (16,125) $ (4,125) $ 7,875 $ 19,875 $ 31,875 $ 43,875 4.34 b) NPV = IRR= c) $ 7,486.68 16% Yes, the project is financially acceptable. The NPV of the project is positive so the IRR is greater than the cost of capital. The project should is financially positive. rate = -0.34375 12% 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 a) The IRRs for both A and B can not be calculated. They are all negative cash flows so this will be a negative internal rate or return. b) Method A NPV = -$556,716.98 Method B NPV= -$493,406.52 Method B should be choosen. This investment strategy looses the least amount of money. 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 Project X Project Y 0 -$10,000 -$10,000 1 $6,500 $3,000 2 $3,000 $3,000 3 $3,000 $3,000 4 $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 a) Project X Project Y -$3,500 -$500 $ 2.17 payback period 966.01 NPV 18% IRR payback period NPV IRR b) Project X is financially acceptable. The NPV is positive also, the IRR is 18% which is greater than the cost of capital at 12%. Project Y is not financial acceptable because the IRR is 8% is below the cost of capital at 12% 3.333333 -$887.95 8% 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 Allowance 1 2 3 4 5 6 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: Operating income Taxes Net operating income Plus: Depreciation Plus: After-tax equipment salvage value* Net cash flow Labor/maintenance costs Utilities costs Supplies Incremental overhead Depreciation * Pretax equipment salvage value MACRS equipment salvage value Difference Taxes After-tax equipment salvage value AL MANAGEMENT tal Budgeting while utilities Year 1 2 3 4 5