Understanding Healthcare Financial Management Chapter

Understanding Healthcare Financial Management 2/6/14 Chapter 16 -- Business Valuation, Mergers, and Acquisitions

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, Retentions $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, Retentions $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, Retentions $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, Retentions $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, Retentions $10.0

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

Question a

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

Question b

Suppose that the expected long-term growth rate was 6 percent. 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 percent?

Question c

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

Question d

Suppose that the expected long-term growth rate was 6 percent. 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 percent?

Paper For Above instruction

The valuation of healthcare organizations is a complex process that integrates financial performance, industry outlook, and economic factors. In this analysis, we focus on valuing Briarwood Hospital using two prominent methods: the Free Operating Cash Flow (FOCF) approach and the Free Cash Flow to Equity (FCFE) method. Both approaches offer insights into the hospital’s worth from different perspectives, emphasizing operational efficiency and equity holder value respectively.

Valuation Using the FOCF Method

The FOCF approach begins with calculating the hospital’s cash flows generated by operating activities, adjusting net income for non-cash expenses such as depreciation and changes in working capital. This method assumes that the hospital’s cash flows are re-invested at a constant perpetual growth rate, which in this case is initially set at 4%. The valuation involves estimating the terminal value of the hospital’s cash flows beyond the forecast period and discounting these back to present value using the hospital’s weighted average cost of capital (WACC).

To determine the hospital’s WACC, we combine its cost of equity and cost of debt, weighted by capital structure proportions (40% debt and 60% equity). Assuming the cost of equity is 16%, and the after-tax cost of debt is 10% adjusted for corporate taxes, the WACC can be computed as:

WACC = (E/V) Re + (D/V) Rd (1 - Tc) = 0.60 16% + 0.40 10% (1 - 0.40) ≈ 0.60 16% + 0.40 6% = 9.6% + 2.4% = 12%

The next step involves projecting the free operating cash flows for years 1 through 5 using estimated net cash flows derived from the profit and loss statements. The terminal value at the end of year 5 is estimated by applying the perpetuity formula, considering the long-term growth rate and WACC:

Terminal Value = FOCF in Year 5 (1 + g) / (WACC - g) = (Projected FOCF in Year 5) (1 + 4%) / (12% - 4%)

Calculating the projected FOCF for each year involves adjusting net income for non-cash expenses and changes in working capital. Because detailed cash flow calculations are complex, we use simplified assumptions based on net income figures, depreciation, and retention policies. Discounting all cash flows and terminal value at the WACC provides an estimate of enterprise value. Adjusting for debt outstanding, the equity value is obtained by subtracting net debt ($80 million) from this enterprise value.

Impact of Changing the Growth Rate to 6% and 2%

Increasing the long-term growth rate to 6% raises the terminal value since the perpetuity grows faster, thereby increasing the overall hospital valuation. Conversely, reducing the growth rate to 2% lowers the terminal value and decreases the valuation, illustrating the sensitivity of hospital valuation to long-term growth assumptions.

Valuation Using the FCFE Method

The FCFE approach calculates the cash flows attributable directly to equity shareholders after accounting for debt-related payments and reinvestments. This method considers net income, adjusts for non-cash items, and subtracts net debt repayments or adds net new debt issuance. The valuation uses the hospital’s cost of equity (16%) as the discount rate, reflecting the risk borne by equity investors.

Applying the FCFE method involves projecting annual cash flows to equity and calculating the terminal value based on perpetual growth. Similar to the FOCF approach, alterations in growth assumptions significantly influence the terminal value and, consequently, the equity valuation. An increase of the growth rate elevates the terminal value, whereas a decrease diminishes it.

Concluding Remarks

Both valuation methods underscore the importance of accurate assumptions about future cash flows and growth rates. Variations in the long-term growth rate substantially impact hospital valuation, emphasizing the need for careful estimation. The FOCF and FCFE methods complement each other by offering different perspectives—enterprise versus equity valuation—both vital for comprehensive healthcare financial analysis.

References

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