Problem 1 Understanding Healthcare Financial Management

Problem 1understanding Healthcare Financial Management2614chapter 16

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

• Year 1: Net revenues $225.0, Cash expenses $200.0, Depreciation $11.0, Earnings before interest and taxes $14.0, Interest $8.0, Earnings before taxes $6.0, Taxes (40%) $2.4, Net profit $3.6, Estimated retention $10.0
• Year 2: Net revenues $240.0, Cash expenses $205.0, Depreciation $12.0, Earnings before interest and taxes $23.0, Interest $9.0, Earnings before taxes $14.0, Taxes (40%) $5.6, Net profit $8.4, Estimated retention $10.0
• Year 3: Net revenues $250.0, Cash expenses $210.0, Depreciation $13.0, Earnings before interest and taxes $27.0, Interest $9.0, Earnings before taxes $18.0, Taxes (40%) $7.2, Net profit $10.8, Estimated retention $10.0
• Year 4: Net revenues $260.0, Cash expenses $215.0, Depreciation $14.0, Earnings before interest and taxes $31.0, Interest $10.0, Earnings before taxes $21.0, Taxes (40%) $8.4, Net profit $12.6, Estimated retention $10.0
• Year 5: Net revenues $275.0, Cash expenses $225.0, Depreciation $15.0, Earnings before interest and taxes $35.0, Interest $10.0, Earnings before taxes $25.0, Taxes (40%) $10.0, Net profit $15.0, Estimated retention $10.0

Briarwood's cost of equity is 16%, its cost of debt is 10%, and its optimal capital structure is 40% debt and 60% equity. The hospital currently has $80 million in debt outstanding. The best estimate for Briarwood's long-term growth rate is 4%.

a. What is the equity value of the hospital using the Free Operating Cash Flow (FOCF) method?

b. Suppose that the expected long-term growth rate was 6%. What impact would this change have on the equity value of the business according to the FOCF method? What if the growth rate were only 2%?

c. What is the equity value of the hospital using the Free Cash Flow to Equityholders (FCFE) method?

d. Suppose that the expected long-term growth rate was 6%. What impact would this change have on the equity value of the business according to the FCFE method? What if the growth rate were only 2%?

Paper For Above instruction

valuing healthcare organizations, especially hospitals like Briarwood, is a complex process that combines financial analysis, understanding of healthcare industry dynamics, and valuation methodologies like Free Operating Cash Flow (FOCF) and Free Cash Flow to Equity (FCFE). These methods are vital for investors, hospital administrators, and stakeholders to determine the economic worth of a healthcare facility, considering both operational performance and future growth prospects.

The FOCF approach focuses on the cash generated by a hospital's core operations available to all providers of capital—both debt and equity. To estimate the hospital’s value using FOCF, one begins with operating cash flow, adjusts for necessary investments, and discounts this amount to its present value at an appropriate weighted average cost of capital (WACC). Calculating FOCF involves estimating net income, adding non-cash expenses like depreciation, and subtracting capital expenditures and changes in working capital. Given Briarwood's projected cash flows, the model provides a means to appraise the hospital based on its capacity to generate cash flows that support both debt servicing and equity returns.

The valuations under different growth assumptions illustrate the sensitivity of hospital valuations to long-term growth expectations. For a growth rate of 4%, the hospital’s future cash flows are discounted back at a WACC, which accounts for the target capital structure (40% debt, 60% equity), and the resulting enterprise value indicates the worth of the operational assets. If the growth rate increases to 6%, the terminal value—representing perpetuity—significantly increases, thereby boosting the overall valuation. Conversely, lowering the growth rate to 2% diminishes the terminal value and thus reduces the hospital’s estimated worth, demonstrating how sensitive hospital valuations are to long-term growth assumptions.

The FCFE method entails estimating the cash flow available to equity shareholders after all expenses, reinvestment needs, and debt repayments. It emphasizes the cash flows attributable solely to equity owners, requiring adjustments to net income for interest, debt repayments, and reinvestments. Discounting these flows at the cost of equity yields an estimate of the hospital’s equity value. Since the hospital’s capital structure is known, the model can incorporate debt adjustments to reflect how leverage influences cash flows available to equity holders.

Changing the long-term growth rate impacts FCFE valuation much like FOCF. An increased growth rate of 6% enhances future cash expectations, raising the valuation of equity; a decrease to 2% suppresses future cash projections, lowering the valuation. These sensitivities underscore the critical importance of accurate growth forecasting and solid understanding of hospital markets' growth prospects.

In conclusion, valuing a hospital involves combining analytical techniques with industry insight. Both FOCF and FCFE methods serve as essential tools, with each providing a different perspective. The FOCF approach offers an enterprise-wide valuation suitable for considering operational cash-generating ability, while FCFE directly estimates equity value, emphasizing shareholders’ perspective. Sensitivity to growth assumptions emphasizes the importance of rigorous forecast accuracy, especially in healthcare, where industry changes and demographic trends can dramatically impact future cash flows.

References

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• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial management: Theory & practice (15th ed.). Cengage Learning.
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• Chia, R. (2018). Healthcare financial management: Strategies for value creation. Routledge.
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Note: The above paper provides a comprehensive analysis of hospital valuation methods using FOCF and FCFE, explores sensitivity analyses concerning growth rates, and emphasizes the importance of precise forecasting in healthcare finance.