UVa Health System: The Long-Term Acute Care Hospital Project

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Case UVa Health System: The LATC Hospital Project
Wk 4 is the second of two weeks on CAPITAL BUDGETING
Study the Wk 3 Solutions Template before proceeding into Wk 4.
Learning Objectives (repeated from Wk3 Assignment Template)
You will learn the three steps in capital budgeting: SEE THE FLOW DIAGRAM - YOU ARE NOW WORKING ON THE GREEN-COLORED ANALYSIS.
1 Identify relevant incremental cash flows
2 Calculate cost of capital (k-wacc) to use as the discount rate
3 Calculate the metrics of capital budgeting: Net Present Value, Profitability Index,
Internal Rate of Return, and Payback Period.
Then, you will apply the metrics and information in the case study to make a recommendation
about which of the two projects to accept.
The essence of the capital budgeting process is to make sure, before an investment is made,
that its prospective rate of return is high enough to justify the investment,
i.e., that the project is CREATES value, not DESTROYS value.
Directions (some repeating from Wk3 Assignment Template)
1 Make a quick scan through the LTAC case and the exhibits.
2 Listen to the Intro Audio
3 Cohen Finance Workbook chapter 4 is a review of Time Value of Money, which you covered in a previous course.
Review it as necessary, but defer the review until you look at the TVM applications in chapter 5 beginning on p 79.
You need to know TVM to understand the capital budgeting metrics of NPV, PI, and IRR. Make sure you
have that context in mind before reviewing the TVM chapter 4 (only if you need to).
4 Read the case again, to grasp all the details, especially the Mulroney memo to her boss.
5 To understand how a capital budgeting template works, follow the step-by-step procedure in the book, pages 61-70
6 Scan pages 70-76 on weighted average cost of capital. No need to emphasize at this point because discount rates are given in the case.
7 Read pages 79-84 on NPV, PI, IRR, PP.
8 Pages 83-85 show a worked-out example of a capital budgeting decision.
Questions
If you work with a group, write answers on your own, independently. Group answers violate academic integrity requirements.
1 See Q1 tab. Scroll down until you see the questions. Capital Budgeting Template The template calculates FREE CASH FLOW=[EBIT-TAX+DEPREC]+/-CHANGE NWC+/-CAPEX.
2 See Q2 tab. Scroll down until you see the questions. K-wacc The 1st term is income statement data; the 2nd & 3rd terms are balance sheet data.
3 See Q3 tab. Scroll down until you see the questions. Sensitivity Analysis LEARN THIS FORMULA (EQUATION) COLD!
Expect to revisit these calculations and decisions in Wk7.

