Case Study: Green Valley Medical Center
Camins, John Ma. Timothy G. Nadonza, John Raphael T. Tarranza, Jerome L. Valencia, Vanessa R.
Overview Green Valley Medical Center was established in the 1930s with a federal grant and is a 330-bed nonprofit teaching hospital affiliated with a large university in a mid-size town located several hours from state’s two urban centers. It was the only regional hospital and in which it had already served a regional patient base over a million. The hospital had grown with continuous support from the state revenues. Also, it had issue municipal revenue bonds on several occasions to finance large expansions and improvements. It is one of only two hospitals in the state with facilities in cardiology, oncology, and neurology. The specialty of the hospital in these fields includes teaching and research as well as clinical use. It prided itself on its state –ofthe-art technology and overall medical expertise. In fact, the hospital was widely regarded for the innovative work and research conducted by its medical community, particularly in the neurological and oncological sciences.
Green Valley Medical Center had already built up a name in the industry and had no problem in generating their revenues but over the course of its success it has had an arising dilemma in making decisions regarding their capital budgeting process. Traditionally, under the old capital budgeting process of the entity, the general practice of the board of trustees and of the previous CFO was to give high priority to medical equipment, and although this policy is highly subjective and not stated in any form of documentation, several department chiefs and clinical program directors are aware with such unwritten policy within the organization. It has been reasoned out by the Director of Cardiology, that though administration is also necessary part of the whole organization, it still the physicians which are the ones who knows the closest to the needs of the hospital and of the patients. Such subjectivity of decision making also extends to the individual medical departments, where priority assessments are also base on how much revenue the department is generating. Such is the example of the Ob/Gyn, where it is at a disadvantage in the capital budgeting process in comparison to larger departments (E.g. Surgery). Each medical department, however, was accordingly ensured to have at least one high priority spot on the master list.
The new CFO, Mr. Klein, is not familiar with the capital budgeting system used by hospitals like Green Valley Medical Center. However, he is aware of the common practice used by the private sector and was certain that the techniques were familiar. As a result, he is considering a system that would be much more objective than what had been typical at Green Valley. Klein hopes to achieve a better balance of information for decision-making and that would result to having an unbiased result in approving or rejecting capital budget requests by different departments.
Statement of the Problem Given the highly subjective nature of its current capital budgeting process, how can Green Valley Medical Center adapt a more objective approach in dealing with capital budgeting decisions?
Objectives
To incorporate both qualitative and quantitative analysis in the capital budgeting decision-making process.
To take into equal importance all other departments in the capital budgeting decisionmaking process.
Areas of Consideration
Current Capital Budgeting process gives priority to Medical Equipment -
The hospital’s board of trustees and previous CFO had maintained a general practice of giving a high priority of medical equipment.
The request and reply of Capital Budgeting process is not clear and subjective
-
According to the director of cardiology, medical departments always wins out in a head to head competition with administration when it comes to capital allocation. Even though administration is a necessary part, but accordingly physicians are more knowledgeable in terms of patient and hospital needs.
Mr. Allen Klein, the new CFO, is not entirely familiar with the capital budgeting systems used by hospitals. However, is generally knowledgeable of its use in the private sector.
Proposal of the new CFO is to apply a NPV approach in its qualitative analysis of determining capital budgeting decisions. -
Under such approach, all requests from the departments are classified into cost groupings, not as means of prioritization but simply to facilitate and organize them for evaluation.
Alternative Courses of Action 1. Employ the payback period method PROS
simple to calculate
CONS
it does not consider the time value of money
provides a quantitative means for
evaluating capital decisions
the accept-reject criterion is stated in terms of years rather than at a discount rate
the firm’s attention is focused on cash flow rather than on rate of return
the salvage value of the proposal is not considered
Quantitative Analysis Payback Method: PET Proposal Payback period = Cost/Annual Cash inflow = $5,800,000/$850,000 = 6.8 yrs. Laundry Proposal Payback period = Cost/Annual Cash inflow = $1,025,000/$247,000 = 4.15 yrs.
