Twin Falls Community Hospital is a 250-bed, not-for-profithospital located
in the city of Twin Falls, the largest city in Idaho’s MagicValley region
and the seventh largest in the state. The hospital was foundedin 1972 and
today is acknowledged to be one of the leading healthcareproviders in the
area.
Twin Falls’ management is currently evaluating a proposedambulatory
(outpatient) surgery center. Over 80 percent of all outpatientsurgery is
performed by specialists in gastroenterology, gynecology,ophthalmology,
otolaryngology, orthopedics, plastic surgery, and urology.Ambulatory surgery
requires an average of about one and one-half hours; minorprocedures take
about one hour or less, and major procedures take about two ormore hours.
About 60 percent of the procedures are performed under generalanesthesia, 30
percent under local anesthesia, and 10 percent under regional orspinal
anesthesia. In general, operating rooms are built in pairs sothat a patient
can be prepped in one room while the surgeon is completing aprocedure in the
other room.
The outpatient surgery market has experienced significant growthsince the
first ambulatory surgery center opened in 1970. This growth hasbeen fueled
by three factors. First, rapid advancements in technology haveenabled many
procedures that were historically performed in inpatientsurgical suites to
be switched to outpatient settings. This shift was caused mainlyby advances
in laser, laparoscopic, endoscopic, and arthroscopictechnologies. Second,
Medicare has been aggressive in approving new minimally invasivesurgery
techniques, so the number of Medicare patients utilizingoutpatient surgery
services has grown substantially. Finally, patients preferoutpatient
surgeries because they are more convenient, and third-partypayers prefer
them because they are less costly.
These factors have led to a situation in which the number ofinpatient
surgeries has grown little (if at all) in recent years while thenumber of
outpatient procedures has been growing at over 10 percentannually and now
totals about 22 million a year. Rapid growth in the number ofoutpatient
surgeries has been accompanied by a corresponding growth in thenumber of
outpatient surgical facilities. The number currently stands atabout 5,000
nationwide, so competition in many areas has become intense.Somewhat
surprisingly, there is no outpatient surgery center in the TwinFalls area,
although there have been rumors that local physicians areexploring the
feasibility of a physician-owned facility.
The hospital currently owns a parcel of land that is a perfectlocation for
the surgery center. The land was purchased five years ago for$350,000, and
last year the hospital spent (and expensed for tax purposes)$25,000 to clear
the land and put in sewer and utility lines. If sold in today’smarket, the
land would bring in $500,000, net of realtor commissions andfees. Land
prices have been extremely volatile, so the hospital’s standardprocedure is
to assume a salvage value equal to the current value of theland.
The surgery center building, which will house four operatingsuites, would
cost $5 million and the equipment would cost an additional $5million, for a
total of $10 million. The project will probably have a longlife, but the
hospital typically assumes a five-year life in its capitalbudgeting analyses
and then approximates the value of the cash flows beyond Year 5by including
a terminal, or salvage, value in the analysis. To estimate theterminal
value, the hospital typically uses the market value of thebuilding and
equipment after five years, which for this project is estimatedto be $5
million, excluding the land value.
The expected volume at the surgery center is 20 procedures aday. The average
charge per procedure is expected to be $1,500, but charity care,bad debts,
insurer discounts (including Medicare and Medicaid), and otherallowances
lower the net revenue amount to $1,000. The center would be openfive days a
week, 50 weeks a year, for a total of 250 days a year. Laborcosts to run the
surgery center are estimated at $800,000 per year, includingfringe benefits.
Supplies costs, on average, would run $400 per procedure,including
anesthetics. Utilities, including hazardous waste disposal,would add another
$50,000 in annual costs. If the surgery center were built, thehospital’s
cash overhead costs would increase by $36,000 annually,primarily for
housekeeping and buildings and grounds maintenance.
One of the most difficult factors to deal with in projectanalysis is
inflation. Both input costs and charges in the healthcareindustry have been
rising at about twice the rate of overall inflation.Furthermore,
inflationary pressures have been highly variable. Because of thedifficulties
involved in forecasting inflation rates, the hospital beginseach analysis by
assuming that both revenues and costs, except for depreciation,will increase
at a constant rate. Under current conditions, this rate isassumed to be 3
percent. The hospital’s corporate cost of capital is 10percent.
When the project was mentioned briefly at the last meeting ofthe hospital’s
board of directors, several questions were raised. Inparticular, one
director wanted to make sure that a risk analysis was performedprior to
presenting the proposal to the board. Recently, the board wasforced to close
a day care center that appeared to be profitable when analyzedbut turned out
to be a big money loser. They do not want a repeat of thatoccurrence.
Another director stated that she thought the hospital wasputting too much
faith in the numbers: “After all,†she pointed out, “that iswhat got us into
trouble on the day care center. We need to start worrying moreabout how
projects fit into our strategic vision and how they impact theservices that
we currently offer.†Another director, who also is thehospital’s chief of
medicine, expressed concern over the impact of the ambulatorysurgery center
on the current volume of inpatient surgeries
To develop the data needed for the risk (scenario) analysis,Jules Bergman,
the hospital’s director of capital budgeting, met withdepartment heads of
surgery, marketing, and facilities. After several sessions, theyconcluded
that only two input variables are highly uncertain: number ofprocedures per
day and building/equipment salvage value. If another entityentered the local
ambulatory surgery market, the number of procedures could be aslow as 15 per
day. Conversely, if acceptance is strong and no competingcenters are built,
the number of procedures could be as high as 25 per day,compared to the most
likely value of 20 per day. If real estate and medical equipmentvalues stay
strong, the building/equipment salvage value could be as high as$7 million,
but if the market weakens, the salvage value could be as low as$3 million,
compared to an expected value of $5 million. Jules alsodiscussed the
probabilities of the various scenarios with the medical andmarketing staffs,
and after a great deal of discussion reached a consensus of 70percent for
the most likely case and 15 percent each for the best and worstcases.
Assume that the hospital has hired you as a financialconsultant. Your task
is to conduct a complete project analysis on the ambulatorysurgery center
and to present your findings and recommendations to thehospital’s board of
directors. To get you started, Table 1 contains the cash flowanalysis for
the first three years.
Table 1
Partial Cash Flow Analysis
0 1 2 3
Land opportunity cost ($500,000)
Building/equipment cost (10,000,000)
Net revenues $5,000,000 $5,150,000 $5,304,500
Less: Labor costs 800,000 824,000 848,720
Utilities costs 50,000 51,500 53,045
Supplies 2,000,000 2,060,000 2,121,800
Incremental overhead 36,000 37,080 38,192
Net income $2,114,000 $2,177,420 $2,242,743
Plus: Net land salvage value
Plus: Net building/equipment salvage value
Net cash flow ($10,500,000) $2,114,000 $2,177,420 $2,242,743
5. Conduct a scenario analysis. What is its expected NPV? Whatis the worst and
best case NPVs? How does the worst case value help in assessingthe
hospital’s ability to bear the risk of this investment?
