BNFN 4304 – Financial Policy

Mr. Masood Aijazi

Case 28: University of Virginia Health System: The Long-Term Acute Care Hospital Project

Spring Semester 2017 – 2018

Authored By

Maryam Barifah 1420023

Nour Abdulaziz 1420149

Shrouq Al-Jaaidi               1420072

Balqees Mekhlafi 1420231

 

 

 

Submission Date

15/04/2018

 

 

Case Assignment

UNIVERSITY OF VIRGINIA HEALTH SYSTEM:

THE LONG-TERM ACUTE CARE HOSPITAL PROJECT

Pages 381-390

 

Idea of the case

This case puts students in the shoes of Larry Fitzgerald, the vice president for business development and finance at the University of Virginia Health System (UVa Health System). Students must decide, based on cash flow analysis and nonfinancial factors, whether or not to propose a long-term acute care hospital (LTAC) project to the board of directors of the U.Va. Health System. The LTAC is a very promising undertaking from the perspective of providing better care for patients, but the financial drivers of the project have yet to be assessed.

 

The primary objective in this case is to portray the major differences in project analysis for nonprofit organizations compared to for-profit companies and to highlight the unique issues relevant in a health care environment.

 

 

Questions

 

1. What are the nonfinancial drivers for adding an LTAC facility to the U.Va. Health System? What are potential reasons the board may not approve the project from a nonfinancial standpoint?

Hints: You can provide points from the case as to why the LTAC facility would be a good addition to the U.Va. Health System from the perspective of the hospital, the patient, and overall health care.

Students could suggest several reasons the board may not approve the project

2. What are the differences between nonprofit institutions and for-profit institutions? For example, how would a for-profit hospital approach the LTAC decision?

3. What is the average cost of capital of the for-profit hospitals provided in case Exhibit 3? Would this serve as a reasonable discount rate to analyze a set of for-profit LTAC facility cash flows? Should Fitzgerald use this number to discount the U.Va. LTAC facility’s cash flows?

Hints: Use a market risk premium (MRP) of 6% and the 10-year Treasury yield as the risk-free rate.

Use the data provided in Exhibit 4 page 390.

Determine the WACC in two cases: tax rate = 35% and tax rate = 0.

4. Using the information in the case and the memo from Karen Mulroney in case Exhibit 1, complete the cash flow projections in the spreadsheet provided. What do you get for the NPV and IRR of those cash flows?

5. What are the main drivers for NPV and IRR? Show the impact on NPV and IRR by changing a couple of these drivers to a “downside scenario” value.

Based on your financial analysis, should Fitzgerald propose the LTAC project in the board meeting.

 

 

Supporting Spreadsheet Data

 

The supporting Excel files are available for the convenience of students:

 

Q1. What are the nonfinancial drivers for adding an LTAC facility to the U.Va. Health System? What are potential reasons the board may not approve the project from a non-financial standpoint?

LTAC will benefit U.V.A in many areas such as; adding up to 25 beds per day for each transferred patient, boost money for patient care, work through matters that oppose many of the hospital systems, improve efficient patient turnover, addressing the bill insurance from both hospital stay and time spent in the LTAC. Moreover, it will be built within the U.Va On January 2007, the Centers of the Medicare and Medicaid services (CMS) halts the establishments of the facility. For them to build the facility they will need to have a loan of $15 million capital investment and the board want to acquire 5% profit margin.

Non-financial drivers for adding an LTAC:

-The LTAC hospitals are attractive financially as they increase revenues from patients who are taken care of by the system. Moreover, the hospital was paid insurance for patients staying regardless the time patients spent. This would allow the hospital to bill the insurance for both services of LTAC service and time spent in hospital. The addition of LTAC benefits the hospital in the reduction of expenses and capacity concerns.

– The hospital would be able to decrease the average expenses of a patient’s stay up to 50% from $3000 to $1500.

– adding an LTAC will increase capacity of beds in the rate of 25 beds per day due to the process of transferring the patients to the LTAC thus providing space for new admissions n the main hospital.