2. Employ the Net Present Value Method as a quantitative analysis measure and additional qualitative analysis that considered a project’s impact on the hospital. PROS
Considers the time value of money
Considers cost of capital
Reliable quantitative measure for capital requests
CONS
Difficult to calculate the appropriate discount rate to be used
Discount rate chosen might not be the appropriate rate as rate in NPV is ased on estimates
Quantitative Analysis using Net Present Value Approach NPV= Initial Investment + Future Cash Flow Find for the discount rate using Weighted Average Cost of Capital WACC = E/D +E (re) + D/D+E (rd) Where: E = Market Value of Equity D = Market Value of debt Re = Cost of Equity Rd = Cost of debt
Debt = $27,106 ; Equity = $17,054; Required rate of equity = 10% ; Debt + Equity = $ 44,160 Required rate of Debt = [($9,300 x 0.06) + ($8, 050 x 0.08) ($9,300 + $ 8,050) = 0.06928 WACC = ($ 17,054/ $ 44,160)(0.1) + ( $ 27,000/$44,160)(0.06928) = 0.08114 or 8.11% Find for the Net Present Value of PET proposal Initial Investment = cyclotron + 2 cameras + facility renovations = $ 1,400,000 + 2( $ 2,000,000) + $ 400,000 = $ 5,800,000 Depreciable life of the equipment = 10 years
PV = FV[1/(1+r) ^ t] NPV = - $ 5,800,000 + (PV of cash flow from year 1 to 10) = - $124,600 Find for the Net Present Value of Laundry Proposal Initial Cost = Cost of CBW + 3 Dryers + Press + Additional Cost of Installation = $ 500,000 + 3( $ 75,000) + $ 100,000 + $ 200,000 = $ 1,025,000 Depreciable life of equipment = 15 years NPV = - $ 1,025,000 + (PV of cash flow from year 1 to 15) = $ 1,075,000 Quantitative Analysis Proposal
Useful Life
Annual Cash Inflow/
Total Cash Inflow /
Savings
Saving
PET
10 years
$ 850,000
$ 8,500,000
Laundry
15 years
$ 247,000
$ 3,705,000
Qualitative Analysis PET Proposal (Exhibit 2) A. Physician Impact Will this project have an effect on the physicians’ attitude toward the Hospital? YES Not accepted: -2
Affected Physicians will be disgruntled
Discuss the lack of expenditure or project in the community and with other physicians
Accepted: + 2
The affected physicians will be very impressed
Discuss the expenditure or project favorably in the community
and with other
physicians
B. Community Impact Will this project have an effect on the community attitude toward the hospital? YES Not Accepted: -3
Widespread negative effect on the hospital’s general age and reputation will result. Accepted: + 3
Widespread positive effect on the hospital’s image a reputation will result
C. Employee Impact Will this project have an effect on the attitude the hospital’s personnel? YES Not accepted: -3
widespread disappointment with the hospital and some negative effects on the hospital’s image among employees Accepted: +2
A limited group of employees will be very pleased
Exhibit 3. Score Sheet Evaluation
Instruction
Potential
Proposed
Score
Project’s Score
Economic
If total investment is less than $100,000
+1
If total investment is more than $100,000
-1
If total annual incremental cost increase are
+1
-1
less than $200,000 (or if there are cost savings) If total annual incremental cost increase are
-1
-1
more than $200,000 If PV is equal to or greater than zero
+2
If PV is less than zero
-1
-2
Total Economic Score Qualitative
-4
Physician Impact
0-8
4
Community Impact
0-8
6
Employee Impact
0-8
5
Total qualitative score
15
Total Score
11
Qualitative Analysis Laundry Proposal (Exhibit 2) A. Physician Impact Will this project have an effect on the physician’s attitude toward the hospital? YES Not Accepted: -2
Affected physicians will be disgruntled
Discuss the lack of expenditure Accepted: +1
Affected physicians will be aware of the expenditure or project
Satisfied that the hospital is maintaining a high level of patient care
B. Community Project Will this project have an effect on the community attitude toward the hospital? YES Not Accepted: -1
The attitudes of a few people will be negatively affected Accepted: +1
Relatively few people will be positively affected
Not many people would focus on the improvement of laundry services
C. Employee Impact Will this project have an effect on the attitude of the hospital’s personnel? YES Not Accepted: -2
Limited group of employees will react negatively
The department’s request for capital had been turned down in for several years Accepted: +3
Nearly all employees will be pleased
Evaluation
Instruction
Potential Score Proposed Project’s Score
Economic
If total investment is less than $100,000
+1
If total investment is more than $100,000
-1
If total annual incremental cost increase are
+1
1
1
less than $200,000 (or if there are cost savings) If total annual incremental cost increase are
-1
more than $200,000 If PV is equal to or greater than zero
+2
If PV is less than zero
-2
Total Score Qualitative
4
Physician Impact
0-8
3
Community Impact
0-8
2
Employee Impact
0-8
5
Total Qualitative Score
10
Total Score
14
3. Apply the Internal Rate of Return method in its capital budgeting process
Pros
2
The rate of return can be easily calculated and understood, especially by decision makers who may not have a financial background
IRR = The rate required when NPV is 0 Internal Rate of return for PET proposal = 7.6% Internal Rate of return for Laundry = 23%
Cons Is largely based on estimate
It is said that, the higher the rate of return, the more attractive the project is. Recommendation We therefore recommend that the Green Valley should employ ACA 2 (net present value method plus survey form and scoring sheet) for Green Valley Medical Center’s capital budgeting process. The net present value method has been proven feasible in providing reliable quantitative analysis regarding the cash inflows and outflows of capital requests as it takes into consideration inflation and the cost of capital. Additionally, the survey form and scoring sheet will provide the needed qualitative analysis. In this approach, it will clearly show whether the project adds value to Green Valley or not. Especially in deciding what projects to take. In the case, since all proposals or project are taken at the same time, Green Valley can easily compare the magnitude of the PET and Laundry proposal. Green Valley will simply choose the option with the highest NPV, as shown in the computation the NPV of PET and Laundry are ($124,600) and $1,075,000 respectively, putting also into consideration the Qualitative aspect of the proposals. Thus it will provide the most additional value for Green Valley.
Potential Problem Analysis
Since Green Valley will opt to adapt NPV as their capital budgeting process it will involve certain risks that would potentially harm the company. First, there is a possible inaccuracy of the figures used in evaluating the proposals or projects. Second would be the physical plant and equipment involved and the length of time that it will take before all conditions of the evaluation become fulfilled. Estimates that will be used in the capital budgeting process could be wrong or inaccurate at times. However, the accuracy depends on how the company obtained the figures. Every type of company has its own degree of risk that is unusual to itself. In the case of Green Valley, there might be risk involved in employing a new capital budgeting process specifically the NPV approach which is based on estimates. It is said that the longer periods are usually
more prone to inaccuracies than those involving shorter periods. In the case, it involves longer periods like 10-15 years, thus Green Valley is more prone to inaccuracies. At the end, inaccuracies might happen most often, because of the changes in the environment that happens sooner than expected.
