READ THIS FIRST CaseUVa Health System The LATC Hospital ProjectWk.docx

READ THIS FIRST CaseUVa Health System: The LATC
Hospital ProjectWk 4 is the second of two weeks on CAPITAL
BUDGETING Study the Wk 3
Solution
s 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.1Identify relevant incremental cash
flows2Calculate cost of capital (k-wacc) to use as the discount
rate3Calculate 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 recommendationabout 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 is CREATES value, not
DESTROYS value.Directions(some repeating from Wk3
Assignment Template)1Make a quick scan through the LTAC
case and the exhibits. 2Listen to the Intro Audio3Cohen 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 youhave that context in mind before reviewing the
TVM chapter 4 (only if you need to).4Read the case again, to
grasp all the details, especially the Mulroney memo to her
boss.5To understand how a capital budgeting template works,
follow the step-by-step procedure in the book, pages 61-
706Scan pages 70-76 on weighted average cost of capital. No
need to emphasize at this point because discount rates are given
in the case.7Read pages 79-84 on NPV, PI, IRR, PP.8Pages 83-
85 show a worked-out example of a capital budgeting
decision.QuestionsIf you work with a group, write answers on
your own, independently. Group answers violate academic
integrity requirements. 1See Q1 tab.Scroll down until you see
the questions.Capital Budgeting TemplateThe template
calculates FREE CASH FLOW=[EBIT-TAX+DEPREC]+/-
CHANGE NWC+/-CAPEX.2See 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.3See Q3
tab.Scroll down until you see the questions.Sensitivity
AnalysisLEARN THIS FORMULA (EQUATION) COLD!Expect
to revisit these calculations and decisions in Wk7.
Q1 Capital Budgeting TemplateUNIVERSITY OF VIRGINIA

MEDICAL CENTERLong Term Acute Care HospitalFree Cash
Flow ProjectionsRevenue and Cost AssumptionsResults-No
NWC RecoveryResults-NWC RecoveryNumber of
Beds50NPV$5,687NPV$10,425(000 ommited)Year 1 Utilization
26%IRR17.6%IRR21.2%Year 2 Utilization 60%Annual Increase
in Utilization4%Operating Expense (% of Revenue)7.0%K-
wacc10%Year12345678910VOLUMEPatient Day Capacity
18,25018,25018,25018,25018,25018,25018,25018,25018,25018,
250Utilization
26%60%62%65%67%70%73%76%79%82%Patient Days
Used4,74510,95011,38811,84412,31712,81013,32213,85514,40
914,986Average Patient Census per
Day13303132343536383941Average Length of Stay
30272727272727272727Number of Patients per
Year158406422439456474493513534555Full-Time
Employees/Census4.83.53.53.53.53.53.53.53.53.5Full-Time
Employees62105109114118123128133138144INSURANCE
PAYER Patient
MixMedicare36%57146152158164171178185192200Medicaid29
%46118122127132138143149155161Commercial
Payers24%3897101105109114118123128133Other9%14373839
414344464850Indigent2%3889991010111115840642243945647
4493513534555BillingAnnual IncrMedicare—bill per
patient$27,7950.0%1,5834,0584,2204,3894,5654,7474,9375,135
5,3405,554Medicaid—bill per

patient$35,0001.3%1,6054,1704,3374,5104,6914,8785,0735,276
5,4875,707Commercial Payers—bill per
day$2,8005.0%3,1897,7268,0358,3578,6919,0399,4009,77610,1
6710,574Other—bill per
patient$38,5001.3%5481,4241,4801,5401,6011,6651,7321,8011,
8731,948Indigent—bill per
patient$35,0001.3%111288299311323336350364378394Total
Revenue(000
omitted)7,03517,66518,37219,10719,87120,66621,49322,35223,
24624,176Less
Uncollectable1%70177184191199207215224232242Total Net
Revenue(000
omitted)6,96517,48918,18818,91619,67220,45921,27822,12923,
01423,935EXPENSESAnnual IncrSalary, Wage, Benefits (based
on $ per
employee)$60,2503%3,7606,5166,9807,4778,0098,5809,1909,8
4510,54611,297Supplies, Drugs, Food (% net
revenue)16.3%1,1352,8512,9653,0833,2073,3353,4683,6073,75
13,901Management Fees (% net
rev)8%5571,3991,4551,5131,5741,6371,7021,7701,8411,915Op
erating Expenses (fixed + 7 % net
rev)$1,200,000NA1,6882,4242,4732,5242,5772,6322,6892,7492
,8112,875Land Lease per
year$200,0003%200206212219225232239246253261Depreciati
on (straight line