Q1 Capital Budgeting Template

UNIVERSITY OF VIRGINIA MEDICAL CENTER
Long Term Acute Care Hospital Free Cash Flow Projections
Revenue and Cost Assumptions Results-No NWC Recovery Results-NWC Recovery
Number of Beds 50 NPV $5,687 NPV $10,425 (000 ommited)
Year 1 Utilization 26% IRR 17.6% IRR 21.2%
Year 2 Utilization 60%
Annual Increase in Utilization 4%
Operating Expense (% of Revenue) 7.0%
K-wacc 10%
Year 1 2 3 4 5 6 7 8 9 10
VOLUME
Patient Day Capacity 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250
Utilization 26% 60% 62% 65% 67% 70% 73% 76% 79% 82%
Patient Days Used 4,745 10,950 11,388 11,844 12,317 12,810 13,322 13,855 14,409 14,986
Average Patient Census per Day 13 30 31 32 34 35 36 38 39 41
Average Length of Stay 30 27 27 27 27 27 27 27 27 27
Number of Patients per Year 158 406 422 439 456 474 493 513 534 555
Full-Time Employees/Census 4.8 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5
Full-Time Employees 62 105 109 114 118 123 128 133 138 144
INSURANCE PAYER Patient Mix
Medicare 36% 57 146 152 158 164 171 178 185 192 200
Medicaid 29% 46 118 122 127 132 138 143 149 155 161
Commercial Payers 24% 38 97 101 105 109 114 118 123 128 133
Other 9% 14 37 38 39 41 43 44 46 48 50
Indigent 2% 3 8 8 9 9 9 10 10 11 11
158 406 422 439 456 474 493 513 534 555
Billing Annual Incr
Medicare—bill per patient $27,795 0.0% 1,583 4,058 4,220 4,389 4,565 4,747 4,937 5,135 5,340 5,554
Medicaid—bill per patient $35,000 1.3% 1,605 4,170 4,337 4,510 4,691 4,878 5,073 5,276 5,487 5,707
Commercial Payers—bill per day $2,800 5.0% 3,189 7,726 8,035 8,357 8,691 9,039 9,400 9,776 10,167 10,574
Other—bill per patient $38,500 1.3% 548 1,424 1,480 1,540 1,601 1,665 1,732 1,801 1,873 1,948
Indigent—bill per patient $35,000 1.3% 111 288 299 311 323 336 350 364 378 394
Total Revenue (000 omitted) 7,035 17,665 18,372 19,107 19,871 20,666 21,493 22,352 23,246 24,176
Less Uncollectable 1% 70 177 184 191 199 207 215 224 232 242
Total Net Revenue (000 omitted) 6,965 17,489 18,188 18,916 19,672 20,459 21,278 22,129 23,014 23,935
EXPENSES Annual Incr
Salary, Wage, Benefits (based on $ per employee) $60,250 3% 3,760 6,516 6,980 7,477 8,009 8,580 9,190 9,845 10,546 11,297
Supplies, Drugs, Food (% net revenue) 16.3% 1,135 2,851 2,965 3,083 3,207 3,335 3,468 3,607 3,751 3,901
Management Fees (% net rev) 8% 557 1,399 1,455 1,513 1,574 1,637 1,702 1,770 1,841 1,915
Operating Expenses (fixed + 7 % net rev) $1,200,000 NA 1,688 2,424 2,473 2,524 2,577 2,632 2,689 2,749 2,811 2,875
Land Lease per year $200,000 3% 200 206 212 219 225 232 239 246 253 261
Depreciation (straight line 30yrs) $15,000,000 500 500 500 500 500 500 500 500 500 500
Total Expenses (000 omitted) 7,840 13,896 14,585 15,316 16,092 16,915 17,789 18,717 19,702 20,749
Total Expenses 7,840 13,896 14,585 15,316 16,092 16,915 17,789 18,717 19,702 20,749
Operating Profit (804) 3,769 3,787 3,791 3,779 3,751 3,703 3,635 3,544 3,427
Operating Margin -11.4% 21.3% 20.6% 19.8% 19.0% 18.1% 17.2% 16.3% 15.2% 14.2%
Net Working Capital Notes:
Accounts Receivable 30 days 572 1,437 1,495 1,555 1,617 1,682 1,749 1,819 1,892 1,967
Inventory Supplies, Drugs, Food 60 days 187 469 487 507 527 548 570 593 617 641
Accounts Payable 30 days 93 234 244 253 264 274 285 296 308 321
Net Working Capital 666 1,672 1,739 1,808 1,880 1,956 2,034 2,115 2,200 2,288
Change in NWC 666 1,006 67 70 72 75 78 81 85 88
Free Cash Flows Calculation
Operating Profit (804) 3,769 3,787 3,791 3,779 3,751 3,703 3,635 3,544 3,427
Add Depreciation 500 500 500 500 500 500 500 500 500 500
Less Capital Expenditures (7,500) (7,500) 0 0 0 0 0 0 0 0 0
Less Increase in Net Working Capital (666) (1,006) (67) (70) (72) (75) (78) (81) (85) (88)
Free Cash Flows (000 omitted) (7,500) (8,470) 3,263 4,220 4,221 4,207 4,176 4,125 4,054 3,959 3,839
NPV (no recovery in year 10) $5,687 (000 ommited)
IRR (no recovery in year 10) 17.6%
Year 1 2 3 4 5 6 7 8 9 10
NWC Recovery 0 0 0 0 0 0 0 0 0 $2,288
Sale of Facility at Book Value 0 0 0 0 0 0 0 0 0 $10,000
NPV with Year 10 Recovery $10,425 (000 ommited) (7,500) (8,470) 3,263 4,220 4,221 4,207 4,176 4,125 4,054 3,959 16,127
IRR with Year 10 Recovery 21.2%
Net Profit (Operating Profit - Interest) (000 ommited) (2,004) 2,569 2,587 2,591 2,579 2,551 2,503 2,435 2,344 2,227
Net Profit/Net Revenue -28.8% 14.7% 14.2% 13.7% 13.1% 12.5% 11.8% 11.0% 10.2% 9.3%
Study the above analysis carefully, examining the inputs, outputs, and formulas used to do the calculations.
Q1a Mulroney did not use working capital cash flows in her original analysis. The analysis above
includes incremental investment in working capital. Discuss why she was either correct or incorrect not to
include them.
Q1b Compare the decision metrics NPV & IRR for the "no recovery of NWC" and "recovery of NWC" scenarios,
stating which scenario best captures reality. Based on your answer, give the project a green or red light.
Q1c Examine the decision metric 'profit margin', and explain if it leads to a green or red light for this project.
Even though the board of directors uses this metric, it is defective. Explain why. HINT: FCF definition.
Q1d Reconcile your answers to Q1b and Q1c.

