University of Virginia Health System The Long-Term Acute Care Hospital Project Harvard Case Solution & Analysis

DECSISION CRITERIA

The decision to go forward with the LTAC facility project would depend on a number of decision criteria. First of all, after projecting the net revenue and total expenses for the 10 years period, the project should generate a profit margin over 5%. After that, based on the assumed discount rate, the net present value of the project should be positive. The internal rate of return for the project should be above the hurdle rate which would be the cost of capital of the project, before the project becomes viable. The interest coverage ratio of the project should also seem to be satisfactory so that it shows that the organization will not default on its debt payments as they fall due. The decision of whether to propose this project to the board or not and whether to initiate it will strongly depend on all these factors. Also there are many assumptions made in the case regarding the revenue generation and the expenses of the organization. Therefore, the projects net present value, internal rate of return and interest coverage ratio all will have to be calculated under the normal scenario and also on the basis of the worst possible scenario. This would show how much the project is sensitive relative to out assumptions made and it would provide a lot of insight of whether to go ahead with the project or not.

ANALYSIS OF PROJECT

The net profit for the project has been calculated under both the scenarios. First of all the net profit of the project has been calculated under the normal scenario, based on the assumption of the financial analysts. The incremental working capital has been also incorporated for the 10 year period. As the hospital will continue its operations for the foreseeable future, therefore it is assumed that the working capital will not be recovered in the 10th year. Apart from that, interest has also been incorporated as it is an expense and will have to be paid once the hospital construction begins. Since there are no taxes in a nonprofit organization, therefore, depreciation of the facility has been ignored since it is a non cash expense and it has no impact on the project’s cash flows.

The discount rate of the project has been calculated by taking the data of Manor Care, since it seems to be similar in nature to U. VA Health systems. Therefore, its capital structure has been used to calculate the cost of capital. The cost of debt is 8% as given and the cost of equity has been calculated by the capital asset pricing model. This gives us a cost of capital for this project of around 7.5%. The working capital adjustment has been made in the net profit to covert them into annual cash flows. Based on the above discount rate, the present values for each year have been calculated. Since, this hospital is going to operate after 10 years for the foreseeable future; therefore, terminal value has been calculated in the 10th year, with the assumption that the cash flows of the 10th year will be generated over the life of the hospital. This gives us a net present value of $40.9 million under normal scenario and $5 million under the worst case scenario. On the other hand the IRR under both scenarios is 20% and 3% respectively.

RECOMMENDATION

Based on the results of the analysis and also the sensitivity analysis performed for the worst possible scenario, it is evident that this project is profitable, but it is risky. However, if the assumptions of the financial analyst prove to hold true then Fitzgerald should propose this project to the board in the next meeting. The company in the normal scenario could maintain a much higher net profit margin and it will also not have problems to pay its debt obligations. Also the IRR is much higher in this case at 20%, which is much higher than the cost of capital. In case of the worst scenario, the profit margin is also above 5%, interest coverage is however low and the IRR is unacceptable. But given the strong assumptions for the project based on other companies, this project seems worthwhile and it needs to be proposed and accepted by the board......................................

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