FNCE 239 Lecture 10: Lecture 10 Notes

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skywolf653

10 Mar 2016

School

UPenn

Department

Finance

Course

FNCE 239

Professor

N I K O L A I R O U S S A N O V

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Document Summary

How does a standard raional decision maker make the decision on how much to gamble? o o o o o. They try to calculate their expected uility in some way or another. They try to calculate eu of their future wealth subject to the payofs that the gamble will give. It"s increasing (people prefer more wealth than less) The irst few addiional 7427$ bring you more uility than the last addiional 7427$ (decreasing marginal uility) Conclusion: your expected uility of taking the gamble is less than the expected uility of not taking the gamble. This is because the expected uility is a straight line below the concave line. Whenever you take a weighted average of 2 points, it"s going to end up in a straight line, which will always be below the concave line. You always prefer with certainty to get the expected value of the gamble than to take the gamble and get the same value.

Related Questions

QUESTION 1

In the lease versus buy decision, leasing is often preferable

	A.	because the lessee owns the property at the end of the least term.
	B.	because lease obligations do not affect the firm's risk as seen by investors.
	C.	because, generally, no down payment is required, and there are no indirect interest costs.
	D.	because it has no effect on the firm's ability to borrow to make other investments.
	E.	because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.

2 points

QUESTION 2

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

True

False

2 points

QUESTION 3

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

True

False

2 points

QUESTION 4

Which of the following statements is CORRECT?

	A.	If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
	B.	If a stock has a negative beta, its expected return must be negative.
	C.	A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
	D.	According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
	E.	A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.

2 points

QUESTION 5

Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases."

True

False

2 points

QUESTION 6

The owner of a convertible bond owns, in effect, both a bond and a call option.

True

False

2 points

QUESTION 7

If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

True

False

2 points

QUESTION 8

Which of the following statements is most CORRECT?

	A.	Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
	B.	One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
	C.	The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
	D.	Warrants have an option feature but convertibles do not.
	E.	The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.

2 points

QUESTION 9

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

True

False

2 points

QUESTION 10

The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners.

True

False

2 points

QUESTION 11

Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

True

False

2 points

QUESTION 12

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

True

False

2 points

QUESTION 13

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

True

False

2 points

QUESTION 14

Operating leases help to shift the risk of obsolescence from the user to the lessor.

True

False

2 points

QUESTION 15

Starting to invest early for retirement increases the benefits of compound interest.

True

False

2 points

QUESTION 16

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

True

False

2 points

QUESTION 17

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

True

False

2 points

QUESTION 18

An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

True

False

2 points

QUESTION 19

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

True

False

2 points

QUESTION 20

If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

True

False

2 points

QUESTION 21

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

True

False

2 points

QUESTION 22

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

	A.	Project C, which is of above-average risk and has a return of 11%.
	B.	Project A, which is of average risk and has a return of 9%.
	C.	None of the projects should be accepted.
	D.	All of the projects should be accepted.
	E.	Project B, which is of below-average risk and has a return of 8.5%.

2 points

QUESTION 23

To finance the construction of a new plant, Pietersen Corporation must raise an additional $10,000,000 of equity capital through the sale of common stock. The firm currently has an EPS of $5.40 and a P/E ratio of 10, with 1,200,000 shares outstanding. If the firm wants its ex-rights price to be $50, what subscription price must it set on the new shares?

	A.	$39.28
	B.	$50.00
	C.	$29.55
	D.	$41.80
	E.	$33.78

2 points

QUESTION 24

Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

	A.	A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage.
	B.	A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
	C.	The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity.
	D.	If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.
	E.	Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

2 points

QUESTION 25

Which of the following statements is CORRECT?

	A.	In the statement of cash flows, a decrease in inventories is reported as a use of cash.
	B.	In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.
	C.	In the statement of cash flows, depreciation charges are reported as a use of cash.
	D.	In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
	E.	Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.

2 points

QUESTION 26

The term "additional funds needed (AFN)" is generally defined as follows:

	A.	A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
	B.	Funds that are obtained automatically from routine business transactions.
	C.	Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
	D.	The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
	E.	The amount of assets required per dollar of sales.

2 points

QUESTION 27

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True

False

2 points

QUESTION 28

Which of the following statements is CORRECT?

	A.	The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
	B.	Identifying an externality can never lead to an increase in the calculated NPV.
	C.	Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
	D.	An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase.
	E.	An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

2 points

QUESTION 29

Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

True

False

2 points

QUESTION 30

A warrant is an option, and as such it cannot be used as a "sweetener."

