2. Inflation is one of the most difficult factors to deal with in project analysis.

a. Complete the inflation impact table shown in exhibit 20.2.1

b. What management information is provided by the inflation impact table?

CASE CORAL BAY HOSPITAL TRADITIONAL PROJECT ANALYSIS ORAL BAY HOSPITAL is a 250-bed, investor-owned hospital located in Coral Bay, Florida, which is known as the "The Sport Fishing Capital of the World."The hospital was founded in 1946 by Dr. Rob Winslow, a prominent Florida physician, on his return from service in World War II. He relinquished control of Coral Bay in 1967 while it was stll small and in a relatively quiet setting. However, in recent years, south Florida has rienced a population explosion, which has fostered high economic growth and the need for more healthcare services. Today, under a succession of excellent CEOs, Coral Bay is recognized as one of the leading healthcare providers in the area. Coral Bay's management is currently evaluating a proposed ambulatory (outpatient) surgery center. (For more information on ambulatory surgery sce the Ambulatory Surgery Center Association website at www.ascassocia- tion.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 and 10 percent under regional anesthesi ia,30 percent under local anesthesia, or spinal anesthesia. In general, operating rooms are built in pairs so that 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 center opened in 1970. By 1990, about 2.5 million he first ambulatory surgery 127 ation of ACHE, 2018. Reproduction without permission is prohibited Cases in Healthcare Finance 128 ed at stand-alone outpatient centers, and procedures were being performed at stand-alone 2017, the number had grown to more than 20 million.Thise enters fieled primarily by three factors. First, rapid advancements in te bled many procedures that were historically performed in in ical suites to be offered at outpatient settings. This shift was ca aten by advances in laser,laparoscopic, endoscopic, and arthroscopic tod miny ve ena Second, Medicare has been aggressive in approving new minimal surgery services has grown substantially: Third, patientspgupt surgeries because they are more convenient, and third them because they are less costly surgery techniques, so the number of Medicare patientrasine Because of these factors, the number of inpatient surgeries has remained more or less flat over the past 20 years, whereas the number of ou procedures has continuously grown more than 10 percent annually. Rapid growth in the number of outpatient surgeries has been accompanied b corresponding growth in the number of outpatient facilities nationwide The number currently stands at about 5,300, so competition in many area has become intense. Somewhat surprisingly, no outpatient exists in Coral Bay's immediate service area, although rumors surgeons are exploring the feasibility of a physician-owned facility. are that Coral Bay 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 spent (and expensed for tax purposes) $25,000 to clear the land and put in sewer and utility lines last year. 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 Coral Bay'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 S5 million, for a total of $10 million. Assume that both the building and the equipment fall into the MACRS (modified accelerated cost recovery system class for tax-depreciation purposes. (In reality, the building woul have to be depreciated over a much longer period than The project will probably have a long life, but Coral Bay typicaly a five-year life in its capital budgeting analyses and then approsim i value of the cash fows beyond Year 5 by including a terminal, or value in the analysis. To estimate the salvage value, Coral Bay typ e equipmen assumes the salvage, typically uss Case 20: Coral Bay Hospital 129 value of the building and equipment after five years, which for estimated to be $5 million before taxes, excluding the land is project is ote that taxes must be paid on the difference between an asset's value and its tax book value at termination. For example, if an asser salvage 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 valuc.) The expected volume at the surgery center is 20 procedures a day. The charge per procedure is expected to be $1,500, but charity care, bad debts, managed care plan discounts, and other allowances lower the net revenue amount to $1,000. The surgery center would be open five 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 dis average tient days posal, 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 Coral Bay's current $2.8 million in administrative overhead costs. On average, each procedure would require $200 in expendable medical supplies, including anesthetics. Although Coal Bay's inventories and receivables would increase 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. Coral Bay's marginal federal-plus-state tax rate is 40 percent. One of the most difficult factors to deal with in project analysis is infla- tion. 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, Coral Bay 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 briefy at the last board of directors meeting, several questions were raised. In particulat, one director wanted to make sure that a complete risk analysis, including sensitivity and scenario analyses, was performed before the presentation of the proposal to the board. hat appeared to be Recently, the board was forced to close a day care center profitable when analyzed two years ago but turned out to be a big money Cases in Healthcare Finance loser. The board does not want a repeat of that occurrence. One tors stated that she thought Coral Bay was putting too much ft diree numbers. 