CASE21 CASE 21 8/13/13 Student Version Copyright 2014 Healt Administration Press NATIONAL REHABILITATION CENTERS Staged Entry Analysis This case is designed to give further insight into the capital budgeting decision process. It focuses on the timing and relevancy of cash flows, the use of decision trees, abandonment, value, and the advantages and disadvantages of staged entry. The model calculates NPV, IRR, MIRR, payback, and discounted payback on the basis of input data for two stages of a project. Note that the model extends to Column K. The model consists of a complete base case analysisno changes need to be made to the existing MODEL-GENERATED DATA section. However, all values in the student version INPUT DATA section have been replaced with zeros. Thus, students must determine the appropriate input values and enter them into the model. These cells are colored red. When this is done, any error cells will be corrected and the base case solution will appear. However, students must create their own graphics (charts) as needed to present their results. Note that the model contains a second sheet to help with the risk calculations. Here, users enter the NPVs and joint probabilities of each branch of the decision tree and the model calculates expected NPV, variance, standard deviation, and coefficient of variation. INPUT DATA: (000s of $) KEY OUTPUT: (000s of $) Stage 1: Stage 1: Facilities Costs: Labor market study costs Land acquisition costs Land salvage value Building / equipment costs Bldg / equip salvage value $0 $0 $0 $0 $0 Expected values: NPV IRR Operating Costs: Variable costs Fixed costs Fixed cost inflation rate Revenue Data: NPV IRR MIRR Payback Disc payback Poor Scenario Good Scenario $0 $0 Err:523 Err:523 10.0% 10.0% 0.0 0.0 100.0 100.0 0.0% $0 0.0% $0 Err:523 Stage 2: High NPV @ Yr 0 IRR MIRR Poor Demand: Page 1 $0 Err:523 10.0% Medium $0 Err:523 10.0% Low $0 Err:523 10.0% CASE21 Year 4 total revenues Revenue growth rate $0 0.0% Good Demand: Year 4 total revenues Revenue growth rate $0 0.0% Other Data: Unexpensed dev. costs Tax rate Corporate cost of capital Risk adj for project risk Demand probabilities: Poor Good $0 0.0% 0.0% 0.0% 0.0% 0.0% Stage 2: Expected NPV Stage 1 poor demand Stage 1 good demand Combined NPV Combined Stage 1 and Stage 2 NPV: Poor Stage 1: Stage 1 + Low demand Stage 1 + Medium demand Stage 1 + High demand $0 $0 $0 Good Stage 1: Stage 1 + Low demand Stage 1 + Medium demand Stage 1 + High demand $0 $0 $0 Expected NPV $0 Cash Flow Data: End of Year 6 7 8 9 10 11 12 High Demand $0 0 0 0 0 0 0 Net Cash Flow Med Demand $0 0 0 0 0 0 0 Poor Stage 1 0.0% 0.0% 0.0% Good Stage 1 0.0% 0.0% 0.0% Other Data: Demand probabilities: Low Medium High $0 $0 $0 MODEL-GENERATED DATA: Stage 1: Depreciation Cash Flow Worksheet: Page 2 Low Demand $0 0 0 0 0 0 0 CASE21 Year 4 5 6 7 8 Build / Equip $0 0 0 0 0 $0 Cash Flow Statements: Poor Demand Scenario: 0 1 Feasibility study costs Land acquisition costs R & D tax savings Building/equipment costs $0 Total facilities costs $0 2 3 4 $0 0 $0 $0 0 0 $0 $0 Total revenues Variable costs Total fixed costs Depreciation Operating income Tax Net income Plus depreciation Operating cash flow Land salvage value Land salvage value tax Building / Equip salvage value Building / Equip SV tax $0 0 0 0 $0 0 $0 0 $0 Net cash flow $0 $0 $0 $0 NPV, IRR, MIRR, and Payback: Project cost of capital = Year 0 1 0.0% Cash Flow PV of Cash Flow $0 0 $0 Cumulative Flows $0 0 Cumulative PV $0 0 Page 3 Terminal Value $0 0 $0 CASE21 2 3 4 5 6 7 8 0 0 0 0 0 0 0 0 0 0 0 0 0 0 NPV IRR MIRR Payback Discounted payback $0 Err:523 10.0% 0.0 100.0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 $0 0 0 0 0 PV of COF TV of CIF $0 $0 Good Demand Scenario: 0 1 Feasibility study costs Land acquisition costs R & D tax savings Building/equipment costs $0 Total facilities costs $0 2 3 4 $0 0 $0 $0 0 0 $0 $0 Total revenues Variable costs Total fixed costs Depreciation Operating income Tax Net income Plus depreciation Operating cash flow Land salvage value Land salvage value tax Building / Equipment salvage value Building / Equipment SV tax Net cash flow $0 0 0 0 $0 0 $0 0 $0 $0 $0 