| Palms Hospital| Memo To: From: CC: Date: Re:Ambulatory Surgical Center Executive Summary The Palms Hospital is considering an expansion project that would utilize land previously purchased. By expanding into ambulatory surgical services, the hospital has the opportunity to increase revenues and capture market share in this area. Investigation in the NPV of the project and a scenario analysis reveal that the project would be profitable. Debt Financing This project will most likely involve debt financing. This means that interest expense would occur and should be taken into account in the analysis of the project.
Interest expense is a cash expense and is automatically included when the net cash flows are adjusted for the time value of money. If you added interest expense into the cash flows outlays, it would get counted twice. Interest expense affects the amount of income taxes; it must be used in calculating income tax expense before subtracting it from cash flow outlay. Thus, interest expense would be accounted for by the cost of capital since the interest expense would be a cost associated with borrowing money for the project. The 10% cost of capital includes the cost of debt financing. What to do with the LandOrder now
The $150,000 that the hospital paid for the land five years ago should be considered a sunk cost because it is a cash outlay that already occurred. Since it has been irrevocably committed, it is an outlay that is unaffected by the current decision to accept or reject the proposed ambulatory surgery center. It is a non-incremental cash flow that is not relevant to the analysis. However, now that the land is valued by the market at $200,000, it is an opportunity cost of accepting this project. If the hospital uses the land for the project, it cannot sell the land and therefore $200,000 is foregone.
Additionally, if the hospital uses the land for the surgical center, it cannot be used for another project. The value of the land should not be disregarded as there is an opportunity cost inherent in the use of the property. For Palms Hospital, the opportunity cost is the cash flow that could be realized from selling the property. Thus, the ambulatory surgical center should have an opportunity cost of $200,000 charged against it. Overhead Costs The overhead costs that should be included are incremental overhead costs for the hospital associated with the new surgical center.
In this case, it states that the hospital’s cash overhead costs will increase by $36,000 annually. Thus, this would be the amount of overhead cost to be included. The case does say that an additional $25,000 would be allocated, but this is a re-distribution of administrative overhead costs and not an incremental addition. Therefore, it should not be included in the project analysis since it is not increasing the hospital’s overall overhead costs. Inpatient Surgery Cannibalization The effect of the surgical center project will have on other business projects should be considered.
When the effect is negative, it is called cannibalization, because the project is expected to reduce other revenue sources within the business. The chief of medicine reported that the surgical center would negative impact up to $1,000,000 in cash revenues annually as patients used the new surgical center instead of other services offered by the hospital. This means that the incremental revenues from the new surgical center are the revenues attributable to the new center, less the revenues lost from forgone surgery services.
However, expenses should also be considered. The costs saved due to the reduction in patient volume of other surgical services would be a benefit of having the new surgical center. Hence, these cost savings should be considered in the analysis. However, if it is believed that surgical patients would be lost to another entity entering the local ambulatory surgery market, then the loss of these patients would not affect the new surgical project at all because these losses would occur regardless of the project being accepted. Sensitivity Analysis
Sensitivity analysis, a risk assessment tool, indicates exactly how much a project’s profitability will change in response to a given change in a single input variable, with all other input variables held constant. Sensitivity analysis can explain the impact of volume and salvage value fluctuations. It provides an understanding for which of the variables will have the greatest impact on the project’s profitability – the larger the NPV change for a given percentage input change, the greater the impact. It provides valuable information in two main ways.
It provides some breakeven information about the project’s uncertain variables. Secondly, it helps identify input variables that are most critical to the project’s profitability and the project’s financial success. Sensitivity analysis begins with the base case (or for this analysis, the “most likely case”) developed using expected values for all uncertain variables. The uncertain variables used in this analysis are procedures per day, average net revenue, and building/equipment salvage value. Procedures Per Day Procedures Per Day| Number| NPV| NPV Change| IRR| IRR Change| 0| $ (3,928,100)| $480,312 | -4. 1%| | 15| $ (1,526,540)| $2,401,560 | 4. 7%| 8. 8%| 20| $ 875,020 | $2,401,560 | 12. 9%| 8. 2%| 25| $ 3,276,580 | $2,401,560 | 20. 7%| 7. 8%| 30| $ 5,678,140 | $2,401,560 | 28. 1%| 7. 4%| This sensitivity analysis shows that the NPV increases $480,312 per procedure. This means that the projects value is very dependent on the number of procedures completed. The success of the ambulatory surgical center will be greatly impacted by the entry of another surgical center in the area.
