Florida Keys Hospital is a 250-bed, investor-owned hospital located in Islamorada, Florida, which is known as the Sport Fishing Capital of the World. The hospital was founded in 1946 by Rob Winslow, a prominent Florida physician, on his return from service in World War II. Winslow relinquished control of the hospital in 1967 while it was still small and in a relatively quiet setting. However, in recent years, the Florida Keys have experienced a population explosion, which has fostered high economic growth as well as a continuing need for more healthcare services. Today, under a succession of excellent chief executive officers, the hospital is acknowledged to be one of the leading healthcare providers in the area.

Florida Keys management is currently evaluating a proposed ambulatory (outpatient) surgery center. Over 80% 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 hoursminor procedures take about one hour or less, and major procedures take about two or more hours. About 60% of the procedures are performed under general anesthesia, 30% under local anesthesia, and 10% 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. By 1990, about 2.5 million procedures were being performed, but by 2005 the number had grown to over 7 million. This growth has been fueled primarily 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.

All of these factors have led to a situation in which the number of inpatient surgeries has remained flat over the last few years while the number of outpatient procedures has continuously grown at over 10 percent annually. Rapid growth in the number of outpatient surgeries has been accompanied by a corresponding growth in the number of outpatient facilities nationwide. The number currently stands at about 3,300, so competition in many areas has become intense. Somewhat surprisingly, there is no outpatient surgery center in the hospitals immediate service area, although there have been rumors that local physicians are exploring the feasibility of a physician-owned facility.

Florida Keys Hospital currently owns a parcel of land adjacent to its facility tht is a perfect location for the surgery center. The hospital bought the land five years ago for $150,000, 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 $200,000, net of all fees, commissions, and taxes. 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. Of course, land is not depreciated for either book or tax purposes.

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. For ease, assume that both the building and the equipment fall into the modified accelerated cost recover system (MACRS) five-year class for tax-depreciation purposes. (In reality, the building would have to be depreciated over a much longer period than the equipment.) 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 salvage 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 before taxes, excluding the land value. (Note that taxes must be paid on the difference between an assts salvage value and it tax book value at termination. For example, if an asset that cost $10,000 has been depreciated down to $5,000 and then sold for $7,000, the firm owes taxes on the $2,000 excess in salvage value over tax book 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, managed care plan discounts, 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 $696,000 per year, including fringe benefits. 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. In addition, the center would be allocated $25,000 of Florida Keys current $2.8 million in administrative overhead costs. On average, each procedure would require $200 in expendable medical supplies, including anesthetics. Although the hospitals inventories and receivables would rise slightly if the center is constructed, its accruals and payables would also increase. The overall change in net working capital is expected to be small and hence not material to the analysis. The hospitals marginal federal-plus-state tax rate is 40 percent.

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.

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 complete risk analysis, including sensitivity and scenario analyses, 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 two years ago but turned out to be a big money loser. They do not want a repeat of that occurrence.

One of Florida Keys directors 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. This concern prompted an analysis by the surgery department head, which indicated that an outpatient surgery center could siphon off up to $1 million in cash revenues annually. When pressed, the department head indicated that such a reduction in volume could also lead to a $500,000 reduction in annual cash expenses.

To develop the data needed for the risk analysis, Jules Bergman, the hospitals director of capital budgeting, met with department heads of surgery, marketing, and facilities. After several sessions, they concluded that three input variables are highly uncertain: number of procedures per day, average revenue per procedure, and building/equipment salvage value. If another entity entered the local ambulatory surgery market, the number of procedures could be as low as 10 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.

The average net revenue amount, with an expected value of $1,000, is a function of the types of procedures performed and the amount of managed care penetration. If surgery severity were high (i.e., if a higher number of complicated procedures were performed than anticipated) and managed care penetration remained low, then the average revenue could be as high as $1,200. Conversely, if the severity were lower than expected and managed care penetration increases, the average revenue could be as low as $800. Finally, if real estate and medical equipment values stay strong, the building/equipment salvage value could be as high as $6 million, but if the market weakens, the salvage value could be as low as $4 million, compared to an expected value of $5 million.

Jules also discussed the probabilities of the various scenarios with the medical and marketing staffs, but after considerable debate no consensus could be reached. To add to the confusion, one member of the medical staff, who had just returned from a University of Michigan executive program on financial management, questioned why the scenario analysis had to be confined to just three scenarios. Why not five or seven? he queried. Additionally, he said that the executive program had taught him a good way to assess the impact of inflation on project profitability, which is to create and analyze an inflation impact table.

To help with the risk-incorporation phase of the analysis, Jules consulted with Mark Hauser, Florida Keys chief financial officer, about both the risk inherent in the hospitals average project and how the hospital typically adjusts for risk. Mark told Jules that based on historical scenario analysis data that use worst, most likely, and best case values, the hospitals average project has a coefficient of variation of net present value (NPV) in the range of 1.0 to 2.0 and that the hospital typically adds or subtracts 4 percentage points to its 10% corporate cost of capital to adjust for differential project risk.

Assume that Florida Keys 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.

Questions to think about as you evaluate, analyze, and present your findings on this particular project:

What is incremental cash flow? Because the project, at least constructively, will be financed in part by debt, should the cash flows include interest expense? Think about why or why not . . .

The hospital already owns the site for the center, so should any cost be attributed to the land? Why or why not . . .

What overhead costs should be included in the analysis?

How should the cannibalization of inpatient surgeries be handled?

What is the projects payback? What is the economic interpretation of payback? What type of information do decision-makers get from the payback?

What is the projects net present value (NPV)? Think about the economic rationale behind this profitability measure.

What is the projects internal rate of return (IRR)? Think about the economic rationale behind IRR. Do the NPV and IRR always lead to the same conclusion about a projects profitability?

What is the projects modified internal rate of return (MIRR)? How does MIRR differ from IRR? Which one is a better measure of a projects true rate of return?

To give the board a better feel for the impact of inflation on the outpatient surgery center, you may wish to construct an inflation impact table.

You may wish to conduct a sensitivity analysiscreating a table and/or graph that shows the sensitivity of NPV to procedures per day, average charge, and salvage value. Assume that each variable can deviate from its base case value by +/-10, +/-20, and +/-30 percent. Think about the advantages and disadvantages of sensitivity analysis.

You may wish to conduct a scenario analysis. Does the expected NPV obtained here agree with the base case NPV? If not, why? Discuss the advantages and disadvantages of scenario analysis.

Should the ambulatory surgery center be classified as high risk, average risk, or low risk on the basis of the analysis thus far?

What is your estimate of the projects corporate risk? Its market risk?

Is there additional data you would seek from other hospital staff members to conduct a more thorough analysis? Can you think of any costs that might be associated with the project that have not been included in the analysis? Are there any potential benefits that have not been included? What qualitative factors should the board consider in making the final judgment on the project?