Coral Bay Hospital is a 250-bed, investor-owned hospital located in Islamorada, Florida, which is known as the “The Sport Fishing Capital of the World.” 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 Keys have experienced a population explosion, which has fostered high economic growth as well as a continuing need for more healthcare services. Today, under a succession of excellent CEOs, the hospital is acknowledged to be one of the leading healthcare providers in the area. The hospital’s management is currently evaluating a proposed ambulatory (outpatient) surgery center. (For more information on ambulatory surgery, see the Ambulatory Surgery Center Association website at www.ascassociation.org.) More than 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 to complete: minor procedures take about one hour or less, and major procedures typically take two or more hours. About 60 percent of the procedures are performed under general anesthesia, 30 per- cent 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 at stand-alone outpatient centers, and by 2009, the number had grown to more than 20 million. This growth has been fueled primarily by three factors. First, rapid advancements in technology have enabled many procedures that were historically performed in inpatient surgical suites to be offered at outpatient settings. This shift was caused mainly by advances in laser, laparoscopic, endoscopic, and arthroscopic technologies. Second, Medicare has been aggressive in approving new minimally invasive surgery techniques, so the number of Medicare patients utilizing out- patient surgery services has grown substantially. Third, patients prefer outpatient surgeries because they are more convenient, and third-party payers prefer them because they are less costly. Because of these factors, the number of inpatient surgeries has remained more or less flat over the past 20 years, while the number of outpatient procedures has continuously grown more than 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 5,000, so competition in many areas has become intense. Somewhat surprisingly, there is no outpatient surgery center in the hospital’s immediate service area, although there have been rumors that local surgeons are exploring the feasibility of a physician-owned facility. Coral Bay Hospital currently owns a parcel of land adjacent to its facility that is a perfect location for the surgery center. The Hospital bought the land five years ago for $150,000 and last year 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, 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 surgery center building, which would house four operating suites, would cost $5 million, and the equipment would cost an additional $5 million, for a total of $10 million. For ease, assume that both the building and the equipment fall into the MACRS (modified accelerated cost recovery system) 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 the hospital 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, the hospital 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 surgery 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 patient revenue amount to $1,000. The center would be open five days a week, 50 weeks a year, for a total of 250 days a year. As detailed in Exhibit 20.1, labor costs to run the surgery center are estimated at $918,000 per year, including fringe benefits. Utilities, including hazardous waste disposal, would add another $50,000 in annual costs. If the surgery center were built, the hospital’s cash overhead costs would increase by $36,000 annually, primarily for housekeeping and buildings and grounds maintenance. In addition, the center would be allocated $25,000 of the hospital’s current $2.8 million in administrative overhead costs. On average, each procedure would require $200 in expendable medical supplies, including anesthetics. Although the hospital’s inventories and receivables would rise slightly if the center is constructed, its accruals and payables would 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, the hospital 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 the presentation of 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. The board does not want a repeat of that occurrence. One of the directors stated that she thought the hospital was putting too much faith in the numbers. “After all,” she pointed out, “that is what got us into trouble on the day care center. We need to start worrying more about how projects fit into our strategic vision and how they affect the services we currently offer.” Another director, who also is 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, who reported that an outpatient surgery center could siphon off up to $1 million in cash revenues annually. When pressed, the department head estimated 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/ equipment salvage value. If another entity enters the local ambulatory surgery market, the number of procedures could be as low as ten per day. 