'After all,"she pointed out, 'that is what got us into tronk the day care center. We need to start worrying more about how pro into our strategic vision and how they affect the services we current h faith in trouble on concern over the impact of the ambulatory surgery center on the curren volume of inpatient surgeries. This concen prompted an analysis by the head Another director, who is also Coral Bay's chief of medicine, of the surgery department, who reported that an outpatient surgery cent could siphon off up to $1 million in cash revenues annually. When pres the department lead to a $500,000 reduction in annual cash t head estimated that such a reduction in volume could also expenses. To develop the data needed for the risk analysis, Jules Bergman, Coral Bay's director of capital budgeting, met with the department heads of sur gery, 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 and 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 surgery centers are built, the number of procedures could be as high as 25 per day, compared with 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 penetra- tion. If surgery severity were high (i.e., if a higher number of complicated procedures than anticipated were performed) and managed care penetra- tion 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 and 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 with 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, confined to just three scenarios. questioned why the scenario analysis had to be "Why not five or seven?" he queried. In Case 20: Coral Bay Hospital 131 t of capital includes an expected inflation estimate be used to make a decision today, but future inflation future. Jules said that a good on project profitability addition, the current cost is uncertain and could affect cash flows in the way to assess the impact of uncertain, future inflation on 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, Coral Bay'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, on the basis of historical scenario analysis data that use worst, most lnkely, and best case values, the average roiect has a coefficient of variation of net present value in the range of 1.0 to 2.0 and that 4 percentage points are typically added or subtracted to the 9 percent corporate cost of capital to adjust for differential project risk Coral Bay has hired you as a financial consultant. Your task is to conduct analysis on the ambulatory surgery center and then pres- a complete project ent your findings and recommendations to the board of directors. Annual Salary FTEsTotal Salary EXHIBIT 20.1 Coral Bay Hospital: Projected Surgery Position s 60,000 $60,000 50,000 35,000 30,000 25,000 60,000 30,000 25,000 Executive director Director of nursing Accounting clerk Collections clerk Scheduling clerk Registered nurses Nursing assistants Transcriptionist 50.000 Center Staffing 35.000 Requirements 30,000 25,000 480,000 60,000 25,000 $765,000 Total 153,000 Plus 20 percent fringe-benefit allowance $918,000 otal salaries and benefits TE: full-time equivalent Cases in Healthcare Finance 132 EXHIBIT 20.2 Impact of Uncertain Future Inflation on NPV of Proposed Ambulatory Level of Net Patient Revenue Inflation 3% 4% 2% 5% 1% 0% 6% 09% NPV NPV NPV NPV NPVNPV NPY Surgery Center Level of 11%! NPV NPV NPV NPV NPV NPV NPV Cost | 2% | NPV NPV NPV NPV NPV NPV NPV Inflation | 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 NPV: net present value CASE CORAL BAY HOSPITAL TRADITIONAL PROJECT ANALYSIS ORAL BAY HOSPITAL is a 250-bed, investor-owned hospital located in Coral Bay, Florida, which is known as the "The Sport Fishing Capital of the World."The hospital was founded in 1946 by Dr. Rob Winslow, a prominent Florida physician, on his return from service in World War II. He relinquished control of Coral Bay in 1967 while it was stll small and in a relatively quiet setting. However, in recent years, south Florida has rienced a population explosion, which has fostered high economic growth and the need for more healthcare services. Today, under a succession of excellent CEOs, Coral Bay is recognized as one of the leading healthcare providers in the area. Coral Bay's management is currently evaluating a proposed ambulatory (outpatient) surgery center. (For more information on ambulatory surgery sce the Ambulatory Surgery Center Association website at www.ascassocia- tion.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 and 10 percent under regional anesthesi ia,30 percent under local anesthesia, or spinal anesthesia. In general, operating rooms are built in pairs so that 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 center opened in 1970. By 1990, about 2.5 million he first ambulatory surgery 127 ation of ACHE, 2018. Reproduction without permission is prohibited Cases in Healthcare Finance 128 ed at stand-alone outpatient centers, and procedures were being performed at stand-alone 2017, the number had grown to more than 20 million.Thise enters fieled primarily by three factors. First, rapid advancements in te bled many procedures that were historically performed in in ical suites to be offered at outpatient settings. This shift was ca aten by advances in laser,laparoscopic, endoscopic, and arthroscopic tod miny ve ena Second, Medicare has been aggressive in approving new minimal surgery services has grown substantially: Third, patientspgupt surgeries because they are more convenient, and third them because they are less costly surgery techniques, so the number of Medicare patientrasine Because of these factors, the number of inpatient surgeries has remained more or less flat over the past 20 years, whereas the number of ou procedures has continuously grown more than 10 percent annually. Rapid growth in the number of outpatient surgeries has been accompanied b corresponding growth in the number of outpatient facilities nationwide The number currently stands at about 5,300, so competition in many area has become intense. Somewhat surprisingly, no outpatient exists in Coral Bay's immediate service area, although rumors surgeons are exploring the feasibility of a physician-owned facility. are that Coral Bay 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 spent (and expensed for tax purposes) $25,000 to clear the land and put in sewer and utility lines last year. 