-LTAC patients are taken of more conscious way due to their circumstances; therefore they receive higher care and morale compared to a regular hospital. This allows a faster recovery period and reduced infection rate. Each patient has his own room that made them more comfortable at their stay. They became proverbial with their caregivers due to their long stay. This built a sense of comfort friendly environment. The personalized care made patients recover faster.

– This addition adds up to the objectives and goals of the hospital of providing highest quality health and continuum care. This is due to the higher quality care that would be offered compared to the service offered at a tradition al hospital.

Reasons for board disapproval:

–cost of the project: the cost would be the $15 million loan. it is vital to evaluate the hospital’s financial state via its bond rating to cover their financial commitments. This is due to the inverse relation between the ratings and cost of debt, as the lower the rating the higher the cost of debt. When it comes to valuating the project, the board’s main objective is to maintain the rating of AA. Moreover, retaining this credit rating allowed the hospital to maintain a low borrowing cost and to compete effectually for debt dollars in future.

–low utilization rate: it is expected for the LTAC facilities to have an increase in capacity to 26% in the upcoming year till the Medicare Certification is approved. Moreover, the usage of facility is essential for maintaining the hospital and for matching it with the costs of the project.

– Hospital’s reputation: in the case of the patient’s increased reside time for more than the 25 days, would concern and worry patients that the hospital may not extend their time. Therefore, the hospital’s reputation may be imperiled.

–Gross Profit Margin– the board wants to achieve a 5% profit margin within the star up of the project, and this may not reach it and thus they may not be able to cover their costs.

 

Question 2: What are the differences between nonprofit institutions and for-profit institutions? For example, how would a for-profit hospital approach the LTAC decision?

A nonprofit institution is more advantageous than the for-profit institution because they do not respond to shareholders as its objectives are focust on stakeholders’ interests and not the goals of its owners.

Difference between Non-profits and For-profits institutions:

Non-profits:

· The institutional culture is service-driven.

· There is no tax burden; however they should cover the borrowing cost.

· Requires a low margin while managing to meet the objectives of providing clinical care. They need to maintain the bond rating at the investment rate.

· Funded by the government, private sector, or corporations that have a CSR policy.

· Non-profit hospitals’ main priority is the heath and not the profits. This improves the society overall.

· They are less likely to generate profits from operations.

· Aims towards the overall well-being of the society by supporting the poor and unprivileged.

For-profits:

· The institutional culture is business-driven.

· There is property and income taxes. They must cover tax expenses and the equity cost of capital.

· Requires a pre-tax profit margin of 15% for a capital investment.

· As any other business, expansion and growth is a strategic objective.

· Their main intention is generating profits, which harms the society indirectly.

· The main purpose is to add value and generate a return for shareholders. They need to meet the investors’ expectations.

· Aims towards the highest quality of services and products to customers in the market, especially for niche members.

For-profit hospital approach to the LTAC Decision

Since the For-profit institutions’ main purpose is to generate profits, increase shareholder value and to increase the quality, the LTAC is a great opportunity as they would add more beds, increase the revenue, and decrease the costs associated with treatments. Moreover, the hospital would be able to increase the capacity of patients in rolled into the hospital. The critical cases would be transferred to the LTAC facility as a critical patient takes more than 25 days to recover while a normal patient takes an average of 5 days to recover. Thus, for-profit hospitals should approach the LTAC facility as that would add overall value to their organization. Furthermore, the LTAC has beneficial financial drivers. The hospital could charge the insurance company for their services; and if the patient is to be transferred to the LTAC, then they could bill for the special treatment provided to the patient during his stay.

 

In order to know how much profits the LTAC must earn to be accepted, we must have a positive NPV that is greater than zero. That would cover all the expenses, as well as give a sufficient ROE. NPV is calculated based on cost of capital upon which both the cost of debt and equity reflect. Other financials that would support the board of directors’ decision would be the projected cash flows, net present value, internal rate of return and the payback period. Through using the WACC, it has been indicated that the NPV is positive, and so the nonprofit entity should rest assured that the investment is creating value. Finally, if the investment meets the for-profit required return, it should easily meet all the financial requirements of a non-profit.

