Case 5

Twin Falls Community Hospital

(Capital Investment Analysis)

Twin Falls Community Hospital is a 250-bed, not-for-profit hospital located

in the city of Twin Falls, the largest city in Idahos Magic Valley region

and the seventh largest in the state. The hospital was founded in 1972 and

today is acknowledged to be one of the leading healthcare providers in the

area.

Twin Falls management is currently evaluating a proposed ambulatory

(outpatient) surgery center. Over 80 percent of all outpatient surgery is

performed by specialists in gastroenterology, gynecology, ophthalmology,

otolaryngology, orthopedics, plastic surgery, and urology. Ambulatory surgery

requires an average of about one and one-half hours; minor procedures take

about one hour or less, and major procedures take about two or more hours.

About 60 percent of the procedures are performed under general anesthesia, 30

percent under local anesthesia, and 10 percent under regional or spinal

anesthesia. In general, operating rooms are built in pairs so that a patient

can be prepped in one room while the surgeon is completing a procedure in the

other room.

The outpatient surgery market has experienced significant growth since the

first ambulatory surgery center opened in 1970. This growth has been fueled

by three factors. First, rapid advancements in technology have enabled many

procedures that were historically performed in inpatient surgical suites to

be switched to outpatient settings. This shift was caused mainly by advances

in laser, laparoscopic, endoscopic, and arthroscopic technologies. Second,

Medicare has been aggressive in approving new minimally invasive surgery

techniques, so the number of Medicare patients utilizing outpatient surgery

services has grown substantially. Finally, patients prefer outpatient

surgeries because they are more convenient, and third-party payers prefer

them because they are less costly.

These factors have led to a situation in which the number of inpatient

surgeries has grown little (if at all) in recent years while the number of

outpatient procedures has been growing at over 10 percent annually and now

totals about 22 million a year. Rapid growth in the number of outpatient

surgeries has been accompanied by a corresponding growth in the number of

outpatient surgical facilities. The number currently stands at about 5,000

nationwide, so competition in many areas has become intense. Somewhat

surprisingly, there is no outpatient surgery center in the Twin Falls area,

although there have been rumors that local physicians are exploring the

feasibility of a physician-owned facility.

2

The hospital currently owns a parcel of land that is a perfect location for

the surgery center. The land was purchased five years ago for $350,000, and

last year the hospital spent (and expensed for tax purposes) $25,000 to clear

the land and put in sewer and utility lines. If sold in todays market, the

land would bring in $500,000, net of realtor commissions and fees. Land

prices have been extremely volatile, so the hospitals standard procedure is

to assume a salvage value equal to the current value of the land.

The surgery center building, which will house four operating suites, would

cost $5 million and the equipment would cost an additional $5 million, for a

total of $10 million. The project will probably have a long life, but the

hospital typically 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, or salvage, value in the analysis. To estimate the terminal

value, the hospital typically uses the market value of the building and

equipment after five years, which for this project is estimated to be $5

million, excluding the land value.

The expected volume at the surgery center is 20 procedures a day. The average

charge per procedure is expected to be $1,500, but charity care, bad debts,

insurer discounts (including Medicare and Medicaid), and other allowances

lower the net revenue amount to $1,000. The center would be open five days a

week, 50 weeks a year, for a total of 250 days a year. Labor costs to run the

surgery center are estimated at $800,000 per year, including fringe benefits.

Supplies costs, on average, would run $400 per procedure, including

anesthetics. Utilities, including hazardous waste disposal, would add another

$50,000 in annual costs. If the surgery center were built, the hospitals

cash overhead costs would increase by $36,000 annually, primarily for

housekeeping and buildings and grounds maintenance.

One of the most difficult factors to deal with in project analysis is

inflation. Both input costs and charges in the healthcare industry have been

rising at about twice the rate of overall inflation. Furthermore,

inflationary pressures have been highly variable. Because of the difficulties

involved in forecasting inflation rates, the hospital begins each analysis by

assuming that both revenues and costs, except for depreciation, will increase

at a constant rate. Under current conditions, this rate is assumed to be 3

percent. The hospitals corporate cost of capital is 10 percent.

When the project was mentioned briefly at the last meeting of the hospitals

board of directors, several questions were raised. In particular, one

director wanted to make sure that a risk analysis was performed prior to

presenting the proposal to the board. Recently, the board was forced to close

a day care center that appeared to be profitable when analyzed but turned out

to be a big money loser. They do not want a repeat of that occurrence.

Another director stated that she thought the hospital was putting too much

faith in the numbers: After all, she pointed out, that is what got us into

trouble on the day care center. We need to start worrying more about how

projects fit into our strategic vision and how they impact the services that

we currently offer. Another director, who also is the hospitals chief of

medicine, expressed concern over the impact of the ambulatory surgery center

on the current volume of inpatient surgeries.

3

To develop the data needed for the risk (scenario) analysis, Jules Bergman,

the hospitals director of capital budgeting, met with department heads of

surgery, marketing, and facilities. After several sessions, they concluded

that only two input variables are highly uncertain: number of procedures per

day and building/equipment salvage value. If another entity entered the local

ambulatory surgery market, the number of procedures could be as low as 15 per

day. Conversely, if acceptance is strong and no competing centers are built,

the number of procedures could be as high as 25 per day, compared to the most

likely value of 20 per day. If real estate and medical equipment values stay

strong, the building/equipment salvage value could be as high as $7 million,

but if the market weakens, the salvage value could be as low as $3 million,

compared to an expected value of $5 million. Jules also discussed the

probabilities of the various scenarios with the medical and marketing staffs,

and after a great deal of discussion reached a consensus of 70 percent for

the most likely case and 15 percent each for the best and worst cases.

Assume that the hospital has hired you as a financial consultant. Your task

is to conduct a complete project analysis on the ambulatory surgery center

and to present your findings and recommendations to the hospitals board of

directors. To get you started, Table 1 contains the cash flow analysis for

the first three years.

Table 1

Partial Cash Flow Analysis

0 1 2 3

Land opportunity cost ($500,000)

Building/equipment cost (10,000,000)

Net revenues $5,000,000 $5,150,000 $5,304,500

Less: Labor costs 800,000 824,000 848,720

Utilities costs 50,000 51,500 53,045

Supplies 2,000,000 2,060,000 2,121,800

Incremental overhead 36,000 37,080 38,192

Net income $2,114,000 $2,177,420 $2,242,743

Plus: Net land salvage value

Plus: Net building/equipment salvage value

Net cash flow ($10,500,000) $2,114,000 $2,177,420 $2,242,743

4

QUESTIONS

1. Complete Table 1 by adding the cash flows for Years 4 and 5.

2. What is the projects payback, NPV, and IRR? Interpret each of these

measures.

3. Suppose that the project would be allocated $10,000 of existing overhead

costs. Should these costs be included in the cash flow analysis? Explain.

4. It is likely that many of the procedures at the outpatient surgery center

would have otherwise been performed at the hospitals inpatient surgery

unit. How should the analysis incorporate the cannibalization of inpatient

surgeries? Would the handling of cannibalization change if you believed that

the local physicians were going to open an outpatient surgery center of

their own? (Only discuss the issues here---no numbers required.)

5. Conduct a scenario analysis. What is its expected NPV? What is the worst and

best case NPVs? How does the worst case value help in assessing the

hospitals ability to bear the risk of this investment?

6. Now assume that the project is judged to have high risk. Furthermore, the

hospitals standard procedure is to use a 3 percentage point risk

adjustment. What is the projects NPV after adjusting for the assessment of

high risk?

7. What is your final recommendation regarding the proposed outpatient surgery

center?