30yrs)$15,000,000500500500500500500500500500500Total
Expenses(000
omitted)7,84013,89614,58515,31616,09216,91517,78918,71719,
70220,749Total
Expenses7,84013,89614,58515,31616,09216,91517,78918,71719
,70220,749Operating
Profit(804)3,7693,7873,7913,7793,7513,7033,6353,5443,427Op
erating Margin-
11.4%21.3%20.6%19.8%19.0%18.1%17.2%16.3%15.2%14.2%N
et Working CapitalNotes:Accounts Receivable 30 days
5721,4371,4951,5551,6171,6821,7491,8191,8921,967Inventory
Supplies, Drugs, Food60
days187469487507527548570593617641Accounts Payable30
days 93234244253264274285296308321Net Working
Capital6661,6721,7391,8081,8801,9562,0342,1152,2002,288Ch
ange in NWC6661,0066770727578818588Free Cash Flows
Calculation Operating
Profit(804)3,7693,7873,7913,7793,7513,7033,6353,5443,427Ad
d Depreciation500500500500500500500500500500Less Capital
Expenditures(7,500)(7,500)000000000Less Increase in Net
Working
Capital(666)(1,006)(67)(70)(72)(75)(78)(81)(85)(88)Free Cash
Flows(000
omitted)(7,500)(8,470)3,2634,2204,2214,2074,1764,1254,0543,
9593,839NPV (no recovery in year 10)$5,687(000 ommited)IRR

(no recovery in year 10)17.6%Year12345678910NWC
Recovery000000000$2,288Sale of Facility at Book
Value000000000$10,000NPV with Year 10
Recovery$10,425(000
ommited)(7,500)(8,470)3,2634,2204,2214,2074,1764,1254,0543
,95916,127IRR with Year 10 Recovery21.2%Net Profit
(Operating Profit - Interest)(000
ommited)(2,004)2,5692,5872,5912,5792,5512,5032,4352,3442,2
27Net Profit/Net Revenue-
28.8%14.7%14.2%13.7%13.1%12.5%11.8%11.0%10.2%9.3%St
udy the above analysis carefully, examining the inputs, outputs,
and formulas used to do the calculations.Q1aMulroney did not
use working capital cash flows in her original analysis. The
analysis aboveincludes incremental investment in working
capital. Discuss why she was either correct or incorrect not to
include them. Q1bCompare the decision metrics NPV & IRR for
the "no recovery of NWC" and "recovery of NWC"
scenarios,stating which scenario best captures reality. Based on
your answer, give the project a green or red light.Q1cExamine
the decision metric 'profit margin', and explain if it leads to a
green or red light for this project.Even though the board of
directors uses this metric, it is defective. Explain why. HINT:
FCF definition.Q1dReconcile your answers to Q1b and Q1c.
Q2 K-waccCOMPUTE WEIGHTED AVERAGE COST OF
CAPITALBASIC:FormulaEquationCase Exhibit 4COST OF