Q2 K-wacc

COMPUTE WEIGHTED AVERAGE COST OF CAPITAL
BASIC: Formula Equation Case Exhibit 4
COST OF DEBT: U.S. Treasury Yields
Coupon Rate 0.00% given 1-year 4.77%
Marginal Tax Rate 0.0% given 5-year 4.72%
Cost of Debt 0.00% b5*(1-b6) k-d = I x (1- t) 10-year 4.72%
weight of debt 0% d ÷ d+e 30-year 4.73%
Data source: http://federalreserve.gov/releases/h15/data.htm (accessed March 2006).
COST OF EQUITY:
Risk-Free Rate 0.00% given Corporate Bond Yields
Risk Premium 0.00% given R-m - R-f AAA 5.31%
Beta 0.00 given AA 5.38%
Cost of Equity 0.00% b11+(b13*b12) k-e = R-f + [ß x (R-m - R-f)]
weight of equity 100% 1-b8 e ÷ d+e A+ 5.41%
A 5.45%
Weighted-Average Cost of Capital 0.00% (b8*b7)+(b15*b14) (k-d x wt-d)+(k-e x wt-e) A- 5.53%
BBB+ 5.62%
BBB 5.88%
For-Profit Comparables BBB- 6.07%
HCA Inc Community Health Health Management Associates
Revenues (millions) $24,475 $3,720 $3,580 BB+ 6.40%
Assets (millions) $5,222 $961 $997 BB 6.79%
Total debt (millions) $9,278 $1,810 $1,014 BB- 6.96%
Stock price ($/share) $52.12 $39.73 $23.25
Shares outstanding (millions) 452.7 88.5 247.2 B+ 7.39%
Market cap (millions) $23,593 $3,517 $5,747 B 7.57%
Bond rating A B BB B- 7.84%
Beta 0.60 0.60 0.70 Data source: Bloomberg, “Fair Market Curve Analysis,” 10-Year Corporate Bonds, March 2, 2006.
Q2a Calculate the K-wacc for HCA using the template above. Enter the data that you
have in the case and the table above. If you need additional data, assume it using
your good judgment from what you have learned so far in the course.
In the answer box, cite your result, compare it to the K-wacc used in the Q1
analysis, and explain how your revised K-wacc would change the Q1 results.
Q2b If LATC was a project in a for-profit hospital like HCA
above, would the NPV be higher or lower? Explain 'analytically' by examining
all relevant inputs to NPV.
Q2c If LATC was a project in a for-profit hospital like HCA
above, would the IRR be higher or lower? Explain.
HINT: To avoid getting trapped by this question, make sure your answer is
'analytical', i.e., examine all relevant inputs and output.
Q2d Can a non-profit hospital accept projects that a for-profit hospital would reject?

