Understanding Healthcare Financial Management Problem 1

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, 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.

Using the Free Operating Cash Flow (FOCF) method, what is the equity value of the hospital? Additionally, how would the valuation change if the long-term growth rate adjusted to 6 percent or 2 percent? Furthermore, estimate the hospital's equity value using the Free Cash Flow to Equity (FCFE) method under the initial 4 percent growth assumption, and evaluate the impact of increasing or decreasing the growth rate to 6 percent and 2 percent in this context.

Paper For Above instruction

The valuation of healthcare entities like hospitals requires a comprehensive analysis of their financial health, growth prospects, and the application of appropriate valuation models. In this paper, we focus on valuing Briarwood Hospital using the Free Operating Cash Flow (FOCF) method and the Free Cash Flow to Equity (FCFE) approach, considering various long-term growth scenarios. Such an analysis helps stakeholders understand the hospital's worth and informs strategic decision-making regarding investments, mergers, or acquisitions.

Introduction

Healthcare organizations such as Briarwood Hospital operate within complex financial frameworks that necessitate detailed valuation techniques to determine their economic value accurately. The primary goal of hospital valuation is to understand intrinsic worth based on projected future cash flows, discounted at appropriate rates that reflect the risk profile of the hospital. This paper utilizes two prominent valuation methods: the Free Operating Cash Flow (FOCF) and the Free Cash Flow to Equity (FCFE) models, to estimate Briarwood's value under varying growth assumptions.

Understanding the Financial Data and Assumptions

The data provided include projected profit and loss statements over five years, with consistent assumptions about retention policies, costs, and depreciation. The capital structure is defined with a debt-to-equity ratio aligned with an optimal 40/60 split, and a stable current debt level of $80 million. The weighted average cost of capital (WACC) serves as the discount rate in the FOCF model, incorporating both the cost of debt and equity, adjusted for tax benefits of debt. The hospital's growth rate profoundly influences the terminal value, which in turn affects the present valuation.

Valuation Using the FOCF Method

The FOCF approach involves calculating the cash flows generated by operations available to both debt and equity holders and discounting these to their present value. The formula considers operating profits, non-cash charges like depreciation, and changes in working capital, adjusted for investments in capital expenditures. The process begins with projecting operating cash flows for the explicit forecast period and then estimating the terminal value using the Gordon Growth Model, assuming perpetual growth at the long-term rate.

Applying this methodology involves several steps: determining the weighted average cost of capital, projecting free cash flows under the initial 4% growth rate, and calculating the terminal value with the assumption of perpetual growth. The initial calculations, based on the provided data, yield an enterprise value, from which subtracting net debt offers the equity valuation.

Impact of Varying Growth Rates

The long-term growth rate is critical in valuation models. An increase from 4% to 6% typically results in a higher terminal value, thus increasing the enterprise and equity valuations due to compounded perpetuity effects. Conversely, decreasing the growth rate to 2% diminishes the valuation, reflecting slower growth expectations. Quantitatively, these shifts directly affect the terminal value calculation, which often constitutes a substantial portion of the total valuation.

Valuation Using the FCFE Method

The FCFE approach estimates the cash flows available solely to equity shareholders after servicing debt and reinvestments. This method requires projecting net income, adjusting for non-cash charges, net capital expenditures, and changes in working capital, followed by discounting these to the present using the cost of equity. As with the FOCF method, the terminal value is calculated assuming a perpetual growth rate, influencing the long-term estimates significantly.

In the context of Briarwood Hospital, the FCFE valuation offers insights into equity-specific value, accounting for leverage effects. Adjustments for different growth rates demonstrate how investor expectations of future profitability influence valuation outcomes. The sensitivity analysis underscores the importance of accurate long-term growth assumptions in hospital valuation models.

Conclusion

Valuing a healthcare organization like Briarwood Hospital involves intricate financial modeling, integrating projected cash flows and risk considerations. Both the FOCF and FCFE models are valuable tools that, when applied with varying growth assumptions, provide a range of estimated values, facilitating sound investment decisions. Recognizing the sensitivity of these models to growth rates emphasizes the importance of careful forecasting and the need for comprehensive analysis in healthcare financial management.

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