# Finance in healthcare

# Finance in healthcare

Finance in healthcare: 14.3 Capitol Healthplans, 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 effected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows. Here are the projected flows:

Year Method A Method B0 ($300,000) ($120,000)1 (66,000) (96,000)2 (66,000) (96,000)3 (66,000) (96,000)4 (66,000) (96,000)5 (66,000) (96,000)

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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?

14.4 Great Lakes Clinic has been asked to provide exclusive healthcare services for next year’s World Exposition. Although flattered by the request, the clinic’s managers want to conduct a financial analysis of the project. There will be an up-front cost of $160,000 to get the clinic in operation. Then, a net cash inflow of $1 million is expected from operations in each of the two years of the Exposition. However, the clinic has to pay the organizers of the exposition a fee for the marketing value of the opportunity. This fee, which must be paid at the end of the second year, is $2 million.a. What are the cash flows associated with the project?b. What is the project’s IRR?c. Assuming a project cost of capital of 10 percent, what is the project’s NPV?

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14.5 Assume that you are the chief financial officer at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capitalinvestment’s 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:Year Project X Project Y0 ($10,000) ($10,000)1 6,500 3,0002 3,000 3,0003 3,000 3,0004 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.

14.6 The director of capital budgeting for Big Sky Health Systems, Inc.,has estimated the following cash flows in thousands of dollars for a proposed new service:Year Expected Net Cash Flow0 ($100)1 702 503 20The project’s cost of capital is 10 percent.a. What is the project’s payback period?b. What is the project’s NPV?c. What is the project’s IRR?

15.1 The managers of Merton Medical Clinic are analyzing a proposed project. The project’s most likely NPV is $120,000, but, as evidenced by the following NPV distribution, there is considerable risk involved:

Probability NPV0.05 ($700,000)0.20 (250,000)0.50 120,0000.20 200,0000.05 300,000

a. What are the project’s expected NPV and standard deviation of NPV?b. Should the base case analysis use the most likely NPV or expected NPV? Explain your answer.

15.2 Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and probabilities:Year Prob = 0.2 Prob = 0.6 Prob = 0.20 ($100,000) ($100,000 ($100,000)1 20,000 30,000 40,0002 20,000 30,000 40,0003 20,000 30,000 40,0004 20,000 30,000 40,0005 30,000 40,000 50,000

The Year 5 values include salvage value. Heywood’s corporate cost of capital is 10 percent.a. What is the project’s expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.)b. What are the project’s most likely, worst, and best case NPVs?c. What is the projec’s expected NPV on the basis of the scenario analysis?d. What is the project’s standard deviation of NPV?e. Assume that Heywood’s managers judge the project to have lower-than-average risk. Furthermore, the company’s policy is toadjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive?

15.3 Consider the project contained in Problem 14.7 in Chapter 14.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.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:Number of Average Equipment Scenario Probability Procedures Collection Salvage ValueWorst 0.25 10 $ 60 $100,000Most likely 0.50 15 80 200,000Best 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?

15.4 The managers of United Medtronics are evaluating the following four projects for the coming budget period. The firms corporate cost of capital is 14 percent.Project Cost IRRA $15,000 17%B 15,000 16C 12,000 15D 20,000 13

a. What is the firms optimal capital budget?b. Now, suppose Medtronics managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm’s optimal capital budget when differential risk is considered? (Hint: The firm’s managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)

16.1 On a typical day, Park Place Clinic writes $1,000 in checks. It generally takes four days for those checks to clear. Each day the clinic typically receives $1,000 in checks that take three days to clear. What is the clinic’s average net float?

16.2 Drugs R Us operates a mail order pharmaceutical business on the WestCoast. The firm receives an average of $325,000 in payments per day.On average, it takes four days for the firm to receive payment, from the time customers mail their checks to the time the firm receives and processes them. A lockbox system that consists of ten local depository banks and a concentration bank in San Francisco would cost $6,500 per month. Under this system, customer’s checks would be received at the lockbox locations one day after they are mailed, and the daily total would be wired to the concentration bank at a cost of $9.75 each.Assume that the firm could earn 10 percent on marketable securities and that there are 260 working days and hence 260 transfers from eachlockbox location per year.a. What is the total annual cost of operating the lockbox system?b. What is the dollar benefit of the system to Drugs R Us?c. Should the firm initiate the lockbox system?