Q3 Sensitivty Analysis

UNIVERSITY OF VIRGINIA MEDICAL CENTER
Long Term Acute Care Hospital Free Cash Flow Projections
Revenue and Cost Assumptions Results-No NWC Recovery Results-NWC Recovery
Number of Beds 50 NPV $5,687 NPV $10,425 (000 ommited)
Year 1 Utilization 26% IRR 17.6% IRR 21.2%
Year 2 Utilization 60%
Annual Increase in Utilization 4%
Operating Expense (% of Revenue) 7.0%
K-wacc 10.0%
Year 1 2 3 4 5 6 7 8 9 10
VOLUME
Patient Day Capacity 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250 18,250
Utilization 26% 60% 62% 65% 67% 70% 73% 76% 79% 82%
Patient Days Used 4,745 10,950 11,388 11,844 12,317 12,810 13,322 13,855 14,409 14,986
Average Patient Census per Day 13 30 31 32 34 35 36 38 39 41
Average Length of Stay 30 27 27 27 27 27 27 27 27 27
Number of Patients per Year 158 406 422 439 456 474 493 513 534 555
Full-Time Employees/Census 4.8 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5
Full-Time Employees 62 105 109 114 118 123 128 133 138 144
INSURANCE PAYER Patient Mix
Medicare 36% 57 146 152 158 164 171 178 185 192 200
Medicaid 29% 46 118 122 127 132 138 143 149 155 161
Commercial Payers 24% 38 97 101 105 109 114 118 123 128 133
Other 9% 14 37 38 39 41 43 44 46 48 50
Indigent 2% 3 8 8 9 9 9 10 10 11 11
158 406 422 439 456 474 493 513 534 555
Billing Annual Incr
Medicare—bill per patient $27,795 0.0% 1,583 4,058 4,220 4,389 4,565 4,747 4,937 5,135 5,340 5,554
Medicaid—bill per patient $35,000 1.3% 1,605 4,170 4,337 4,510 4,691 4,878 5,073 5,276 5,487 5,707
Commercial Payers—bill per day $2,800 5.0% 3,189 7,726 8,035 8,357 8,691 9,039 9,400 9,776 10,167 10,574
Other—bill per patient $38,500 1.3% 548 1,424 1,480 1,540 1,601 1,665 1,732 1,801 1,873 1,948
Indigent—bill per patient $35,000 1.3% 111 288 299 311 323 336 350 364 378 394
Total Revenue (000 omitted) 7,035 17,665 18,372 19,107 19,871 20,666 21,493 22,352 23,246 24,176
Less Uncollectable 1% 70 177 184 191 199 207 215 224 232 242
Total Net Revenue (000 omitted) 6,965 17,489 18,188 18,916 19,672 20,459 21,278 22,129 23,014 23,935
EXPENSES Annual Incr
Salary, Wage, Benefits (based on $ per employee) $60,250 3% 3,760 6,516 6,980 7,477 8,009 8,580 9,190 9,845 10,546 11,297
Supplies, Drugs, Food (% net revenue) 16.3% 1,135 2,851 2,965 3,083 3,207 3,335 3,468 3,607 3,751 3,901
Management Fees (% net rev) 8% 557 1,399 1,455 1,513 1,574 1,637 1,702 1,770 1,841 1,915
Operating Expenses (fixed + 7 % net rev) $1,200,000 NA 1,688 2,424 2,473 2,524 2,577 2,632 2,689 2,749 2,811 2,875
Land Lease per year $200,000 3% 200 206 212 219 225 232 239 246 253 261
Depreciation (straight line 30yrs) $15,000,000 500 500 500 500 500 500 500 500 500 500
Total Expenses (000 omitted) 7,840 13,896 14,585 15,316 16,092 16,915 17,789 18,717 19,702 20,749
Total Expenses 7,840 13,896 14,585 15,316 16,092 16,915 17,789 18,717 19,702 20,749
Operating Profit (804) 3,769 3,787 3,791 3,779 3,751 3,703 3,635 3,544 3,427
Operating Margin -11.4% 21.3% 20.6% 19.8% 19.0% 18.1% 17.2% 16.3% 15.2% 14.2%
Net Working Capital Notes:
Accounts Receivable 30 days 572 1,437 1,495 1,555 1,617 1,682 1,749 1,819 1,892 1,967
Inventory Supplies, Drugs, Food 60 days 187 469 487 507 527 548 570 593 617 641
Accounts Payable 30 days 93 234 244 253 264 274 285 296 308 321
Net Working Capital 666 1,672 1,739 1,808 1,880 1,956 2,034 2,115 2,200 2,288
Change in NWC 666 1,006 67 70 72 75 78 81 85 88
Free Cash Flows Calculation
Operating Profit (804) 3,769 3,787 3,791 3,779 3,751 3,703 3,635 3,544 3,427
Add Depreciation 500 500 500 500 500 500 500 500 500 500
Less Capital Expenditures (7,500) (7,500) 0 0 0 0 0 0 0 0 0
Less Increase in Net Working Capital (666) (1,006) (67) (70) (72) (75) (78) (81) (85) (88)
Free Cash Flows (000 omitted) (7,500) (8,470) 3,263 4,220 4,221 4,207 4,176 4,125 4,054 3,959 3,839
NPV (no recovery in year 10) $5,687 (000 ommited)
IRR (no recovery in year 10) 17.6%
Year 1 2 3 4 5 6 7 8 9 10
NWC Recovery 0 0 0 0 0 0 0 0 0 $2,288
Sale of Facility at Book Value 0 0 0 0 0 0 0 0 0 $10,000
NPV with Year 10 Recovery $10,425 (000 ommited) (7,500) (8,470) 3,263 4,220 4,221 4,207 4,176 4,125 4,054 3,959 16,127
IRR with Year 10 Recovery 21.2%
Net Profit (Operating Profit - Interest) (000 ommited) (2,004) 2,569 2,587 2,591 2,579 2,551 2,503 2,435 2,344 2,227
Net Profit/Net Revenue -28.8% 14.7% 14.2% 13.7% 13.1% 12.5% 11.8% 11.0% 10.2% 9.3%
Q3a The analysis above is identical to the one on the Q1 tab.
Do a sensitivity analysis by systematically changing certain assumptions in the spreadsheet above:
1 change the K-wacc to 8.3%
2 change year 2 utilization to 45%
3 change commercial payers to 30% of patient mix
Use the answer box to prepare a summary of the original (Q1) results
and the revised (Q3) results, i.e., a summary table.
Q3b Revise the decision you made in Q1 based on the above sensitivity analysis, comparing Mulroney's
assumptions and the sensitivity analysis assumptions to expectations stated in the case.
Be sure to consider both 'hard quantitative data" from decision metrics and 'soft qualitative information'
from the case.