Average Net Revenue Per Procedure Revenue Per Procedure| Revenue| NPV| NPV Change| IRR| IRR Change| $ 600. 00 | $ (3,928,100)| $12,008 | -4. 1%| | $ 700. 00 | $ (2,727,320)| $1,200,780 | 0. 4%| 4. 5%| $ 800. 00 | $ (1,526,540)| $1,200,780 | 4. 7%| 4. 3%| $ 900. 00 | $ (325,760)| $1,200,780 | 8. 9%| 4. 2%| $ 1,000. 00 | $ 875,020 | $1,200,780 | 12. 9%| 4. 0%| $ 1,100. 00 | $ 2,075,800 | $1,200,780 | 16. 8%| 3. 9%| $ 1,200. 00 | $ 3,276,580 | $1,200,780 | 20. %| 3. 9%| $ 1,300. 00 | $ 4,477,360 | $1,200,780 | 24. 4%| 3. 7%| $ 1,400. 00 | $ 5,678,140 | $1,200,780 | 28. 1%| 3. 7%| The NPV increases $12,008 per dollar in revenue per procedure. For each $100 increase in revenue, the NPV will increase $1,200,780, so the value of the project will be greatly affected by the amount in revenues obtained by each procedure. Estimated Salvage Value Estimated Salvage Value| Actual Value| NPV| NPV Change| IRR| IRR Change| $ 3,000,000 | $ 129,914 | $0. 37 | 10. %| | $ 4,000,000 | $ 502,467 | $372,553 | 11. 7%| 1. 2%| $ 5,000,000 | $ 875,020 | $372,553 | 12. 9%| 1. 2%| $ 6,000,000 | $ 1,247,573 | $372,553 | 14. 1%| 1. 2%| $ 7,000,000 | $ 1,620,125 | $372,553 | 15. 1%| 1. 0%| $ 8,000,000 | $ 1,992,678 | $372,553 | 16. 2%| 1. 1%| For each $1,000,000 increase in the salvage value of the building and equipment, the NPV will increase by $372,553. The sensitivity analysis revealed that there are larger increases in IRR with changes in the number of procedures.
It appears that the average net revenue is the next best influence on NPV and the estimate salvage value is the least sensitive to the NPV of the project. Therefore, Palms Hospital should pay particular attention to the number of procedures that it assumes can be completed. Project Payback, IRR, and NPV Project Payback Period measures time breakeven. Payback is defined as the expected number of years required to recover the investment in the project. The best way to determine the project’s payback is to construct the project’s cumulative cash flows. Payback has been used as a financial evaluation tool in project analyses.
However, payback has two serious deficiencies when it is used as a project selection criterion. First, payback ignores all cash flows that occur after the payback period. Second, payback ignores the opportunity costs associated with the capital employed. For these reasons it shouldn’t be used as the primary evaluation tool. However, the payback period can be useful in capital investment analysis. The shorter the payback, the more quickly the funds invested in a project become available for redeployment with the organization, and hence the more liquid the project.
Also cash flows expected in the distant future are generally more difficult to forecast than near-term cash flows, so shorter payback projects are generally less risky than those with longer paybacks. Therefore, payback is often used as a rough measure of a project’s liquidity and risk. For Palms Hospital, the payback period is the quickest with best case, followed by the most likely case, then the worst case. Net Present Value, NPV, is a profitability measure that uses the discounted cash flow technique.
An NPV of zero signifies that the project’s cash inflows are just sufficient to return the capital invested in the project and provide the required rate of return on that invested capital. If the NPV is positive, then it is generating excess cash flows, and these excess cash flows are available to management to reinvest in the firm. If a project has a negative NPV, its cash inflows will not ever recover the invested capital, so the project is unprofitable and acceptance would cause the financial condition of the business to deteriorate.
For Palms Hospital, the NPV is the highest with best case, followed by the most likely case, then the worst case. Internal Rate of Return, IRR, is another profitability measure that yields the project’s profitability or expected rate of return as opposed to the project’s dollar profitability given by NPV. IRR is the discount rate that equates the present value of the project’s expected cash inflows to the present value of the project’s expected cash outflows. If the IRR exceeds the project’s cost of capital, a surplus remains after recovering the invested capital and paying for its use, and this surplus accrues.
Reversely, if the IRR is less than the project cost of capital, then taking the project impose a cost on the organization. To have a positive NPV, the project’s IRR must be greater than its cost of capital, and a negative NPV signifies a project with an IRR less than its cost of capital. For Palms Hospital, the IRR is the highest with best case, followed by the most likely case, then the worst case. Projects that are deemed profitable by the NPV method will also be deemed profitable by the IRR method. Therefore, NPV and IRR are perfect substitutes for one another in estimating whether a project is profitable or not.
In general, academics prefer the NPV profitability measure. This preference stems from two factors: NPV measures profitability in dollars, which is a direct measure of the contribution of the project to the value of the business, and both the NPV and IRR, because they are discounted cash flow techniques require an assumption about the rate at which project cash flows can be reinvested, and the NPV method has the better assumption – reinvestment at the cost of capital is a better assumption than reinvestment at the IRR rate, so NPV is a theoretically better measure of profitability than IRR.
The returns from capital reinvested within the firm are more likely to be around the cost of capital than at the project’s IRR. Typically, an organization can obtain outside capital at a cost roughly equal to the cost of capital so cash flows generated by a project could be replaced by capital having this cost. This was also seen in the case with Palms Hospital and the ambulatory surgical center. Recommendation Upon analyzing the NPV, it is recommended to proceed with the project. The IRR and payback period also reveal the potential profitability of the project.
A scenario analysis revealed that the NPV of the project is greatly dependent on the number of procedures performed by the surgical center. The Palms Hospital should ensure that appropriate assumptions were made as to how many procedures could be performed. If competitors are expected to enter, then the hospital should re-evaluate the number of procedure that could be performed and try to capture the bulk of the market. Management needs to be sure that bias hasn’t entered the analysis and overstated the forecasted number of procedures because this would exaggerate the profitability of the project.