Project Analysis Case Study Boca Grande Hospital Boca Grande Hospital is a 250-bed,…


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Project Analysis Case Study Boca Grande Hospital Boca Grande Hospital is a 250-bed, investor-owned hospital located in Boca Grande, Florida, which is known as the Tarpon Capital of the World for its fine fishing. 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 lower west coast has experienced a population explosion, which has fostered high economic growth as well as a continuing need for healthcare services. Today, under a succession of excellent CEOs, Boca Grande Hospital is acknowledged to be one of the leading healthcare providers in the area. Boca Grande’s management is currently evaluating a proposed ambulatory (outpatient) surgery center. (For more information on ambulatory surgery see the Federated Ambulatory Surgery Association Web site athttp://www.fasa.org). 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 a 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. By 1990, about 2.5 million procedures were being performed, but by 2006 the number had grown to over 6 million. This growth has been fueled primarily by three factors. First, rapid advances in technology—mainly in laser, laparoscopic, endoscopic, and arthroscopic technologies—have enabled many procedures historically performed in inpatient surgical suites to be switched to outpatient settings. 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 2,700, so competition in many areas has become intense. Somewhat surprisingly, there is no outpatient surgery center in Boca Grande’s immediate service area, though there have been rumors that local physicians are exploring the feasibility of a physician-owned facility. Boca Grande owns a parcel of land adjacent to the hospital that is a perfect location for the surgery center. It 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 today’s market, the land would bring in $200,000, net of all fees, commissions, and taxes. Land prices have been extremely volatile in the Boca Grande area, so the hospital’s 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 building, which will house four operating suites, will cost $5 million and the equipment will cost an additional $5 million, for a total of $10 million. Assume that both the building and the equipment fall into the Modified Accelerated Cost Recovery 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 Boca Grande 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, Boca Grande 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 asset’s salvage value and its 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 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 per procedure. 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 $672,000 per year including fringe benefits. Utilities, including hazardous waste disposal, will add another $50,000 in annual costs. If the surgery center is built, the hospital’s cash overhead costs will increase by $36,000 annually, primarily for housekeeping and buildings and grounds maintenance. In addition, the center will be allocated $25,000 of Boca Grande’s current $2,800,000 in administrative overhead costs. On average, each procedure will require $200 in expendable medical supplies, including anesthetics. Although the hospital’s inventories and receivables will rise slightly if the center is constructed, its accruals and payables will also increase. The overall change in net working capital is expected to be small and hence not material to the analysis. The hospital’s 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, Boca Grande 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 hospital’s 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 Boca Grande’s directors states that the hospital was putting too much faith in numbers. “After all,” she pointed out, “that is what got us into trouble with 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 is also the hospital’s 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 $1,000,000 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 hospital’s 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 and equipment salvage value. If another entity enters the local ambulatory surgery market, the number of procedures per day could be as low as 10. Conversely, if acceptance is strong and no competing centers are built, the number of procedures can be as high as 25 per day, compared to the most likely value of 20. 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 remains high (that is, if a higher number of complicated procedures are performed than anticipated) and managed care penetration remains low, the average revenue can be as high as $1,200. Conversely, if the severity is lower than expected and managed care penetration increases, the average revenue can be as low as $800. Finally, if real estate and medical equipment values stay strong, the building and equipment salvage value can be as high as $6 million, but if the market weakens, the salvage value can be as low as $4 million, compared to an expected value of $5 million. Jules also discusses the probabilities of the various scenarios with the medical and marketing staffs, but after considerable debate no consensus is reached. To add to the confusion, one member of the medical staff, who has just returned from a University of Michigan executive program on financial management, questions the rationale for confining the scenario analysis to three scenarios. “Why not five or seven?” he queries. Additionally, he says that the executive program has taught him a good way to assess the impact of inflation on project profitability, which is to create and analyze an inflation impact table, such as the one shown in Table 2. To help with the risk incorporation phase of the analysis, Jules consults Mark Hauser, Boca Grande’s CFO, about both the risk inherent in the hospital’s average project and how the hospital typically adjusts for risk. Mark tells Jules that based on historical scenario analysis data that use worst, most likely, and best case values, the hospital’s average project has a coefficient of variation of net present value (NPV) in the range of 0.3 to 0.6 and that the hospital typically adds or subtracts 4 percentage points from its 10 percent corporate cost of capital to adjust for differential project risk. However, Mark is quick to admit that the risk adjustment factor is arbitrary and that it can just as easily be 2 percentage points or 6 percentage points. Assume that Boca Grande 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 hospital’s board of directors. Optional: This case is well suited for the application of the Monte Carlo simulation. If you are familiar with this risk assessment technique, and have access to the appropriate add-in software, apply it to this case. Table 1: Boca Grande Hospital: Projected Surgery Center Staffing Position Annual salary Full-time equivalent (FTEs) Total Salary Executive director 55,000 1 55,000 Director of nursing 45,000 1 45,000 Accounting clerk 35,000 1 35,000 Collections clerk 30,000 1 30,000 Scheduling clerk 25,000 1 25,000 Registered nurses 40,000 8 320,000 Nursing assistants 15,000 2 30,000 Transcriptionist 20,000 1 20,000 Total 560,000 Plus 20 percent fringe benefit allowance 112,000 Total salaries and benefits 672,000 Table 2: Boca Grande Hospital: Inflation Impact Table Level of Revenue Inflation 0% 3.0% 6.0% 9.0% 12.0% Level of Cost Inflation 0% NPV NPV NPV NPV NPV 3.0% NPV NPV NPV NPV NPV 6.0% NPV NPV NPV NPV NPV 9.0% NPV NPV NPV NPV NPV 12.0% NPV NPV NPV NPV NPV Attachments: Book1.xlsx

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