DEBT:U.S. Treasury Yields Coupon Rate0.00%given1-
year4.77% Marginal Tax Rate0.0%given5-year4.72% Cost of
Debt0.00%b5*(1-b6)k-d = I x (1- t)10-year4.72% weight of
debt0%d ÷ d+e30-year 4.73%Data source:
http://federalreserve.gov/releases/h15/data.htm (accessed March
2006).COST OF EQUITY: Risk-Free
Rate0.00%givenCorporate Bond Yields Risk
Premium0.00%givenR-m - R-fAAA5.31% Beta0.00givenAA
5.38% Cost of Equity0.00%b11+(b13*b12)k-e = R-f + [ß x (R-
m - R-f)] weight of equity100%1-b8e ÷
d+eA+5.41%A5.45%Weighted-Average Cost of
Capital0.00%(b8*b7)+(b15*b14)(k-d x wt-d)+(k-e x wt-e)A-
5.53%BBB+5.62%BBB5.88%For-Profit Comparables BBB-
6.07%HCA IncCommunity HealthHealth Management
AssociatesRevenues
(millions)$24,475$3,720$3,580BB+6.40%Assets
(millions)$5,222$961$997BB6.79%Total debt
(millions)$9,278$1,810$1,014BB-6.96%Stock price
($/share)$52.12$39.73$23.25Shares outstanding
(millions)452.788.5247.2B+7.39%Market cap
(millions)$23,593$3,517$5,747B7.57%Bond rating ABBBB-
7.84%Beta 0.600.600.70Data source: Bloomberg, “Fair Market
Curve Analysis,” 10-Year Corporate Bonds, March 2,
2006.Q2aCalculate the K-wacc for HCA using the template
above. Enter the data that youhave in the case and the table

above. If you need additional data, assume it usingyour good
judgment from what you have learned so far in the course.In the
answer box, cite your result, compare it to the K-wacc used in
the Q1analysis, and explain how your revised K-wacc would
change the Q1 results.Q2bIf LATC was a project in a for-profit
hospital like HCAabove, would the NPV be higher or lower?
Explain 'analytically' by examiningall relevant inputs to
NPV.Q2cIf LATC was a project in a for-profit hospital like
HCAabove, would the IRR be higher or lower? Explain.HINT:
To avoid getting trapped by this question, make sure your
answer is'analytical', i.e., examine all relevant inputs and
output. Q2dCan a non-profit hospital accept projects that a for-
profit hospital would reject?
Q3 Sensitivty AnalysisUNIVERSITY OF VIRGINIA MEDICAL
CENTERLong Term Acute Care HospitalFree Cash Flow
ProjectionsRevenue and Cost AssumptionsResults-No NWC
RecoveryResults-NWC RecoveryNumber of
Beds50NPV$5,687NPV$10,425(000 ommited)Year 1 Utilization
26%IRR17.6%IRR21.2%Year 2 Utilization 60%Annual Increase
in Utilization4%Operating Expense (% of Revenue)7.0%K-
wacc10.0%Year12345678910VOLUMEPatient Day Capacity
18,25018,25018,25018,25018,25018,25018,25018,25018,25018,
250Utilization
26%60%62%65%67%70%73%76%79%82%Patient Days
Used4,74510,95011,38811,84412,31712,81013,32213,85514,40

914,986Average Patient Census per
Day13303132343536383941Average Length of Stay
30272727272727272727Number of Patients per
Year158406422439456474493513534555Full-Time
Employees/Census4.83.53.53.53.53.53.53.53.53.5Full-Time
Employees62105109114118123128133138144INSURANCE
PAYER Patient
MixMedicare36%57146152158164171178185192200Medicaid29
%46118122127132138143149155161Commercial
Payers24%3897101105109114118123128133Other9%14373839
414344464850Indigent2%3889991010111115840642243945647
4493513534555BillingAnnual IncrMedicare—bill per
patient$27,7950.0%1,5834,0584,2204,3894,5654,7474,9375,135
5,3405,554Medicaid—bill per
patient$35,0001.3%1,6054,1704,3374,5104,6914,8785,0735,276
5,4875,707Commercial Payers—bill per
day$2,8005.0%3,1897,7268,0358,3578,6919,0399,4009,77610,1
6710,574Other—bill per
patient$38,5001.3%5481,4241,4801,5401,6011,6651,7321,8011,
8731,948Indigent—bill per
patient$35,0001.3%111288299311323336350364378394Total
Revenue(000
omitted)7,03517,66518,37219,10719,87120,66621,49322,35223,
24624,176Less
Uncollectable1%70177184191199207215224232242Total Net