16.4 Langley Clinics, Inc., buys $400,000 in medical supplies a year (at gross prices) from its major supplier, Consolidated Services, which offers Langley terms of 2.5/10, net 45. Currently, Langley is paying the supplier the full amount due on Day 45, but it is considering taking the discount, paying on Day 10, and replacing the trade credit with a bank loan that has a 10 percent annual cost.a. What is the amount of free trade credit that Langley obtains from Consolidated Services? (Assume 360 days per year throughout this problem.)b. What is the amount of costly trade credit?c. What is the approximate annual cost of the costly trade credit?d. Should Langley replace its trade credit with the bank loan? Explain your answer.e. If the bank loan is used, how much of the trade credit should be replaced?

16.5 Milwaukee Surgical Supplies, Inc., sells on terms of 3/10, net 30.Gross sales for the year are $1,200,000 and the collections department estimates that 30 percent of the customers pay on the tenth day and take discounts, 40 percent pay on the thirtieth day, and the remaining 30 percent pay, on average, 40 days after the purchase. (Assume 360days per year.)a. What is the firms average collection period?b. What is the firms current receivables balance?c. What would be the firms new receivables balance if Milwaukee Surgical toughened up on its collection policy, with the result that all non discount customers paid on the 30th day?d. Suppose that the firms cost of carrying receivables was 8 percent annually. How much would the toughened credit policy save the firm in annual receivables carrying expense? (Assume that the entire amount of receivables had to be financed.)

17.1 a. Modern Medical Devices has a current ratio of 0.5. Which of the following actions would improve (i.e., increase) this ratio?Use cash to pay off current liabilities.Collect some of the current accounts receivable.Use cash to pay off some long-term debt.Purchase additional inventory on credit (i.e., accounts payable).Sell some of the existing inventory at cost.b. Assume that the company has a current ratio of 1.2. Now, which of the above actions would improve this ratio?

17.4 Consider the following financial statements for BestCare HMO, a not-for-profit managed care plan: BestCare HMOStatement of Operations and Change in Net AssetsYear Ended June 30, 2004 (in thousands)Revenue:Premiums earned $26,682Co-insurance 1,689Interest and other income 242Total revenue $28,613Expenses:Salaries and benefits $15,154Medical supplies and drugs 7,507Insurance 3,963Provision for bad debts 19Depreciation 367Interest 385Total expenses $27,395Net income $ 1,218

Net assets, beginning of year $ 900Net assets, end of year $ 2,118BestCare HMOBalance SheetJune 30, 2004(in thousands)

AssetsCash and cash equivalents $ 2,737Net premiums receivable 821Supplies 387Total current assets $ 3,945Net property and equipment $ 5,924Total assets $ 9,869

Liabilities and Net AssetsAccounts payable medical services $ 2,145Accrued expenses 929Notes payable 141Current portion of long-term debt 241Total current liabilities $ 3,456Long-term debt $ 4,295Total liabilities $ 7,751Net assets (equity) $ 2,118

Total liabilities and net assets $ 9,869

a. Perform a Du Pont analysis on BestCare. Assume that the industry average ratios are as follows:Total margin 3.8%Total asset turnover 2.1Equity multiplier 3.2Return on equity (ROE) 25.5%b. Calculate and interpret the following ratios for BestCare:Industry AverageReturn on assets (ROA) 8.0%Current ratio 1.3Days cash on hand 41daysAverage collection period 7daysDebt ratio 69%Debt-to-equity ratio 2.2Times interest earned (TIE) ratio 2.8Fixed asset turnover ratio 5.2

17.5 Consider the following financial statements for Green Valley Nursing Home, Inc., a for-profit, long-term care facility:

Green Valley Nursing Home, Inc.Statement of Income and Retained EarningsYear Ended December 31, 2004

Revenue:Net patient service revenue $ 3,163,258Other revenue 106,146Total revenues $ 3,269,404Expenses:Salaries and benefits $ 1,515,438Medical supplies and drugs 966,781Insurance and other 296,357Provision for bad debts 110,000Depreciation 85,000Interest 206,780Total expenses $ 3,180,356Operating income $ 89,048Provision for income taxes 31,167

Net income $ 57,881

Retained earnings, beginning of year $ 199,961

Retained earnings, end of year $ 257,842

Green Valley Nursing Home, Inc.Balance SheetDecember 31, 2004

AssetsCurrent Assets:Cash $ 105,737Marketable securities 200,000Net patient accounts receivable 215,600Supplies 87,655Total current assets $ 608,992Property and equipment $ 2,250,000Less accumulated depreciation 356,000Net property and equipment $ 1,894,000

