Hello,

I have a question regarding a multi-part healthcare finance question. The question begins on tab C11 Problem 7 and continues into C12 Problem 3. I am attaching the Excel Spreadsheet.

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 Data Project Cost Net Cash Flows Years Cost of Capital ($52,125) $12,000 8 12% 0 Net Cash Flows Cumulative Cash Flow $ (52,125.00) $ (52,125.00) $ 1 $12,000 (40,125.00) Years to Payback Answer A Year 0 1 2 3 4 5 6 7 8 4.34375 Annual Cash Cumulative Cash Flow Flow ($52,125) ($52,125) 12,000 ($40,125) 12,000 ($28,125) 12,000 ($16,125) 12,000 ($4,125) 12,000 12,000 12,000 12,000 $7,875 $19,875 $31,875 $43,875 $ Year 4 2 3 $12,000 $12,000 $12,000 (28,125.00) $ (16,125.00) $ (4,125.00) $ NPV Answer B Break Even Point -0.34 5 6 $12,000 $12,000 7,875.00 $ 19,875.00 IRR $7,486.68 16% Answer C $ 7 8 $12,000 $12,000 31,875.00 $ 43,875.00 A positive NPV indicates the investment is potentially lucrative. From a financial perspective, a the greater the NPV, the more beneficial the investment/project. $7000 is not too great a number, but still positive. An IRR of 16% is greater than the capital cost of 12%. This is a good project investment and financially acceptable. 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 0 1 2 3 4 5 Method B -$300,000 -$66,000 -$66,000 -$66,000 -$66,000 -$66,000 -$120,000 -$96,000 -$96,000 -$96,000 -$96,000 -$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 Data Method A 0 $ (300,000.00) $ Method B 0 $ (120,000.00) $ 1 (66,000.00) $ 2 (66,000.00) 1 (96,000.00) $ 2 (96,000.00) Cash Outflows 3 $ (66,000.00) $ Cash Outflows 3 $ (96,000.00) $ 4 (66,000.00) 4 (96,000.00) Capital 9% Method A 0 $ (300,000.00) $ Method B 0 1 66,000.00 $ 1 Net Cash Outflows 2 3 66,000.00 $ 66,000.00 $ Net Cash Outflows 2 3 4 66,000.00 4 $ (120,000.00) $ 96,000.00 $ 96,000.00 $ 96,000.00 $ 96,000.00 h services to its d revenues are are all outflows. Answer IRR for A $ 5 (66,000.00) Answer NPV A 3% IRR for B $ 5 (96,000.00) NPV B 75% IRR must be calculated using positive or net cash outflows. If negative cash outflows are used, IRR cannot be calculated. $ 5 66,000.00 5 ($556,716.98) ($493,406.52) To calculate NPV, the net cash outflows are summed.The most positive NPV would be chosen. That would be method B. $ 96,000.00 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 Data Year Project X Project Y Cost of Capital 0 -10000 -10000 12% 1 6500 3000 2 3000 3000 3 3000 3000 4 1000 3000 Answer A NPV of X NPV of Y IRR of X IRR of Y Answer B $966.01 ($887.95) 18.03% 7.71% A project with a positive NPV should be considered. This is the case with project X. An IRR that is greater than the cost of capital is also considered the better choice. Again, project X has an IRR of 18%>12 (cost of capital). Project X should be selected. 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.) 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 * Pretax equipment salvage value MACRS equipment salvage value 1 Difference Taxes After-tax equipment salvage value Year 2 3 4 5 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 Volume NPV 3750 $214,220.07 Net Present Value Volume Changes -30% -20% -10% 0% 10% 20% 30% 2625.00 3000.00 3375.00 3750.00 4125.00 4500.00 4875.00 $214,220.07 ? ? ? 3750.00 ? ? ? Answer A The sensitivity analysis reveals the project is much more sensitive to salvage changes versus volume changes. Salvage Changes -30% -20% -10% 0% 10% 20% 30% $140,000.00 $160,000.00 $180,000.00 $200,000.00 $220,000.00 $240,000.00 $260,000.00 Sensitivity Analysis 300000.00 250000.00 200000.00 150000.00 100000.00 50000.00 0.00 -30% -20% -10% On Volume 0% On Salvage 10% 20% Answer B Scenario Probability Worst 0.25 Most likely 0.50 Best 0.25 Number of Procedures Average Collection 10 $60 15 $80 20 $100 Equipment Salvage Value $100,000 $200,000 $300,000 NPV ($335,905) 74,904 610,230 30% 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. Net Present Value $214,220.07 ? ? ? $200,000.00 ? ? ? Data for Graphing Percentage Change -30% -20% -10% 0% 10% 20% 30% On Volume On Salvage 2625.00 3000.00 3375.00 3750.00 4125.00 4500.00 4875.00 $140,000.00 $160,000.00 $180,000.00 $200,000.00 $220,000.00 $240,000.00 $260,000.00 20% 30% 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 Year System X System Y Corporate Cost of Capital Corporate Cost of Capital Corporate Cost of Capital 0 1 2 3 NPV -$500.00 -$500.00 -$500.00 -$500.00 ($1,743.43) -$1,000.00 -$300.00 -$300.00 -$300.00 ($1,746.06) 10% 12% 8% Answer A The NPV with the most positive value should be chosen - System X. The NPV with the most positive value should be chosen - System X. Answer B Answer B System Y System X with with NPV @ NPV @ 12% ($1,700.92) 12% System Y System X with with NPV @ NPV @ 8% ($1,788.55) 8% At 12% system X would be chosen ($1,720.55) ($1,773.13) At 8% sytem Y would be chosen 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 $1,500 The sharpest rise in slope is number of home visits. The sensitivity analysis shows that the project is most sensitive to numer of home visits. $1,000 $500 $0 -30% -$500 -$1,000 Num Sensitivity Analysis $1,500 $1,000 $500 $0 -30% -20% -10% 0% 10% 20% -$500 -$1,000 Number of home visits Revenue per home visit Level of fixed costs 30%