True

False

2 points

QUESTION 31

BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

	A.	The life of the option is increased, i.e., the time until it expires is lengthened.
	B.	The exercise price of the option is increased.
	C.	The Federal Reserve takes actions that increase the risk-free rate.
	D.	BLW's stock price becomes more risky (higher variance).
	E.	BLW's stock price suddenly increases.

2 points

QUESTION 32

Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

	A.	$48.62
	B.	$40.00
	C.	$42.00
	D.	$46.31
	E.	$44.10

2 points

QUESTION 33

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price?

	A.	$18.29
	B.	$17.39
	C.	$19.22
	D.	$18.75
	E.	$17.84

2 points

QUESTION 34

If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth.

True

False

2 points

QUESTION 35

The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

	A.	$783.75
	B.	$744.56
	C.	$825.00
	D.	$866.25
	E.	$707.33

2 points

QUESTION 36

Which of the following statements is CORRECT?

	A.	If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
	B.	If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
	C.	If a coupon bond is selling at par, its current yield equals its yield to maturity.
	D.	If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
	E.	If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.

2 points

QUESTION 37

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

True

False

2 points

QUESTION 38

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

	A.	Project S's NPV is more sensitive to changes in WACC than Project L's.
	B.	If the WACC is 13%, Project S will have the lower NPV.
	C.	If the WACC is 6%, Project S will have the higher NPV.
	D.	If the WACC is 10%, both projects will have positive NPVs.
	E.	If the WACC is 10%, both projects will have a negative NPV.

2 points

QUESTION 39

A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

True

False

2 points

QUESTION 40

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

	A.	Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.
	B.	Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
	C.	Corporations generally find it relatively difficult to raise large amounts of capital.
	D.	Corporations generally face relatively few regulations.
	E.	Corporate investors are exposed to unlimited liability.

2 points

QUESTION 41

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

True

False

2 points

QUESTION 42

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio?

	A.	Use cash to reduce accruals.
	B.	Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
	C.	Use cash to reduce accounts payable.
	D.	Borrow using short-term notes payable and use the proceeds to reduce accruals.
	E.	Use cash to reduce short-term notes payable.

2 points

QUESTION 43

ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.

True

False

2 points

QUESTION 44

High current and quick ratios always indicate that a firm is managing its liquidity position well.

True

False

2 points

QUESTION 45

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

True

False

2 points

QUESTION 46

"Capital" is sometimes defined as funds supplied to a firm by investors.

True

False

2 points

QUESTION 47

Heavy use of off-balance sheet lease financing will tend to

	A.	affect a company's cash flows but not its degree of risk.
	B.	make a company appear less risky than it actually is because its stated debt ratio will appear lower.
	C.	make a company appear more risky than it actually is because its stated debt ratio will be increased.
	D.	affect the lessee's cash flows but only due to tax effects.
	E.	have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

2 points

QUESTION 48

As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

True

False

2 points

QUESTION 49

On the balance sheet, total assets must always equal total liabilities and equity.

True

False

2 points

QUESTION 50

The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity.

True

False

Pete Slokowsky and Mary Jackson are facing an important decision. After having discussed different financial scenarios into the wee hours of the morning, the two computer engineers felt it was time to finalize their cash flow projections and move to the next stage â decide which of two possible projects they should undertake.

Both had a bachelor degree in engineering and had put in several years as maintenance engineers in a large chip manufacturing company. About six months ago, they were able to exercise their first stock options. That was when they decided to quit their safe, steady job and pursue their dreams of starting a venture of their own. In their spare time, almost as a hobby, they had been collaborating on some research into a new chip that could speed up certain specialized tasks by as much as 25%. At this point, the design of the chip was complete. While further experimentation might improve the performance of their design, any delay in entering the market now may prove to be costly, as one of the established players might introduce a similar product of their own. The duo knew that now was the time to act if at all.

They estimated that they would need to spend about $5,000,000 on plant, equipment and supplies. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once the product had established a name for itself, the price could be raised. By the end of the fifth year, their product in its current form was likely to be obsolete. However, the innovative approach that they had devised and patented could be sold to a larger chip manufacturer for a decent sum. Accordingly, the two budding entrepreneurs estimated the cash flows for this project (call it Project A) as follows:

Year	Project A Expected Cash flows ($)
0	(5,000,000)
1	200,000
2	875,000
3	2,140,000
4	3,100,000
5	3,100,000

An alternative to pursuing this project would be to immediately sell the patent for their innovative chip design to one of the established chip makers. They estimated that they would receive around $300,000 for this. It would probably not be reasonable to expect much more as neither their product nor their innovative approach had a track record.