NPV, IRR, MIRR, and Payback: Project cost of capital = $0 0.0% Page 4 $0 $0 $0 CASE21 Cash Flow Year 0 1 2 3 4 5 6 7 8 PV of Cash Flow Cumulative Flows $0 0 0 0 0 0 0 0 0 $0 0 0 0 0 0 0 0 0 NPV IRR MIRR Payback Discounted pay $0 Err:523 10.0% 0.0 100.0 Cumulative PV $0 0 0 0 0 0 0 0 0 Terminal Value $0 0 0 0 0 0 0 0 0 $0 0 0 0 0 PV of COF TV of CIF $0 $0 Stage 2: High Demand Scenario: Year 6 7 8 9 10 11 12 Cash Flow PV of Cash Flow $0 0 0 0 0 0 0 Project cost of capital = NPV @ Year 6 IRR MIRR Payback Discounted payback NPV @ Year 0 Cumulative Flows $0 0 0 0 0 0 0 Cumulative PV Terminal Value $0 0 0 0 0 0 0 $0 0 0 0 0 0 0 PV of COF TV of CIF $0 $0 0.0% $0 Err:523 10.0% 99.9 100.0 $0 Medium Demand Scenario: Page 5 0 0 0 0 CASE21 Year 6 7 8 9 10 11 12 Cash Flow PV of Cash Flow $0 $0 $0 $0 $0 $0 $0 Project cost of capital = Cumulative Flows $0 0 0 0 0 0 0 Cumulative PV $0 0 0 0 0 0 0 Terminal Value $0 0 0 0 0 0 0 0 0 0 0 PV of COF TV of CIF $0 $0 0.0% NPV @ Year 6 IRR MIRR Payback Discounted payback NPV @ Year 0 $0 Err:523 10.0% 99.9 100.0 $0 Low Demand Scenario: Year 6 7 8 9 10 11 12 Cash Flow PV of Cash Flow $0 0 0 0 0 0 0 Project cost of capital = NPV @ Year 6 IRR MIRR Payback Discounted payback NPV @ Year 0 Cumulative Flows $0 0 0 0 0 0 0 Cumulative PV $0 0 0 0 0 0 0 Terminal Value $0 0 0 0 0 0 0 0 0 0 0 PV of COF TV of CIF $0 $0 0.0% $0 Err:523 10.0% 100.0 100.0 $0 Page 6 CASE21 yright 2014 Health ministration Press Page 7 CASE21 Page 8 CASE21 5 6 7 8 $0 $0 $0 $0 $0 $0 $0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 0 0 0 0 $0 $0 $0 $0 Page 9 CASE21 5 6 7 8 $0 $0 $0 $0 $0 $0 $0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 $0 0 0 0 $0 0 $0 0 $0 0 0 0 0 $0 $0 $0 $0 Page 10 CASE21 Page 11 CASE21 END Page 12 STANDARD DEVIATION CALCULATOR INPUT DATA: Branch NPV $0 $0 $0 $0 $0 $0 Joint Probability 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 100.0% KEY OUTPUT: E(NPV) = Variance = Standard Deviation = Coefficient of Variation = $0 0 $0 #DIV/0! END National Rehabilitation centers (NRC) is one of the nations leading providers of outpatient rehabilitative medicine. It was founded in 1988 in Phoenix Arizona by a group of 5 individuals who recognized the need for cost effective alternatives to traditional hospital based rehabilitative services. This vision has become the hallmark of the company, and NRC continues to provide the highest quality, most cost-effective care available. (for more information on rehabilitative medicine, see the American Academy of Physical Medicine and rehabilitation website at www.aapmr.org) In its quest to lower the costs of rehabilitative services, NRC uses the latest in noninvasive treatment procedures, which reduces direct costs and results in quicker recoveries. In addition, the company encourages patients to begin aggressive rehabilitation as early as possible, which helps them return to normal functioning more quickly than under conventional treatment protocols. In spite of NRCs relatively short history, its strategy has worked wonders, and it quickly expanded from a local to a regional to a national company with nearly 750 locations in all 50 states, Puerto Rico, the United Kingdom, and Australia. For several years, NRCs board of directors has been considering expanding its service line to include sports medicine. The American College of Sports Medicine defines this field as the physiological, biomechanical, psychological, and pathological phenomena associated with exercise and sports. Because there is a considerable degree of commonality between rehabilitative and sports medicine services, expansion into this rapidly growing area of healthcare seems natural NRCs boar is examining two proposals related to the expansion. Proposal A involves a single, large investment that would immediately give the company a national presence in sports medicine. In essence, all of the current rehabilitation facilities deemed suitable to offer sports medicine services would be renovated, equipped, and staffed as required to offer sports medicine services. The amount of capital investment at each earmarked location would vary significantly, but the average cost is estimated at