Revenue(000
omitted)6,96517,48918,18818,91619,67220,45921,27822,12923,
01423,935EXPENSESAnnual IncrSalary, Wage, Benefits (based
on $ per
employee)$60,2503%3,7606,5166,9807,4778,0098,5809,1909,8
4510,54611,297Supplies, Drugs, Food (% net
revenue)16.3%1,1352,8512,9653,0833,2073,3353,4683,6073,75
13,901Management Fees (% net
rev)8%5571,3991,4551,5131,5741,6371,7021,7701,8411,915Op
erating Expenses (fixed + 7 % net
rev)$1,200,000NA1,6882,4242,4732,5242,5772,6322,6892,7492
,8112,875Land Lease per
year$200,0003%200206212219225232239246253261Depreciati
on (straight line
30yrs)$15,000,000500500500500500500500500500500Total
Expenses(000
omitted)7,84013,89614,58515,31616,09216,91517,78918,71719,
70220,749Total
Expenses7,84013,89614,58515,31616,09216,91517,78918,71719
,70220,749Operating
Profit(804)3,7693,7873,7913,7793,7513,7033,6353,5443,427Op
erating Margin-
11.4%21.3%20.6%19.8%19.0%18.1%17.2%16.3%15.2%14.2%N
et Working CapitalNotes:Accounts Receivable 30 days
5721,4371,4951,5551,6171,6821,7491,8191,8921,967Inventory

Supplies, Drugs, Food60
days187469487507527548570593617641Accounts Payable30
days 93234244253264274285296308321Net Working
Capital6661,6721,7391,8081,8801,9562,0342,1152,2002,288Ch
ange in NWC6661,0066770727578818588Free Cash Flows
Calculation Operating
Profit(804)3,7693,7873,7913,7793,7513,7033,6353,5443,427Ad
d Depreciation500500500500500500500500500500Less Capital
Expenditures(7,500)(7,500)000000000Less Increase in Net
Working
Capital(666)(1,006)(67)(70)(72)(75)(78)(81)(85)(88)Free Cash
Flows(000
omitted)(7,500)(8,470)3,2634,2204,2214,2074,1764,1254,0543,
9593,839NPV (no recovery in year 10)$5,687(000 ommited)IRR
(no recovery in year 10)17.6%Year12345678910NWC
Recovery000000000$2,288Sale of Facility at Book
Value000000000$10,000NPV with Year 10
Recovery$10,425(000
ommited)(7,500)(8,470)3,2634,2204,2214,2074,1764,1254,0543
,95916,127IRR with Year 10 Recovery21.2%Net Profit
(Operating Profit - Interest)(000
ommited)(2,004)2,5692,5872,5912,5792,5512,5032,4352,3442,2
27Net Profit/Net Revenue-
28.8%14.7%14.2%13.7%13.1%12.5%11.8%11.0%10.2%9.3%Q3
aThe analysis above is identical to the one on the Q1 tab. Do a