 

Q3. What is the average cost of capital of the for-profit hospitals provided in case Exhibit 3? Would this serve as a reasonable discount rate to analyze a set of for-profit LTAC facility cash flows? Should Fitzgerald use this number to discount the U.V.A. LTAC facility’s cash flows?

Hints: Use a market risk premium (MRP) of 6% and the 10-year Treasury yield as the risk-free rate.

Use the data provided in Exhibit 4 page 390.

Determine the WACC in two cases: tax rate = 35% and tax rate = 0.

 

The weighted average cost of capital (WACC) is defined as the cost of the individual sources of capital. The make-up of capital is usually comprised of the equity that shareholders have decided to invest in the company, with each source being proportionally weighted individually. By calculating the WACC shareholders or lenders would will be able to appropriately estimate the return that would be earned if and when they decide to invest in the company. So, the WACC (Weighted Average Cost of Capital) can also be defined as the minimum rate of return that investors will expect to get from their investment. It is the lowest rate of return that a firm will have to earn in order to achieve a breakeven point.

 

The data that will be provided in the excel sheet in Exhibit 3 shows that the cost of capital, and cost of debt were calculated in order to get the WACC for the for-profit hospitals. By viewing WACC sheet in the attached excel one can see the summary of the WACC calculations for each for-profit healthcare company.

The steps that will be used to calculate the WACC are shown in the excel sheet, but they are also listed below:

Steps for WACC calculation as seen in the excel sheet:

· The formula used is:

Weighted Average Cost of Capital (WACC)= Wd x Rd x (1-T) + We x Re

Where: Wd= weight of debt Rd= cost of debt We= weight of equity

Re= cost of equity T= tax rate

· To calculate the WACC the first step that needs to be taken is for us to calculate the percentage of debt (Wd) in the capital structure, this is done by using this formula: Debt/ (Debt + Market Capitalization).

· The percentage of equity (We) should also be taken into consideration this is done by subtracting the percentage of debt calculated in step 1 from 1 (1-Wd or % debt).

· Calculating the cost of debt (Rd) comes next, where the corporate bond yields from Exhibit 4 (US Treasuries and Corporate Bond Yields) were used for the A, B, and BB ratings.

· The cost of equity (Re) is calculated by using the CAPM (Capital Asset Pricing Model) formula: Rf + Beta * Rm, using the risk-free rate (Rf) as the 10-year Treasury Yield and a market risk premium (MRP, Rm) of 6% these numbers were taken from the excel sheet and from the hints above.

· The last calculation that needs to happen to determine the WACC from the above-mentioned formula is to see the effects on it using two different tax rates, tax=35% and tax=0%.

What is noticeable in the attached excel for the for-profit healthcare companies, the higher the rating of the bond, the lower the WACC is and vice versa. The lowest achieved WACC in a tax = 35% category is by HCA Inc. (6.97%), it carried a bond rating of A, a yield of 5.45% and a beta of 0.60. The highest achieved WACC when using the same tax rate is by Manor Care Company (8.42%) which had a BB rating, a 6.79% yield and a 0.80 beta. When using a tax rate of 0% to calculate WACC it will show the same results were achieved, with HCA Inc. with the lowest WACC (7.51%) and the highest WACC with Manor Care (8.93%), this shows that the most important factors when calculating the WACC are cost of debt, beta and tax bracket.

Cost of debt, one of the three components, is considered to be the most important. This is due to the increase in the shareholder’s concern, since the investors have a belief that the greater the amount of debt a company has, the greater the risk of a default. This will result in a greater return on investment expectation from investors. Beta is also considered to be an important component as it will measure the covariance between the rate of return of a particular company and the systematic risk (overall market return). Lastly, tax bracket also contributes to the WACC as that means that the lower the tax the greater the WACC and vice versa.