They could then invest in some plant and equipment that would test silicon wafers for zircon content before the wafers were used to make chips. Too much zircon would affect the long-term performance of the chips. The task of checking the level of zircon was currently being performed by chip makers themselves. However, many of them, especially the smaller ones, did not have the capacity to permit 100% checking. Most tested only a sample of the wafers they received.

Pete and Mary were confident that they could persuade at least some of the chip makers to outsource this function to them. By exclusively specializing in this task, their little company would be able to slash costs by more than half, and thus allow the chip manufacturers to go in for 100% quality check for roughly the same cost as what they were incurring for a partial quality check today. The life of this project too (call it project B) is expected to be only about five years.

The initial investment for this project is estimated at $ 4,500,000. After taking into account the sale of their patent, the net investment would be $4,200,000. As for the future, Mary and Pete were pretty sure that there would be sizable profits in the first couple of years. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry. Keeping all this in mind, they estimate the cash flows for this project as follows:

Year	Project B Expected Cash flows ($)
0	(4,200,000)
1	2,500,000
2	2,000,000
3	905,000
4	550,000
5	250,000

Mary and Pete now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 15% for both projects. Ideally, they would prefer that the project they choose have a payback period of less than 4 years and a discounted payback period of less than 5 years.

Below are the results of the analysis they have carried out so far:

Metrics	Project A	Project B
Payback period (in years)	3.58	1.85
Discounted payback period (in years)	4.64	2.86
Net Present Value (NPV)	$556,306	$520,011
Internal Rate of Return (IRR)	18.35%	22.51%
Profitability Index	1.11	1.12
Modified Internal Rate of Return (MIRR)	17.45%	17.72%

One of the concerns that Mary and Pete have is regarding the reliability of their cash flow estimates. All the analysis in the table above is based on âexpectedâ cash flows. However, they are both aware that actual future cash flows may be higher or lower.

Suppose that Pete and Mary have hired you as a consultant to help them make the decision. Please draft an official memo to them with your analysis and recommendations.

Your submission should cover the following questions:

1.Briefly, summarize the key facts of the case and identify the problem being faced by our two budding entrepreneurs. In other words, what is the decision that they need to make?

An excellent paper will demonstrate the ability to construct a clear and insightful problem statement while identifying all underlying issues.

2.What are some approaches that can be used to solve this problem? What are some various criteria or metrics that can be used to help make this decision?

An excellent paper will propose solutions that are sensitive to all the identified issues.

3.a) Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV, IRR, Profitability Index, and MIRR.

b) Mary believes that the best approach to make the decision is the NPV approach. However, Pete is not so sure that ignoring the other metrics is a good idea. Which of the approaches or metrics would you propose? In other words, would you prefer one or more of these approaches over the others? Explain why.

An excellent paper includes an evaluation of solutions containing thorough and insightful explanations, feasibility of solutions, and impacts of solutions.

4.a) Which of these projects would you recommend? Explain why.

b) Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend.

magentalion116

Florida Keys Hospital is a 250-bed, investor-owned hospital located in Islamorada, Florida, which is known as the âSport Fishing Capital of the World.â The hospital was founded in 1946 by Rob Winslow, a prominent Florida physician, on his return from service in World War II. Winslow relinquished control of the hospital in 1967 while it was still small and in a relatively quiet setting. However, in recent years, the Florida Keys have experienced a population explosion, which has fostered high economic growth as well as a continuing need for more healthcare services. Today, under a succession of excellent chief executive officers, the hospital is acknowledged to be one of the leading healthcare providers in the area.

Florida Keysâ management is currently evaluating a proposed ambulatory (outpatient) surgery center. Over 80% of all outpatient surgery is performed by specialists in gastroenterology, gynecology, ophthalmology, otolaryngology, orthopedics, plastic surgery, and urology. Ambulatory surgery requires an average of about one and one-half hoursâminor procedures take about one hour or less, and major procedures take about two or more hours. About 60% of the procedures are performed under general anesthesia, 30% under local anesthesia, and 10% under regional or spinal anesthesia. In general, operating rooms are built in pairs so that a patient can be prepped in one room while the surgeon is completing a procedure in the other room.