Total assets $ 2,502,992

Liabilities and Shareholder’s EquityCurrent Liabilities:Accounts payable $ 72,250Accrued expenses 192,900Notes payable 100,000Current portion of long-term debt 80,000Total current liabilities $ 445,150Long-term debt $ 1,700,000Shareholder’s Equity:Common stock, $10 par value $ 100,000Retained earnings 257,842Total shareholder’s equity $ 357,842

Total liabilities and shareholder’s equity $ 2,502,992

a. Perform a Du Pont analysis on Green Valley. Assume that the industry average ratios are as follows:Total margin 3.5%Total asset turnover 1.5Equity multiplier 2.5Return on equity (ROE) 13.1%

b. Calculate and interpret the following ratios:Industry Average Return on assets (ROA) 5.2% Current ratio 2.0 Days cash on hand 22 daysAverage collection period 19 daysDebt ratio 71 %Debt-to-equity ratio 2.5Times interest earned (TIE) ratio 2.6Fixed asset turnover ratio 1.4

c. Assume that there are 10,000 shares of Green Valley’s stock outstanding and that some recently sold for $45 per share.What is the numbers price/earnings ratio?What is its market/book ratio?

18.1 Suncoast Healthcare is planning to acquire a new x-ray machine that costs $200,000. The business can either lease the machine using an operating lease or buy it using a loan from a local bank. Suncoast’s balance sheet prior to acquiring the machine is as follows:Current assets $ 100,000 Debt $ 400,000Net fixed assets 900,000 Equity 600,000Total assets $1,000,000 Total claims $1,000,000a. What is Suncoast’s current debt ratio?b. What would the new debt ratio be if the machine were leased? If it is purchased?c. Is the financial risk of the business different under the two acquisition alternatives?

18.2 Big Sky Hospital plans to obtain a new MRI that costs $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI or it can lease the equipment. Assume that the following facts apply to the decision:By The MRI falls into the three-year class for tax depreciation, so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively.Estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.Big Sky’s marginal tax rate is 40 percent.The bank loan would have an interest rate of 15 percent.If leased, the lease (rental) payments would be $400,000 payable at the end of each of the next four years.The estimated residual (and salvage) value is $250,000.a. What are the NAL and IRR of the lease? Interpret each value.b. Assume now that the salvage value estimate is $300,000, but all other facts remain the same. What is the new NAL? The new IRR?

18.3 HealthPlan Northwest must install a new $1 million computer to track patient records in its three service areas. It plans to use the computer for only three years, at which time a brand new system will be acquired that will handle both billing and patient records. The company can obtain a 10 percent bank loan to buy the computer or it can lease the computer for three years. Assume that the following facts apply to the decision:The computer falls into the three-year class for tax depreciation,so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years1 through 4, respectively.The company’s marginal tax rate is 34 percent.Tentative lease terms call for payments of $320,000 at the end of each year.The best estimate for the value of the computer after three years of wear and tear is $200,000.a. What are the NAL and IRR of the lease? Interpret each value.b. Assume now that the bank loan would cost 15 percent, but all other facts remain the same. What is the new NAL? The new IRR?

18.4 Assume that you have been asked to place a value on the ownership position in Briarwood Hospital. Its projected profit and loss statements and equity reinvestment (asset) requirements are shown below (in millions):

2005 2006 2007 2008 2009Net revenues $225.0 $240.0 $250.0 $260.0 $275.0Cash expenses 200.0 205.0 210.0 215.0 225.0Depreciation 11.0 12.0 13.0 14.0 15.0Earnings before interest and taxes (EBIT) $ 14.0 $ 23.0 $ 27.0 $ 31.0 $ 35.0Interest 8.0 9.0 9.0 10.0 10.0Earnings before taxes (EBT) $ 6.0 $ 14.0 $ 18.0 $ 21.0 $ 25.0Taxes (40 percent) 2.4 5.6 7.2 8.4 10.0

Net profit $ 3.6 $ 8.4 $ 10.8 $ 12.6 $ 15.0

Asset requirements $ 6.0 $ 6.0 $ 6.0 $ 6.0 $ 6.0

Briarwood’s cost of equity is 16 percent. The best estimate for Briarwood’s long-term growth rate is 4 percent.a. What is the equity value of the hospital?b. Suppose that the expected long-term growth rate was 6 percent. What impact would this change have on the equity value of the business? What if the growth rate were only 2 percent?

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