 

The WACC that are calculated in the excel sheet would be able to serve as a reasonable discount rate to analyze the for-profit LTAC facility cash flows. In addition, this rate can be used by Fitzgerald to discount the University of Virginia Hospital LTAC facilities’ cash flows even though they are both different in nature as UVA being a non-profit hospital. The WACC that should be the most appropriate to use is the average of all the for-profit healthcare companies, so the assumption will be that UVA will operate like a for-profit. So, for the valuation and forecasts purposes, the average WACC for a tax rate of 0% is 8.21%; the reason for this specific tax rate is since UVA is a non-profit they will not pay any taxes. When comparing UVA to different healthcare service providers, HCA Inc. will be considered to be the most comparable company since they have an A bond rating and University of Virginia Hospital has an AA bond rating.

 

Q4. Using the information in the case and the memo from Karen Mulroney in case Exhibit 1, complete the cash flow projections in the spreadsheet provided. What do you get for the NPV and IRR of those cash flows?

To calculate the Net Present Value (NPV), we should calculate first the difference between the present value of cash inflows and cash outflows. The NPV is used to analyze the profitability of an investment or project.

The formula for NPV is:

The Ct in this case represents the net cash inflow, the Co represents the total initial investment costs, the r represents the discount rate, and the t represents the number of time periods. The NPV that is calculated gave a total of ($15,124.13), which is a positive number, what this number indicates is that their earnings exceed their costs, this means that their project is profitable.

In addition, the Internal Rate of Return (IRR) is the discount rate that will depend of the NPV calculations of all cash flows, this is used to measure the profitability of investments. The IRR that was found after calculation is (22.67%) and this will be used to rank the multiple projects of the firm.

· For the financial projections, the first step taken was to compute the number of patients each year for insurance payers. The total number of patients was then multiplied by the patient mix percentages. The following step was to multiply the number of patients by each insurance payer’s billing rate per patient. The last step in this process is to deduct the (1%) uncollectible billings from the revenues.

 

· Second, the total expenses were calculated which includes the salaries, wages and benefits, supplies, management fees, fixed and variable operating expenses, land leases and construction. For the salaries, wages, and benefits expenses were calculated by multiplying the full-time employees by the patient days per year. The supplies, drugs, food and management fees were calculated by multiplying the net revenue by the percentage of the net revenue.

· The second calculation to be done is, the total expenses were calculated which includes the salaries, wages, benefits, supplies, management fees, fixed and variable operating expenses land leases and construction. To calculate salaries, wages and benefits expenses this was done by multiplying the full-time employees by patient days per patient days per year. The supplies, drugs, food and management fees were calculated by multiplying the net revenue by the percentage of the net revenue. Operating expenses are an annual fixed charge of $1.2 million. Land lease is 200,000 and divided by 1000 then after the first year then will be an annual increase of 3%. Moreover, the cost of the construction of the building was depreciated by 30 years of the 15,000,000.

· Then the operating profit and operating margin was calculated. The operating profit was then calculated by deducting the expenses from the revenues. For the operating margin, the operating profit was divided by the total revenue.

· The next calculation there is a change in net working capital, this change was calculated by calculating the account receivables, inventories and account payable. The Net Working Capital = current assets – current liabilities which in this case is ((AR + Inventories) – AP).

· Free cash flows is measured by adding the operating profit with deprectiation, deducting the capital expenditure and the net working capital. Then to compute the NPV of the cash flows, the addition of the Net Working Capital Recovery and the Sale of Facility at book value is done.

· NPV is ($15,124.13) and IRR is (22.67%)

· All these steps for calculations are shown in the excel sheet.

 

Q5. What are the main drivers for NPV and IRR? Show the impact on NPV and IRR by changing a couple of these drivers to a “downside scenario” value?

For us to comprehend the main drivers for IRR and NPV we will have to examine the values that greatly affect the hospital’s cash flow. Most of the profits earned is from admitted patients, and the amount of capacity they use on patient days. So therefore one of the main drivers of the IRR and NPV is from utilization rate. If we considered the worst case scenario for the utilization rate in the second year is 45% , according to Mulroney’s memo exhibit. However, the growth rate that relates to the utilization rate