Twin Falls Community Hospital is a 250-bed, not-for-profit hospital located in the city of Twin Falls, the largest city in Idaho’s Magic Valley region and the seventh largest in the state. The hospital was founded in 1972 andtoday is acknowledged to be one of the leading healthcare providers in thearea.

Twin Falls’ management is currently evaluating a proposed ambulatory(outpatient) surgery center. Over 80 percent of all outpatient surgery isperformed by specialists in gastroenterology, gynecology, ophthalmology, otolaryngology, orthopedics, plastic surgery, and urology. Ambulatory surgeryrequires an average of about one and one-half hours; minor procedures takeabout one hour or less, and major procedures take about two or more hours.About 60 percent of the procedures are performed under general anesthesia, 30percent under local anesthesia, and 10 percent under regional or spinalanesthesia. In general, operating rooms are built in pairs so that a patientcan be prepped in one room while the surgeon is completing a procedure in theother room.

The outpatient surgery market has experienced significant growth since thefirst ambulatory surgery center opened in 1970. This growth has been fueledby three factors. First, rapid advancements in technology have enabled manyprocedures that were historically performed in inpatient surgical suites tobe switched to outpatient settings. This shift was caused mainly by advancesin laser, laparoscopic, endoscopic, and arthroscopic technologies. Second,Medicare has been aggressive in approving new minimally invasive surgerytechniques, so the number of Medicare patients utilizing outpatient surgeryservices has grown substantially. Finally, patients prefer outpatientsurgeries because they are more convenient, and third-party payers preferthem because they are less costly.

These factors have led to a situation in which the number of inpatientsurgeries has grown little (if at all) in recent years while the number ofoutpatient procedures has been growing at over 10 percent annually and nowtotals about 22 million a year. Rapid growth in the number of outpatientsurgeries has been accompanied by a corresponding growth in the number ofoutpatient surgical facilities. The number currently stands at about 5,000nationwide, so competition in many areas has become intense. Somewhatsurprisingly, there is no outpatient surgery center in the Twin Falls area,although there have been rumors that local physicians are exploring thefeasibility of a physician-owned facility.

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The hospital currently owns a parcel of land that is a perfect location forthe surgery center. The land was purchased five years ago for $350,000, andlast year the hospital spent (and expensed for tax purposes) $25,000 to clearthe land and put in sewer and utility lines. If sold in today’s market, theland would bring in $500,000, net of realtor commissions and fees. Landprices have been extremely volatile, so the hospital’s standard procedure isto assume a salvage value equal to the current value of the land.

The surgery center building, which will house four operating suites, wouldcost $5 million and the equipment would cost an additional $5 million, for atotal of $10 million. The project will probably have a long life, but thehospital typically assumes a five-year life in its capital budgeting analysesand then approximates the value of the cash flows beyond Year 5 by includinga terminal, or salvage, value in the analysis. To estimate the terminalvalue, the hospital typically uses the market value of the building andequipment after five years, which for this project is estimated to be $5million, excluding the land value.

The expected volume at the surgery center is 20 procedures a day. The averagecharge per procedure is expected to be $1,500, but charity care, bad debts,insurer discounts (including Medicare and Medicaid), and other allowanceslower the net revenue amount to $1,000. The center would be open five days aweek, 50 weeks a year, for a total of 250 days a year. Labor costs to run thesurgery center are estimated at $800,000 per year, including fringe benefits.Supplies costs, on average, would run $400 per procedure, includinganesthetics. Utilities, including hazardous waste disposal, would add another$50,000 in annual costs. If the surgery center were built, the hospital’scash overhead costs would increase by $36,000 annually, primarily forhousekeeping and buildings and grounds maintenance.

One of the most difficult factors to deal with in project analysis isinflation. Both input costs and charges in the healthcare industry have beenrising at about twice the rate of overall inflation. Furthermore,
inflationary pressures have been highly variable. Because of the difficultiesinvolved in forecasting inflation rates, the hospital begins each analysis byassuming that both revenues and costs, except for depreciation, will increaseat a constant rate. Under current conditions, this rate is assumed to be 3percent. The hospital’s corporate cost of capital is 10 percent.When the project was mentioned briefly at the last meeting of the hospital’sboard of directors, several questions were raised. In particular, onedirector wanted to make sure that a risk analysis was performed prior topresenting the proposal to the board. Recently, the board was forced to closea day care center that appeared to be profitable when analyzed but turned outto 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 muchfaith in the numbers: “After all,” she pointed out, “that is what got us intotrouble on the day care center. We need to start worrying more about howprojects fit into our strategic vision and how they impact the services thatwe currently offer.” Another director, who also is the hospital’s chief ofmedicine, expressed concern over the impact of the ambulatory surgery centeron the current volume of inpatient surgeries.

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To develop the data needed for the risk (scenario) analysis, Jules Bergman,the hospital’s director of capital budgeting, met with department heads ofsurgery, marketing, and facilities. After several sessions, they concludedthat only two input variables are highly uncertain: number of procedures perday and building/equipment salvage value. If another entity entered the localambulatory surgery market, the number of procedures could be as low as 15 perday. 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 mostlikely value of 20 per day. If real estate and medical equipment values staystrong, 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 theprobabilities of the various scenarios with the medical and marketing staffs,and after a great deal of discussion reached a consensus of 70 percent forthe 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 taskis to conduct a complete project analysis on the ambulatory surgery centerand to present your findings and recommendations to the hospital’s board ofdirectors. To get you started, Table 1 contains the cash flow analysis forthe first three years.

Table 1

Partial Cash Flow Analysis

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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

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

2. What is the project’s payback, NPV, and IRR? Interpret each of thesemeasures.

3. Suppose that the project would be allocated $10,000 of existing overheadcosts. Should these costs be included in the cash flow analysis? Explain.

4. It is likely that many of the procedures at the outpatient surgery centerwould have otherwise been performed at the hospital’s inpatient surgeryunit. How should the analysis incorporate the cannibalization of inpatientsurgeries? Would the handling of cannibalization change if you believed thatthe local physicians were going to open an outpatient surgery center oftheir own? (Only discuss the issues here---no numbers required.)

5. Conduct a scenario analysis. What is its expected NPV? What is the worst andbest case NPVs? How does the worst case value help in assessing thehospital’s ability to bear the risk of this investment?

6. Now assume that the project is judged to have high risk. Furthermore, thehospital’s standard procedure is to use a 3 percentage point riskadjustment. What is the project’s NPV after adjusting for the assessment ofhigh risk?

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