about $800,000 per facility. With roughly 500 locations identified as being suitable for the sports medicine service line, the estimated cost of Proposal A is in the vicinity of $400 million. Although the profitability analysis of Proposal A is only preliminary, its internal rate of return is thought to be in the range of 20 to 25 percent Proposal B, on the other hand, involves a more deliberate, two stage approach to the expansion. Stage 1 of Proposal B calls for a trial program in which only one of NRCs nine regions would offer sports medicine services, if the results of Stage 1 meet the company's profit targets, Stage 2, which calls for the expansion of sports medicine services into the remaining eight regions, would be implemented. Proposal A requires a much larger capital investment than does Stage 1 of Proposal B. however, Proposal B is more costly than Proposal A overall even when the time value of money is considered, because Proposal A's large up front investment leads to greater efficiencies in contracting, construction, recruitment, and marketing. In spite of proposal A's cost advantage, several board members are concerned about the wisdom of Proposal A because it requires NRC to make a very large investment in a service line that is new to the company, other board members though, see no difference between rehabilitation and sports medicine services and one board member even said, healthcare is healthcare. The primary task at hand now is to evaluate proposal B, which includes the trial program and possible expansion into all regions. To date, NRC has spent 7 million to develop a sports medicine concept that matches its approach to rehabilitative medicine. Of the 7 million, 2 million have been expensed for tax purposes, while the remaining 5 million have been capitalized and will amortized over the 5 year operating life of stage1. According to a specific internal revenue service ruling requested by NRC, if neither proposal A nor B is implemented, the 5 million could be immediately expensed. If it decides to go ahead with Stage 1, NRC would immediately spend 2 million to perform local labor-market studies to ensure that the locations identified for the sports medicine program could be staffed. The next step would be to buy the land needed at locations where totally new facilities are required. In total, land acquisitions cots, which are assumed to occur at the end of Year 1, are expected to be $10 million. New construction and renovations at the chosen locations would take place during years 2 and 3, and equipment would be installed during the last quarter, of year 3. Also, additional personnel would be hired as needed at the end of year 3. The total amount required for new buildings, renovations to exiting buildings, and equipment (plus a relatively small amount for recruitment) is estimated to be $50 million. For planning purposes, half of this amount is assumed to be spent at the end of Year 2 and the other half at the end of Year 3. Although any new buildings actually would fall into the modified accelerated cost recover systems (MACRS) 39-year tax depreciation class for tax purposes, for simplicity both the buildings and equipment needed are assumed to fall into the MACRS seven-year class. Appropriate depreciation allowances are given in Exhibit 21.1 NRC would begin to depreciate the buildings and equipment during Year 4, the year in which the trail sports medicine program would be initiated. The trial program would be evaluated at the begging of Year 6. If the results are satisfactory, the program would be expanded to the remaining eight regions. If the program does not meet expectations, it would be terminated at the end of Year 8. If terminated, the land would have an estimated market value of $10 million at that time, while the buildings and equipment would have a market value of $30 million. NRCs marketing department has projected two demand scenarios for Stage 1. If demand for the sports medicine program is poor, total revenues are forecasted to be $40 million for Year 4, the first year of operations. However, if demand is good, revenues are expected to be $60 million. At this point the