The outpatient surgery market has experienced significant growth since the first ambulatory surgery center opened in 1970. By 1990, about 2.5 million procedures were being performed, but by 2005 the number had grown to over 7 million. This growth has been fueled primarily by three factors. First, rapid advancements in technology have enabled many procedures that were historically performed in inpatient surgical suites to be switched to outpatient settings. This shift was caused mainly by advances in laser, laparoscopic, endoscopic, and arthroscopic technologies. Second, Medicare has been aggressive in approving new minimally invasive surgery techniques, so the number of Medicare patients utilizing outpatient surgery services has grown substantially. Finally, patients prefer outpatient surgeries because they are more convenient, and third-party payers prefer them because they are less costly.

All of these factors have led to a situation in which the number of inpatient surgeries has remained flat over the last few years while the number of outpatient procedures has continuously grown at over 10 percent annually. Rapid growth in the number of outpatient surgeries has been accompanied by a corresponding growth in the number of outpatient facilities nationwide. The number currently stands at about 3,300, so competition in many areas has become intense. Somewhat surprisingly, there is no outpatient surgery center in the hospitalâs immediate service area, although there have been rumors that local physicians are exploring the feasibility of a physician-owned facility.

Florida Keys Hospital currently owns a parcel of land adjacent to its facility tht is a perfect location for the surgery center. The hospital bought the land five years ago for $150,000, and last year the hospital spent (and expensed for tax purposes) $25,000 to clear the land and put in sewer and utility lines. If sold in todayâs market, the land would bring in $200,000, net of all fees, commissions, and taxes. Land prices have been extremely volatile, so the hospitalâs standard procedure is to assume a salvage value equal to the current value of the land. Of course, land is not depreciated for either book or tax purposes.

The surgery center building, which will house four operating suites, would cost $5 million and the equipment would cost an additional $5 million, for a total of $10 million. For ease, assume that both the building and the equipment fall into the modified accelerated cost recover system (MACRS) five-year class for tax-depreciation purposes. (In reality, the building would have to be depreciated over a much longer period than the equipment.) The project will probably have a long life, but the hospital typically assumes a five-year life in its capital budgeting analyses and then approximates the value of the cash flows beyond Year 5 by including a terminal, or salvage, value in the analysis. To estimate the salvage value, the hospital typically uses the market value of the building and equipment after five years, which for this project is estimated to be $5 million before taxes, excluding the land value. (Note that taxes must be paid on the difference between an asstâs salvage value and it tax book value at termination. For example, if an asset that cost $10,000 has been depreciated down to $5,000 and then sold for $7,000, the firm owes taxes on the $2,000 excess in salvage value over tax book value.)

The expected volume at the surgery center is 20 procedures a day. The average charge per procedure is expected to be $1,500, but charity care, bad debts, managed care plan discounts, and other allowances lower the net revenue amount to $1,000. The center would be open five days a week, 50 weeks a year, for a total of 250 days a year. Labor costs to run the surgery center are estimated at $696,000 per year, including fringe benefits. Utilities, including hazardous waste disposal, would add another $50,000 in annual costs.

If the surgery center were built, the hospitalâs cash overhead costs would increase by $36,000 annually, primarily for housekeeping and buildings and grounds maintenance. In addition, the center would be allocated $25,000 of Florida Keysâ current $2.8 million in administrative overhead costs. On average, each procedure would require $200 in expendable medical supplies, including anesthetics. Although the hospitalâs inventories and receivables would rise slightly if the center is constructed, its accruals and payables would also increase. The overall change in net working capital is expected to be small and hence not material to the analysis. The hospitalâs marginal federal-plus-state tax rate is 40 percent.

One of the most difficult factors to deal with in project analysis is inflation. Both input costs and charges in the healthcare industry have been rising at about twice the rate of overall inflation. Furthermore, inflationary pressures have been highly variable. Because of the difficulties involved in forecasting inflation rates, the hospital begins each analysis by assuming that both revenues and costs, except for depreciation, will increase at a constant rate. Under current conditions, this rate is assumed to be 3 percent.

When the project was mentioned briefly at the last meeting of the hospitalâs board of directors, several questions were raised. In particular, one director wanted to make sure that a complete risk analysis, including sensitivity and scenario analyses, was performed prior to presenting the proposal to the board. Recently, the board was forced to close a day care center that appeared to be profitable when analyzed two years ago but turned out to be a big money loser. They do not want a repeat of that occurrence.