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 most likely value of 20 per day. The expected average net patient revenue of $1,000 is a function of the types of procedures performed and the amount of managed care penetration. If surgery severity were high (i.e., if a higher number of complicated procedures than anticipated were performed) and managed care penetration remained low, then the average revenue could be as high as $1,200. Conversely, if the severity were lower than expected and managed care penetration increases, the average revenue could be as low as $800. Finally, if real estate and medical equipment values stay strong, the building/equipment salvage value could be as high as $6 million, but if the market weakens, the salvage value could be as low as $4 million, compared to an expected value of $5 million. Jules also discussed the probabilities of the various scenarios with the medical and marketing staffs, but after considerable debate no consensus could be reached. To add to the confusion, one member of the medical staff, who had just returned from a University of Michigan executive program on financial management, questioned why the scenario analysis had to be confined to just three scenarios. “Why not five or seven?” he queried. Additionally, the current cost of capital includes an expected inflation estimate of 2 percent that will be used to make a decision today, but future inflation is uncertain and could affect cash flows in the future. Jules said that a good way to assess the impact of uncertain, future inflation on project profitability is to create a table such as the one shown in Exhibit 20.2. To help with the risk incorporation phase of the analysis, Jules consulted with Mark Hauser, the hospital’s chief financial officer, about both the risk inherent in the hospital’s average project and how the hospital typically adjusts for risk. Mark told 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 in the range of 1.0 to 2.0 and that the hospital typically adds or subtracts 4 percentage points to its 10 percent corporate cost of capital to adjust for differential project risk. Assume that Coral Bay 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. Exhibit 20.1: Coral Bay Hospital: Projected Surgery Center Staffing Requirements Position Annual Salary FTEs Total Salary Executive director $60,000 1 $60,000 Director of nursing 50,000 1 50,000 Accounting clerk 35,000 1 35,000 Collections clerk 30,000 1 30,000 Scheduling clerk 25,000 1 25,000 Registered nurses 60,000 8 480,000 Nursing assistants 30,000 2 60,000 Transcriptionist 25,000 1 25,000 Total $765,000 Plus 20% fringe-benefit allowance 153,000 Total salaries and benefits $918,000 FTE: full-time equivalent Exhibit 20.2: Impact of Uncertain Future Inflation on NPV Proposed Ambulatory Surgery Center Level of Net Patient Revenue Inflation 0% 1% 2% 3% 4% 5% 6% 0% NPV NPV NPV NPV NPV NPV NPV 1% NPV NPV NPV NPV NPV NPV NPV 2% NPV NPV NPV NPV NPV NPV NPV 3% NPV NPV NPV NPV NPV NPV NPV 4% NPV NPV NPV NPV NPV NPV NPV 5% NPV NPV NPV NPV NPV NPV NPV 6% NPV NPV NPV NPV NPV NPV NPV (Level of Cost Inflation is vertical on the table; NPV: net present value) Questions: A) What are the NPV, IRR, and MIRR, and payback of the proposed ambulatory surgery center? Do the measures indicate acceptance or rejection of the proposed ambulatory surgery center? B) Inflation is one of the most difficult factors to deal with in project analysis. B1) Complete the inflation impact table shown in Exhibit 20.2 B2) What management information is provided by the inflation impact table? C) One board member wants to make sure that a complete risk analysis, including sentitivity and scenario analyses, is performed before the proposal is sent to the board. C1) Performa sensitivity analysis. C2) What management information is provided by the sensitivity analysis? D1) Perform a scenario analysis. D2) What management information is provided by the scenario analysis? D3) Why is the expected NPV obtained in the scenario analysis different from the base case NPV? E) A board member is interested in the utilization breakeven of the Center. E1) What are the breakeven values of the three input variables that are highly uncertain? E2) What management information is provided by the breakeven analysis? F) To help with the risk-incorporation phase of the analysis, Jules consulted with Mark Hauser, the hospital's CFO, about both the risk inherent in the hospital's average project and how the hospital typically adjusts for risk. F1) What is the project's differential risk-adjusted NPV? F2) Assess the corporate risk of the project. (No calculations are required. Think about correlation of the surgery center and hospital cash flows.) G) Jules Bergman is aware that there are some qualitative factors that are relevant to the surgery center decision. G1) What qualitative factors might support project acceptance? G2) What qualitative factors might preclude project acceptance? G3) Can you think of any costs that might be associated with the project that have not been included in the analysis? G4) Are there any potential benefits that have not been included? G5) What additional data would you seek from other hospital staff members to conduct a more thorough analysis? H) Considering all points, would you build the ambulatory surgery center?