Read This First: UVA Health System The Latc Hospital Project

Read This Firstcaseuva Health System The Latc Hospital Projectwk 4 Is

Read This Firstcaseuva Health System The Latc Hospital Projectwk 4 Is

READ THIS FIRST Case UVa Health System: The LATC Hospital Project Wk 4 is the second of two weeks on CAPITAL BUDGETING Study the Wk 3 Solutions Template before proceeding into Wk 4. Learning Objectives (repeated from Wk3 Assignment Template) You will learn the three steps in capital budgeting: SEE THE FLOW DIAGRAM - YOU ARE NOW WORKING ON THE GREEN-COLORED ANALYSIS. 1 Identify relevant incremental cash flows 2 Calculate cost of capital (k-wacc) to use as the discount rate 3 Calculate the metrics of capital budgeting: Net Present Value, Profitability Index, Internal Rate of Return, and Payback Period. Then, you will apply the metrics and information in the case study to make a recommendation about which of the two projects to accept.

The essence of the capital budgeting process is to make sure, before an investment is made, that its prospective rate of return is high enough to justify the investment, i.e., that the project creates value, not destroys it. Directions (some repeating from Wk3 Assignment Template) 1 Make a quick scan through the LTAC case and the exhibits. 2 Listen to the Intro Audio 3 Cohen Finance Workbook chapter 4 is a review of Time Value of Money, which you covered in a previous course. Review it as necessary, but defer the review until you look at the TVM applications in chapter 5 beginning on p 79. You need to know TVM to understand the capital budgeting metrics of NPV, PI, and IRR.

Make sure you have that context in mind before reviewing the TVM chapter 4 (only if you need to). 4 Read the case again, to grasp all the details, especially the Mulroney memo to her boss. 5 To understand how a capital budgeting template works, follow the step-by-step procedure in the book, pages Scan pages 70-76 on weighted average cost of capital. No need to emphasize at this point because discount rates are given in the case. 7 Read pages 79-84 on NPV, PI, IRR, PP. 8 Questions If you work with a group, write answers on your own, independently. Group answers violate academic integrity requirements. 1 See Q1 tab. Scroll down until you see the questions. Capital Budgeting Template The template calculates FREE CASH FLOW=[EBIT-TAX+DEPREC]+/-CHANGE NWC+/-CAPEX. 2 See Q2 tab. Scroll down until you see the questions. K-wacc The 1st term is income statement data; the 2nd & 3rd terms are balance sheet data. 3 See Q3 tab. Scroll down until you see the questions.

Sensitivity Analysis LEARN THIS FORMULA (EQUATION) COLD! Expect to revisit these calculations and decisions in Wk7. Q1 Capital Budgeting Template UNIVERSITY OF VIRGINIA MEDICAL CENTER Long Term Acute Care Hospital Free Cash Flow Projections Revenue and Cost Assumptions Results-No NWC Recovery Results-NWC Recovery Number of Beds 50 NPV $5,687 NPV $10, ommited) Year 1 Utilization 26% IRR 17.6% IRR 21.2% Year 2 Utilization 60% Annual Increase in Utilization 4% Operating Expense (% of Revenue) 7.0% K-wacc 10% Year VOLUME Patient Day Capacity 18,,,,,,,,,,250 Utilization 26% 60% 62% 65% 67% 70% 73% 76% 79% 82% Patient Days Used 4,,,,,,,,,,986 Average Patient Census per Day Average Length of Stay Number of Patients per Year Full-Time Employees/Census 4.8 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 Full-Time Employees INSURANCE PAYER Patient Mix Medicare 36% Medicaid 29% Commercial Payers 24% Other 9% Indigent 2% Billing Annual Incr Medicare—bill per patient $27,.0% 1,,,,,,,,,,554 Medicaid—bill per patient $35,.3% 1,,,,,,,,,,707 Commercial Payers—bill per day $2,.0% 3,,,,,,,,,,574 Other—bill per patient $38,.3% ,,,,,,,,,948 Indigent—bill per patient $35,.3% Total Revenue (000 omitted) 7,,,,,,,,,,176 Less Uncollectable 1% Total Net Revenue (000 omitted) 6,,,,,,,,,,935 EXPENSES Annual Incr Salary, Wage, Benefits (based on $ per employee) $60,% 3,,,,,,,,,,297 Supplies, Drugs, Food (% net revenue) 16.3% 1,,,,,,,,,,901 Management Fees (% net rev) 8% ,,,,,,,,,915 Operating Expenses (fixed + 7 % net rev) $1,200,000 NA 1,,,,,,,,,,875 Land Lease per year $200,% Depreciation (straight line 30yrs) $15,000, Total Expenses (000 omitted) 7,,,,,,,,,,749 Total Expenses 7,,,,,,,,,,749 Operating Profit (,,,,,,,,,427 Operating Margin -11.4% 21.3% 20.6% 19.8% 19.0% 18.1% 17.2% 16.3% 15.2% 14.2% Net Working Capital Notes: Accounts Receivable 30 days ,,,,,,,,,967 Inventory Supplies, Drugs, Food 60 days Accounts Payable 30 days Net Working Capital ,,,,,,,,,288 Change in NWC , Free Cash Flows Calculation Operating Profit (,,,,,,,,,427 Add Depreciation Less Capital Expenditures (7,, Less Increase in Net Working Capital (,) Free Cash Flows (000 omitted) (7,,,,,,,,,,,839 NPV (no recovery in year 10) $5, ommited) IRR (no recovery in year .6% Year NWC Recovery $2,288 Sale of Facility at Book Value $10,000 NPV with Year 10 Recovery $10, ommited) (7,,,,,,,,,,,127 IRR with Year 10 Recovery 21.2% Net Profit (Operating Profit - Interest) (000 ommited) (2,,,,,,,,,,227 Net Profit/Net Revenue -28.8% 14.7% 14.2% 13.7% 13.1% 12.5% 11.8% 11.0% 10.2% 9.3%

