Question

NCU Medical Group (NCU MG) is a profitable and very busy multi-specialty group practice. As a part of its growth strategy, NCU MG is considering purchasing one of three medical practices in the community. Each of the practices provides a unique strategic advantage that is aligned with NCU MG’s long-term plans.

Senior Clinic is located in a community offering extensive and very popular services for older patients. Junior Clinic serves a growing but younger population with the largest population of children in the area. Sports Clinic provides sports medicine services and is the preferred provider for the local all-state high school teams as well as the local college sports programs.

As the vice president of operations for NCU MG, you’ve been asked to lead this effort and recommend a decision to the board. Although all three practices are very attractive and have expressed an interest in being acquired, the board will only choose one. The others may be considered at a later date.

You’ve collected the following data related to acquisition costs, cash inflows, and overhead expenses for the next 5 years. The cost of capital is determined to be 11%:

• Senior Clinic will cost $20M to acquire. Additionally, there are several roofing and facility maintenance needs that will cost $200,000 in Year 1, and $150,000 in Year 2. Finally, lab services will cost $100,000 per year beginning in Year 1. Expected cash inflows from Senior Clinic are $4.5M, $8.5M, $10.265M, $11M, and $500K for Years 1 to 5.
• Pediatric Clinic will cost $19M to acquire. The practice is only two years old, and the facilities are in excellent condition. However, the clinic will have debt payments of $130,000 in Years 4 and 5. Finally, Pediatric Clinic has a lab outreach program that generates $20,000 in revenue every year beginning in Year 1. Half of this revenue will flow to NCU MG. In addition to the lab revenue, expected cash inflows from Pediatric Clinic are $6M, $6.5M, $7M, $7.5M, and $8M for Years 1 to 5.
• Sports Clinic will cost $21M to acquire. The clinic is in a state-of-the-art facility with owned and leased equipment. Annual lease payments are $90,000 per year and maintenance agreement costs are $50,000 per year, both beginning in Year 1. Finally, the clinic receives $75,000 per year from the local college for medical coverage beginning in Year 1, all of which will flow to NCU MG. In addition to the college revenue, expected inflows from Sports Clinic are $9M, 7.5M, $8.5M, $6M, and $3.25M for Years 1 to 5.

In addition to the above information, you’ve determined that for the selected clinic, the NPV probabilities are:

• 20% for the worst-case scenario
• 60% for the most-likely scenario
• 20% for the best-case scenario

Finally, the board would like your recommendation on other financing options. Ignoring the previous 11% cost of capital, you’ve discovered that:

• equity financing costs 15%
• 20% debt financing costs 10% (after tax) with equity costing 16%
• 45% debt financing costs 11% (after-tax) with equity costing 17%

As VP-Operations for NCU MG, assess each clinic option. In your assessment, develop tables showing the NPV and IRR for each option. After selecting a clinic to recommend, determine its expected NPV and make a financing (equity and/or debt) recommendation to the board.

Answer 1

Selection of the Most Suitable Project of the 3 Options

Given the above information, we find the NPV and IRR for each of the alternatives using a cost of capital of 11% and over a time period of 5 years.

A. Senior Clinic

Particulars (all figures in '000)	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
1. Acquisition Costs (Outflow)	($20,000.00)
2. Roofing and Facility Maintenance (Outflow)		($200.00)	($150.00)
3. Lab Services (Outflow)		($100.00)	($100.00)	($100.00)	($100.00)	($100.00)
4. Expected Cash Inflows		$4,500.00	$8,500.00	$10,265.00	$11,000.00	$500.00
Net Cash Flow	($20,000.00)	$4,200.00	$8,250.00	$10,165.00	$10,900.00	$400.00

Cost of Capital	11.00%
Net Present Value	$4,801.60
IRR	21.19%

B. Pediatric Clinic

Particulars (all figures in '000)	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
1. Acquisition Costs (Outflow)	($19,000.00)
2. Debt Payments (Outflow)					($130.00)	($130.00)
3. Revenue from Lab Outreach Program attributed to NCU MG (Inflow)		$10.00	$10.00	$10.00	$10.00	$10.00
4. Expected Cash Inflows		$6,000.00	$6,500.00	$7,000.00	$7,500.00	$8,000.00
Net Cash Flow	($19,000.00)	$6,010.00	$6,510.00	$7,010.00	$7,380.00	$7,880.00

Cost of Capital	11.00%
Net Present Value	$5,731.13
IRR	22.95%

C. Sports Clinic

Particulars (all figures in '000)	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
1. Acquisition Costs (Outflow)	($21,000.00)
2. Annual Leasing Payments (Outflow)		($90.00)	($90.00)	($90.00)	($90.00)	($90.00)
3. Maintenance Agreement Costs (Outflow)		($50.00)	($50.00)	($50.00)	($50.00)	($50.00)
4. Cash inflow from Local College (Inflow)		$75.00
5. Cash Inflows		$9,000.00	$7,500.00	$8,500.00	$6,000.00	$3,250.00
Net Cash Flow	($21,000.00)	$8,935.00	$7,360.00	$8,360.00	$5,860.00	$3,110.00

Cost of Capital	11.00%
Net Present Value	$4,361.84
IRR	21.16%

Having assessed all the three projects we find that the NPV, as well as the IRR, is the highest for acquiring the Pediatric Clinic.

Calculation of Expected NPV and Recommendation of the Financing Option

A. Calculation of Discount Factor

1. Complete Equity Financing:

The cost of financing, i.e. WACC, for this option would be 15%.

2. 20% Debt and 80% Equity:

The weighted average cost of capital for this option would be calculated as:

WACC = (0.8)(0.16) + (0.2)(0.10) = 0.148 or 14.80%

3. 45% Debt and 55% Equity:

The weighted average cost of capital for this option would be calculated as:

WACC = (0.55)(0.17) + (0.45)(0.11) = 0.143 or 14.30%

2. Calculation of Expected NPV

For each of these options, the calculation of NPV for acquiring the Pediatric Clinic is as follows:

Details of Financing Option	WACC	NPV	Probability
Complete Equity Financing	15.00%	$3,387.01	20.00%
20% Debt and 80% Equity	14.80%	$3,492.33	60.00%
45% Debt and 55% Equity	14.30%	$3,760.73	20.00%

Hence, the expected NPV, E(NPV), would be calculated as:

E(NPV) = (0.20)(3,387.01) + (0.60)(3,492.33) + (0.20)(3,760.73) = $3,524.94

Given the three financing options, the board should select the third option i.e. 45% debt and 55% equity, for financing the acquisition of the Pediatric Clinic.