One of Florida Keysâ directors stated that she thought the hospital was putting too much faith in the numbers: âAfter allâ, she pointed out, âthat is what got us into trouble on the day care center. We need to start worrying more about how projects fit into our strategic vision and how they impact the services that we currently offer.â

Another director, who also is the hospitalâs chief of medicine, expressed concern over the impact of the ambulatory surgery center on the current volume of inpatient surgeries. This concern prompted an analysis by the surgery department head, which indicated that an outpatient surgery center could siphon off up to $1 million in cash revenues annually. When pressed, the department head indicated that such a reduction in volume could also lead to a $500,000 reduction in annual cash expenses.

To develop the data needed for the risk analysis, Jules Bergman, the hospitalâs director of capital budgeting, met with department heads of surgery, marketing, and facilities. After several sessions, they concluded that three input variables are highly uncertain: number of procedures per day, average revenue per procedure, and building/equipment salvage value. If another entity entered the local ambulatory surgery market, the number of procedures could be as low as 10 per day. Conversely, if acceptance is strong and no competing centers are built, the number of procedures could be as high as 25 per day, compared to the most likely value of 20 per day.

The average net revenue amount, with an expected value of $1,000, is a function of the types of procedures performed and the amount of managed care penetration. If surgery severity were high (i.e., if a higher number of complicated procedures were performed than anticipated) and managed care penetration remained low, then the average revenue could be as high as $1,200. Conversely, if the severity were lower than expected and managed care penetration increases, the average revenue could be as low as $800. Finally, if real estate and medical equipment values stay strong, the building/equipment salvage value could be as high as $6 million, but if the market weakens, the salvage value could be as low as $4 million, compared to an expected value of $5 million.

Jules also discussed the probabilities of the various scenarios with the medical and marketing staffs, but after considerable debate no consensus could be reached. To add to the confusion, one member of the medical staff, who had just returned from a University of Michigan executive program on financial management, questioned why the scenario analysis had to be confined to just three scenarios. âWhy not five or seven?â he queried. Additionally, he said that the executive program had taught him a good way to assess the impact of inflation on project profitability, which is to create and analyze an inflation impact table.

To help with the risk-incorporation phase of the analysis, Jules consulted with Mark Hauser, Florida Keysâ chief financial officer, about both the risk inherent in the hospitalâs average project and how the hospital typically adjusts for risk. Mark told Jules that based on historical scenario analysis data that use worst, most likely, and best case values, the hospitalâs average project has a coefficient of variation of net present value (NPV) in the range of 1.0 to 2.0 and that the hospital typically adds or subtracts 4 percentage points to its 10% corporate cost of capital to adjust for differential project risk.

Assume that Florida Keys has hired you as a financial consultant. Your task is to conduct a complete project analysis on the ambulatory surgery center and to present your findings and recommendations to the hospitalâs board of directors.

Questions to think about as you evaluate, analyze, and present your findings on this particular project:

What is âincremental cash flowâ? Because the project, at least constructively, will be financed in part by debt, should the cash flows include interest expense? Think about why or why not . . .

The hospital already owns the site for the center, so should any cost be attributed to the land? Why or why not . . .

What overhead costs should be included in the analysis?

How should the cannibalization of inpatient surgeries be handled?

What is the projectâs payback? What is the economic interpretation of payback? What type of information do decision-makers get from the payback?

What is the projectâs net present value (NPV)? Think about the economic rationale behind this profitability measure.

What is the projectâs internal rate of return (IRR)? Think about the economic rationale behind IRR. Do the NPV and IRR always lead to the same conclusion about a projectâs profitability?

What is the projectâs modified internal rate of return (MIRR)? How does MIRR differ from IRR? Which one is a better measure of a projectâs true rate of return?

To give the board a better feel for the impact of inflation on the outpatient surgery center, you may wish to construct an inflation impact table.

You may wish to conduct a sensitivity analysisâcreating a table and/or graph that shows the sensitivity of NPV to procedures per day, average charge, and salvage value. Assume that each variable can deviate from its base case value by +/-10, +/-20, and +/-30 percent. Think about the advantages and disadvantages of sensitivity analysis.

You may wish to conduct a scenario analysis. Does the expected NPV obtained here agree with the base case NPV? If not, why? Discuss the advantages and disadvantages of scenario analysis.

Should the ambulatory surgery center be classified as high risk, average risk, or low risk on the basis of the analysis thus far?

What is your estimate of the projectâs corporate risk? Its market risk?

Is there additional data you would seek from other hospital staff members to conduct a more thorough analysis? Can you think of any costs that might be associated with the project that have not been included in the analysis? Are there any potential benefits that have not been included? What qualitative factors should the board consider in making the final judgment on the project?

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FNCE 239 Lecture 10: Lecture 10 Notes

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