Paper For Above instruction

The capital budgeting process is fundamental in evaluating large healthcare projects, such as the construction of the UCLA Health System’s LATC (Long-term Acute Care) Hospital. This process involves a systematic analysis of potential investment returns, ensuring that the projects selected are capable of creating value for the healthcare organization. It includes three core steps: identifying relevant cash flows, calculating the appropriate cost of capital (k-wacc), and applying decision metrics like NPV, IRR, and PI to evaluate project viability. This paper examines the application of these steps to the LATC Hospital Project case, discusses the importance of proper cash flow analysis, and evaluates the impact of different assumptions on project viability.

Understanding the essence of capital budgeting is crucial—its purpose is to select projects that generate a return higher than the organization's minimum acceptable hurdle rate, thus creating value and ensuring financial sustainability. In the case of the LATC Hospital, the initial analysis involves detailed projections of revenues, costs, depreciation, and working capital. The case emphasizes the significance of incremental cash flows—cash flows that change directly as a result of undertaking the project—such as operating profit, changes in net working capital, and capital expenditures. Notably, the inclusion or exclusion of working capital cash flows can significantly alter project valuation and decision-making.

First, an accurate assessment of relevant cash flows requires understanding that working capital investments are essential because they reflect the additional liquidity needed to support increased operational activity. In the case study, the initial analysis did not include changes in working capital, which could underestimate the project’s cash flows and mislead decision-makers. Incorporating incremental working capital increases in the cash flow projections often results in lower initial NPV but provides a more realistic view of the project’s capital requirement and liquidity needs. Therefore, I argue that Cohen’s original analysis was incorrect in omitting working capital cash flows, as doing so ignores the true cash effects of project initiation and termination.

Secondly, the decision metrics—NPV and IRR—offer different perspectives on project viability. The NPV, calculated as the present value of all relevant cash flows discounted at the project’s cost of capital, directly measures the expected value addition. In comparing scenarios with and without working capital recovery at the end of the project, the project with recovery generally shows a higher NPV, as the recovered working capital increases the terminal cash inflow. The IRR reflects the project's internal rate of return, which should exceed the weighted average cost of capital (k-wacc) for the project to be considered acceptable. The analysis indicates that the scenario including working capital recovery yields a higher IRR (21.2%) versus the no-recovery case.

Third, evaluating project profitability using the profit margin metric reveals potential pitfalls. While a higher profit margin indicates efficiency, it can be misleading if based solely on net profit relative to revenue, especially when free cash flows (FCFs) are the true economic measure of profitability. FCFs account for capital expenditures, changes in working capital, and taxes, providing a comprehensive view of cash generation quality. Thus, relying solely on profit margin could lead to an overly optimistic or pessimistic view, making it a defective metric for capital budgeting decisions.

Reconciliation of these findings underscores the importance of comprehensive cash flow analysis. While NPV and IRR direct managers toward projects adding value and exceeding hurdle rates, the profit margin may not accurately reflect the project’s true financial health. The inclusion of working capital cash flows is vital—their treatment can alter project attractiveness. For instance, the recovery of working capital at project end boosts NPV and IRR, favoring acceptance. Conversely, ignoring working capital can underestimate a project’s benefits, risking rejection of viable projects.

In the second part of the analysis, the second week focuses on capital cost estimation using the weighted average cost of capital (k-wacc). Accurate estimation of k-wacc considers debt and equity costs, their respective weights, and tax effects. The case details the calculation of the k-wacc, highlighting its role as the discount rate in present value calculations. In a hypothetical context, increasing financial risk or changing market conditions alter the components of k-wacc, emphasizing its sensitivity and importance.

Adjustments to the parameters, such as higher coupon rates or beta, significantly impact the calculated k-wacc. For example, an increase in beta from a low value to 1.5 indicates higher market risk, which elevates the cost of equity, thus raising k-wacc. An increased coupon rate and tax rate modify the cost of debt and its weight. When the target debt proportion decreases to 30%, the overall cost of capital shifts, reflecting higher or lower risk premiums. These recalibrations influence the discount rate used in project evaluations, affecting NPV and IRR outcomes, and potentially changing project acceptability decisions.

In the context of healthcare projects, especially non-profit hospitals like UVA, the cost of capital is often lower than private firms due to different risk profiles. However, similar principles apply: increasing risk factors lead to higher k-wacc, which diminishes present values of future cash flows, making projects less attractive. Conversely, if UVA’s risk profile is lower or its debt costs decrease, project valuation improves. Thus, understanding and accurately estimating k-wacc directly influence capital allocation decisions.

The sensitivity analysis—altering key assumptions such as discount rate, utilization rates, or payer mix—demonstrates the robustness of project evaluations. For instance, lowering k-wacc from 10% to 8.3% increases NPV significantly, making the project more attractive. Conversely, changing utilization or payer mix impacts revenue projections and cost structures, further modifying project viability. These insights reinforce the importance of scenario analysis in capital budgeting, ensuring decisions remain sound under different assumptions.

In conclusion, the case illustrates vital concepts in capital budgeting, emphasizing correct cash flow identification—including working capital effects—the impact of cost of capital estimations, and the importance of scenario analysis. Evaluating projects holistically ensures investments like the LATC Hospital are chosen based on rigorous analysis, creating sustainable value for healthcare providers and stakeholders.

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