Question

Current Situation

You are and Vice President and CFO at Warrington Regional Hospital, a not-for-profit tertiary care facility with 225 beds located in a growing city in Southern California. The chair of the board of directors has informed you that the board, in concert with local community and political leadership, believes the hospital should consider expanding services. They want you to analyze the financial feasibility of either building an ambulatory orthopedic center on a parcel of land located 31 miles northeast of the hospital near a large housing development currently under construction or adding a new wing containing 25 beds onto the hospital. The land for the new ambulatory orthopedic center is owned by the county and they have indicated a willingness to lease it to the hospital for $1 per year on a 99-year lease. On the surface, both projects appear to be sound investments but only one can be undertaken. Before deciding, the board and other stakeholders want to understand the financial consequences of the alternatives and expect a recommendation based on the analysis.

The Board’s Requirements

The board is requesting a study covering the first 5 years of the new initiative, including construction time. At a minimum, the board seeks the NPV and IRR for each option. Detail should be calculated and presented at the annual level. Ultimately, the board is looking for your recommendation with a detailed supporting explanation. How you choose to summarize your recommendation has not been specified but the more clearly you present your findings, the better it will be received. The material should be prepared as if it will be given to the Board of Directors for their consideration and decision.

Your Approach

You assemble a team from your finance and administrative staff and begin by preparing a work plan showing the steps you will follow to meet the objective. A critical early step will be to estimate cash flows (revenues and expenses) for the first five years of each alternative (including the year for construction). In addition, the team must make and document key assumptions that will be used in the analysis. After working on the problem for 30 days, the team publishes its financial projection data assumptions for comment. Once the discussions with key stakeholders have concluded, these data are finalized, and the analysis commences. The approved data is summarized in the table that follows. Note that if you believe there are assumptions missing you are free to define and use reasonable ones in your work, however they must be specifically identified and justified.

Warrington Regional Hospital

Financial Assumptions

New Wing Assumptions		Orthopedic Center Assumptions
Cost to construct and equip	$11,250,000	Cost to construct and equip	$2,500,000
Months to construct and equip	12	Months to construct and equip	12
Avg. occupied beds per mo. in year 1	9	Avg. patient visits per mo. in year 1	300
Revenue per occupied bed per mo. in year 1	$69,000	Revenue per patient per visit in year 1	$1,900
Fixed cost per mo.	$46,800	Fixed cost per mo.	$9,400
Variable cost per mo. per occupied bed	$1,400	Variable cost per visit per mo.	$850
Annual rate of increase for all costs	2.5%	Annual rate of increase in all costs	2.5%
Annual rate of increase in the occupancy rate	2.3%	Annual rate of increase in number of visits	2.4%

For both options, assume that:

• Warrington Regional Hospital has sufficient capital to pay for either project without financing
• The discount rate (cost of capital) per year is 5.5%
• Amount billed for an occupied bed or a patient visit will not change during the operation of either alternative
• The construction and equipping phase of both projects would start and end in fiscal year 0 (the year immediately prior to starting operation)

Answer 1

New Wing
Years	0	1	2	3	4	5
Cost of Construction	-11250000
Revenue		7452000	7623396	7798734	7978105	8161601
		(9*12*69000)	Year 1 * 102.3%	Year 2 * 102.3%	Year 3 * 102.3%	Year 4 * 102.3%
Variable Cost		-151200	-158545	-166246	-174321	-182789
		(9*12*1400)	Year 1 * 102.3% * 102.5%	Year 2 * 102.3% * 102.5%	Year 3 * 102.3% * 102.5%	Year 4 * 102.3% * 102.5%
Fixed Cost		-561600	-575640	-590031	-604782	-619901
		(46800*12)	Year 1 * 102.5%	Year 2 * 102.5%	Year 3 * 102.5%	Year 4 * 102.5%
Total Cashflows	-11250000	6739200	6889211	7042457	7199002	7358911
PV Factor @ 5.5%	1.0000	0.9479	0.8985	0.8516	0.8072	0.7651
PV of cash flows	-11250000	6387867	6189629	5997453	5811155	5630556
NPV of New Wing Option	18766660
(IRR is the internal rate of return, calculated on total cash flows)
0=NPV=t=1∑T​(1+IRR)tCt​​−C0​
Ct: Net cash flow during the period
C0: Cash outflow during the beginning of the period
t= number of time periods
IRR of New Wing Option	55%
Orthopedic Centre
Years	0	1	2	3	4	5
Cost of Construction	-2500000
Revenue		6840000	7004160	7172260	7344394	7520660
		(300*12*1900)	Year 1 * 102.4%	Year 2 * 102.4%	Year 3 * 102.4%	Year 4 * 102.4%
Variable Cost		-3060000	-3211776	-3371080	-3538286	-3713785
		(300*12*850)	Year 1 * 102.4% * 102.5%	Year 2 * 102.4% * 102.5%	Year 3 * 102.4% * 102.5%	Year 4 * 102.4% * 102.5%
Fixed Cost		-112800	-115620	-118510.5	-121473	-124510
		(9400*12)	Year 1 * 102.5%	Year 2 * 102.5%	Year 3 * 102.5%	Year 4 * 102.5%
Total Cashflows	-2500000	3667200	3676764	3682669	3684635	3682365
PV Factor @ 5.5%	1.0000	0.9479	0.8985	0.8516	0.8072	0.7651
PV of cash flows	-2500000	3476019	3303397	3136211	2974299	2817504
NPV of Orthopedic centre Option	13207431
IRR of New Wing Option	145%

Conclusion : Since the NPV of new wing option is higher than Orthopedic center option, thus it is advisable to go with new wing option to earn more cash return during the tenure of 5 months. However IRR of orthopedic center option is higher which means that for every 1 rupee investment we are earning 1.45 rupees, thus orthopedic center option is much beneficial only if the option is scalable for higher amount of investment.