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 Coral Bay'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 S5 million, for a total of $10 million. Assume that both the building and the equipment fall into the MACRS (modified accelerated cost recovery system class for tax-depreciation purposes. (In reality, the building woul have to be depreciated over a much longer period than The project will probably have a long life, but Coral Bay typicaly a five-year life in its capital budgeting analyses and then approsim i value of the cash fows beyond Year 5 by including a terminal, or value in the analysis. To estimate the salvage value, Coral Bay typ e equipmen assumes the salvage, typically uss Case 20: Coral Bay Hospital 129 value of the building and equipment after five years, which for estimated to be $5 million before taxes, excluding the land is project is ote that taxes must be paid on the difference between an asset's value and its tax book value at termination. For example, if an asser salvage 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 valuc.) The expected volume at the surgery center is 20 procedures a day. The charge per procedure is expected to be $1,500, but charity care, bad debts, managed care plan discounts, and other allowances lower the net revenue amount to $1,000. The surgery center would be open five 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 dis average tient days posal, 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 Coral Bay's current $2.8 million in administrative overhead costs. On average, each procedure would require $200 in expendable medical supplies, including anesthetics. Although Coal Bay's inventories and receivables would increase 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. Coral Bay's marginal federal-plus-state tax rate is 40 percent. One of the most difficult factors to deal with in project analysis is infla- tion. 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, Coral Bay 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 briefy at the last board of directors meeting, several questions were raised. In particulat, one director wanted to make sure that a complete risk analysis, including sensitivity and scenario analyses, was performed before the presentation of the proposal to the board. hat appeared to be Recently, the board was forced to close a day care center profitable when analyzed two years ago but turned out to be a big money Cases in Healthcare Finance loser. The board does not want a repeat of that occurrence. One tors stated that she thought Coral Bay was putting too much ft diree numbers. 'After all,"she pointed out, 'that is what got us into tronk the day care center. We need to start worrying more about how pro into our strategic vision and how they affect the services we current h faith in trouble on concern over the impact of the ambulatory surgery center on the curren volume of inpatient surgeries. This concen prompted an analysis by the head Another director, who is also Coral Bay's chief of medicine, of the surgery department, who reported that an outpatient surgery cent could siphon off up to $1 million in cash revenues annually. When pres the department lead to a $500,000 reduction in annual cash t head estimated that such a reduction in volume could also expenses. To develop the data needed for the risk analysis, Jules Bergman, Coral Bay's director of capital budgeting, met with the department heads of sur gery, 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 and 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 surgery centers are built, the number of procedures could be as high as 25 per day, compared with 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 penetra- tion. If surgery severity were high (i.e., if a higher number of complicated procedures than anticipated were performed) and managed care penetra- tion 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 and 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 with 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, confined to just three scenarios. questioned why the scenario analysis had to be "Why not five or seven?" he queried. In Case 20: Coral Bay Hospital 131 t of capital includes an expected inflation estimate be used to make a decision today, but future inflation future. Jules said that a good on project profitability addition, the current cost is uncertain and could affect cash flows in the way to assess the impact of uncertain, future inflation on 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, Coral Bay'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, on the basis of historical scenario analysis data that use worst, most lnkely, and best case values, the average roiect has a coefficient of variation of net present value in the range of 1.0 to 2.0 and that 4 percentage points are typically added or subtracted to the 9 percent corporate cost of capital to adjust for differential project risk Coral Bay has hired you as a financial consultant. Your task is to conduct analysis on the ambulatory surgery center and then pres- a complete project ent your findings and recommendations to the board of directors. Annual Salary FTEsTotal Salary EXHIBIT 20.1 Coral Bay Hospital: Projected Surgery Position s 60,000 $60,000 50,000 35,000 30,000 25,000 60,000 30,000 25,000 Executive director Director of nursing Accounting clerk Collections clerk Scheduling clerk Registered nurses Nursing assistants Transcriptionist 50.000 Center Staffing 35.000 Requirements 30,000 25,000 480,000 60,000 25,000 $765,000 Total 153,000 Plus 20 percent fringe-benefit allowance $918,000 otal salaries and benefits TE: full-time equivalent Cases in Healthcare Finance 132 EXHIBIT 20.2 Impact of Uncertain Future Inflation on NPV of Proposed Ambulatory Level of Net Patient Revenue Inflation 3% 4% 2% 5% 1% 0% 6% 09% NPV NPV NPV NPV NPVNPV NPY Surgery Center Level of 11%! NPV NPV NPV NPV NPV NPV NPV Cost | 2% | NPV NPV NPV NPV NPV NPV NPV Inflation | 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 NPV: net present value