sensitivity analysis by systematically changing certain
assumptions in the spreadsheet above:1change the K-wacc to
8.3%2change year 2 utilization to 45%3change commercial
payers to 30% of patient mixUse the answer box to prepare a
summary of the original (Q1) resultsand the revised (Q3)
results, i.e., a summary table.Q3bRevise the decision you made
in Q1 based on the above sensitivity analysis, comparing
Mulroney'sassumptions and the sensitivity analysis assumptions
to expectations stated in the case.Be sure to consider both 'hard
quantitative data" from decision metrics and 'soft qualitative
information'from the case.
READ THIS FIRST CaseUVa Health System: The Long-Term
Acute Care Hospital ProjectWk 3 is the first of two consecutive
weeks on CAPITAL BUDGETING. You will learn the three
steps in capital budgeting:1Identify relevant incremental cash
flows2Calculate cost of capital (k-wacc) to use as the discount
rate3Calculate 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 recommendationwhether to accept or reject
the LTAC project.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.ReadingCohen 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 youhave that
context in mind before reviewing the TVM chapter 4 (only if
you need to). Give the Uva Health Care System: The Long-Term
Acute Care Hospital Project Case a quick read to understand
what is going on - about calculating k-wacc and the decision
metrics for the project, to give it either a green light or a red
light.Wk 3 gives you practice on the basics. You won't have a
full understanding of what the LTAC Project case is about atthe
end of Wk3. In Wk4, you will return to the case, analyze the
project, and make a recommendation.Look at the Wk 3
assignment questions in the Q1, Q2, Q3 tabs.Read Cohen
Finance Workbook chapter 5 selectively. Focus on:See the
FLOW DIAGRAM in GREEN depicting the CAPITAL
BUDGETING template.See the IS/BS Model in GREEN
depicting the connection between PPE (BS) and operating
expense (IS).Read pps 61-65 as a general introduction to capital
budgeting.Read pps 70-76 on weighted average cost of capital
to answer Q1.Read bottom p 67 to 69 on Net Working Capital to
answer Q2.Read pps 79-85 on NPV, PI, IRR, PP to answer
Q3.QuestionsSee tabs for Q1, Q2, Q3THESE QUESTIONS
MUST BE ANSWERED USING EXCEL.MAKING

CALCULATIONS OUTSIDE THE SPREADSHEET AND
ENTERING THE RESULTS IS NOT USING EXCEL.YOU
MUST USE EXCEL FORMULAS FOR MAKING
CALCULATIONS!
Q1-COST of CAPITAL (K-wacc)COMPUTE WEIGHTED
AVERAGE COST OF CAPITALenter data in blue-colored
cellsBASIC:FormulaEquationCOST OF DEBT: Coupon
Rate0.00%given Marginal Tax Rate0.0%given Cost of
Debt0.00%b5*(1-b6)k-d = I x (1-t) weight of debt0%d ÷
d+eCOST OF EQUITY: Risk-Free Rate0.00%given Risk
Premium0.00%givenR-m - R-f Beta0.00given Cost of
Equity0.00%b11+(b13*b12)k-e = R-f + [ß x (R-m - R-f)]
weight of equity100%1-b8e ÷ d+eWeighted-Average Cost of
Capital0.00%(b8*b7)+(b15*b14)(k-d x wt-d)+(k-e x wt-e)Above
is the template explained in chapter 5 pps 70-76.Use the
template to answer Q1.Q1:Page 75 in Cohen Finance Workbook
displays a K-wacc calculation for a company.Suppose that the
inputs to that k-wacc calculation have changed.The company's
financial risk has increased, so its coupon rate is now 9%.Its
marginal tax rate increased to 30%.To reduce financial risk, its
'target' weight of debt is reduced to 30%.The risk-free rate on
treasury bonds is now 2%.The risk premium stays the same at
8%.The beta, reflecting higher financial risk, rises to
1.5.Recalculate k-wacc, using the template at the top of this
page.Explain the significance of the change in k-wacc to the