best guess is that there is a %0 percent chance of poor demand a 50 percent chance of good demand. If demand is good, revenues are expected to increase by 6 percent each year after Year 4. If demand is poor, revenue growth is expected to be only 3 percent. In terms of operating costs, variable costs are expected to be 30 percent of revenues. Fixed costs (other than depreciation), which are expected to total 25 million in year 4, are forecasted to increase after the initial year of operations at the anticipated overall rate of inflation 2 percent. If the board approves Stage 2, NRC would spend an additional $480 million on land, buildings, and equipment to expand into the other 8 regions. This expenditure would be evenly split between Years 6 and 7. As shown, in the following table, the net cash inflows forecasted for Stage 2 depend on the demand scenario: End of Year 6 7 8 9 10 11 12 High Demand ($240,000,000) (240,000,000) 210,000,000 228,000,000 241,000,000 256,000,000 500,000,000 Medium demand ($240,000,000) (240,000,000) 160,000,000 170,000,000 175,000,000 180,000,000 350,000,000 Low Demand ($240,000,000) (240,000,000) 70,000,000 75,000,000 75,000,000 75,000,000 150,000,000 Note that the net cash flows have been \"bumped up\" in Year 9 to reflect the cash flows from those facilities in the test region. Also, note that the project is expected to last beyond year 12, and an allowance for the value of these future cash flows is embedded in the Year 12 cash flows. The estimated probabilities of the Stage 2 demand scenarios are related to the response to the stage 1 trial program. If acceptance is poor in stage 1 there is a 10 percent probability that demand will be high during stage 2, a 40 percent probability that demand will be medium and a 50 percent probability that demand will be low. However, if acceptance during stage 1 is good, there is a 50 percent probability that demand will be high during stage 2, a 40 percent probability that demand will be medium, and a 10 percent probability that demand will be low. Of course these expectation may change over time as new information becomes available. Furthermore, the actual demand scenario for stage 2 is not expected to be known until midway through Year 8, after the program has been operational nationally for six months. NRCs current effective income tax rate is 30 percent and this rate is projected to remain roughly constant into the future, the firms corporate cost of capital is 10.0 percent, and NRC adjusts this amount up or down by 3 percentage points to adjust for project risk. NRC defines low-risk projects as those that have a coefficient of variation (CV) of net present value less than 0.8 average-risk projects as those that have CVs in the range of 0.8 to 1.2 and high risk projects as those that have CVs of more than 1.2 One of the most important advantages of staged entry is that new information will become available throughout the investment period. NRCs managers recognize the value of this feature and believe that they will have a better estimate of the Stage 2 probabilities and cash flows prior to making the Year 6 investment. Even if stage 2 is undertaken there is some possibility that the project could be abandoned at the end of year 8 if the low0demand scenario materializes. If the project is terminated at the point, the best estimate for the Year 8 abandonment cash flow is $420 million. The uncertainty of whether or not abandonment would occur lies more in the politics than in the economics of the decision. In the past, NRCs managers have not been inclined to admit mistakes and cut losses, so some doubt lingers about whether the abandonment decision would be make even if it is the financially right thing to do at the time. Assume that you have been hired as a consultant to analyze the situation regarding that sports medicine program and to make a recommendation to NRCs board of directors regarding the best course of action. In addition to a detailed analysis of Proposal B, you have been asked to subjectively compare the relative merits of the two proposals A and B. Recovery of year MACRS Class 7 year 1 14.3 % 2 24.5% 3 17.5% 4 12.5% 5 8.9%