capital budgeting analysis and recommendation. Use the box
below:
Q2-NWCGo to the bottom of p 68 in the Cohen Finance
Workbook.There is no picture of a faucet - but - visualize a sink
faucet turning on and off, controlling the flow of water.Picture
a receivables faucet, an inventory faucet, and a payables
faucet.The number of days can be lower (faucet turned low) or
higher (faucet turned high).This is how net working capital is
controlled, by setting the number of days of each.The
investment in working capital is one of the entries in a
forecast.This question helps you learn how to forecast net
working capital.Q2a - Explain how the table below works, i.e.,
what are the inputs, what are the outputs, and howare the inputs
transformed into the outputs.HINT: Examine the formulas in the
cells.Change in Net Working
Capital:Revenue1000.01000.01000.01000.01000.0Cost of goods
sold22.022.022.022.022.0$ signs in the formula 'fix' the cell so
Receivables (enter days in Column
B)3082.282.282.282.282.2the formula can be copied to other
cells Inventory (enter days in Column
B)503.03.03.03.03.0without changing that cell, i.e.,Payables
(enter days in Column B)251.51.51.51.51.5copying on a 'fixed'
rather than a 'relative' basisNet working capital
needs83.783.783.783.783.7Liquidation of working capital0.0at
the end of a project's life, working capital is

liquidatedInvestment in working capital83.70.00.00.00.0Answer
Q2a in this box:Q2b - Row 43 changes compared to row 14 in
Q2a. Explain how the investment in working capital changes
(compared to the amount in Q2a) and why.Change in Net
Working Capital:Revenue1000.01100.01200.01300.01400.0Cost
of goods sold22.024.226.428.630.8Receivables (enter days in
Column B)3082.290.498.6106.8115.1Inventory (enter days in
Column B)503.03.33.63.94.2Payables (enter days in Column
B)251.51.71.82.02.1Net working capital
needs83.792.1100.4108.8117.2Liquidation of working
capital0.0Investment in working capital83.78.48.48.48.4Answer
Q2b in this box:Q2c - B71 and B72 are changed from the
number of days in Q2a and Q2b. Explain how theinvestment in
working capital changes (compared to the amount in Q2b) and
why.Change in Net Working
Capital:Revenue1000.01100.01200.01300.01400.0Cost of goods
sold22.024.226.428.630.8Receivables (enter days in Column
B)60164.4180.8197.3213.7230.1Inventory (enter days in
Column B)1006.06.67.27.88.4Payables (enter days in Column
B)251.51.71.82.02.1Net working capital
needs168.9185.8202.7219.6236.5Liquidation of working
capital0.0Investment in working
capital168.916.916.916.916.9Answer Q2c in this box:
Q3-METRICSRecall the Internal Rate of Return (IRR)
calculations that were discussed in MBAD 6233 Financial

Markets.Free cash flow:Operating cash
flow72.688.8105.1109.6124.3Minus: Invesment in net working
capital12.33.13.10.91.8Minus: Investment in PPE
(CapEx)300.00.00.00.00.00.0Plus: Salvage value0.0Free cash
flow-300.060.385.7102.0108.7122.5rounding errorCumulative
free cash flow-300.0-239.7-154.0-52.056.7179.2Discount rate
(K-wacc)10.9%Net Present Value (NPV)43.7Profitability Index
(PI)1.1Internal Rate of Return (IRR)15.9%Payback Period
(PP)inspectionThe panel above is extracted from p 85 in Cohen
Finance Workbook.Examine the formulas that calculate NPV,
PI, and IRR.Estimate PP by inspection using row 9 cumulative
free cash flow-the year when cumulative free cash flow
becomes a positive number.Q3aUsing the data below for the
three projects, and the formulas you discerned in B12, B13, and
B14,calculate NPV, PI, and IRR for the three projects, using
two different k-wacc discount rates, 8% and 11%.The data for
Projects A,B,C are arrayed vertically; they are the same as row
8 in the horizontal panel above.Project AProject BProject
CInitial Outlay-50,000-100,000-450,000Cash Inflows: Yr
110,00025,000200,000 Yr 215,00025,000200,000
Yr 320,00025,000200,000 Yr 425,00025,000
Yr 530,00025,000enter formulas in the cells in this boxNPV at
8%NPV at 11%PI at 8%PI at 11%IRRPPQ3bInterpret the
meaning of the calculations you made in Q3a.Hint: Do you
recommend accepting or rejecting the projects?Hint: What is the

impact on the decision metrics when k-wacc changes from 8%
to 11%?Hint: Do all three decision metrics lead to the same
recommendation?

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