Maizee Hospital is a 300-bed hospital in Nishingwa, Montana. It is part of a small investor-owned hospital chain, Corporation of Hospitals of America's Inland Northwest (CHAIN). CHAIN is traded on the Vancouver Stock Exchange. CHAIN employs a decentralized approach to capital expenditure decision-making but a centralized approach to capital access. Maizee Hospital is acknowledged to be one of the leading health care providers in the western Montana area.

Maizee's management is currently evaluating a proposed ambulatory (outpatient) surgery center. Over 80 percent of all outpa¬tient surgery is performed by specialists in gastroenterology, gynecol¬ogy, ophthalmology, otolaryngology, orthopedics, plastic surgery, and urology. Ambulatory surgery requires an average of about one and one-¬half hours, with minor procedures taking about one hour and major procedures taking about two or more hours. About 60 percent of the procedures are performed under general anesthesia, 30 percent under local anesthesia, and 10 percent under regional or spinal anesthesia. In general, operating rooms are built in pairs so one patient can be prepped while the surgeon is completing a procedure in the other room.

The outpatient surgery market has experienced significant growth in recent years. This growth has been fueled by three main factors. First, rapid advance¬ments in technology have enabled many procedures that were histori¬cally performed in inpatient surgical suites to be switched to outpatient settings. This shift has been due mainly to advances in laser, laparoscopic, endoscopic, and arthroscopic technologies. Second, Medicare has been aggressive in approving new outpatient surgery techniques, so the num¬ber 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 where the number of inpatient surgeries has remained flat over the last few years while the number of outpatient procedures has been growing at about five percent annually. Rapid growth in the number of outpatient surgeries has been accompanied by a corresponding growth in the number of out¬patient facilities nationwide, so competition in many areas is becoming intense. Growing competition means that market rates of growth in ambulatory surgery volume may not be experienced by individual providers.

MaizeeHospital owns a parcel of land adjacent to the hospital that is suitable for the center. It bought the land five years ago for $1,000,000, and last year the hospital spent $200,000 to clear the land and put in sewer and utility lines. If sold in today's market, the land would bring in $2,000,000, net of all fees, commissions, and taxes. Of course, land is not depreciated for either book or tax purposes. The building and equipment that will house and equip four operating rooms would cost $24 million ($16m for building and $8m for equipment). Assume that the building falls into the MACRS 20-year class for tax depreciation purposes and that the equipment falls into the five-year class.

The project will probably have a long life, but Maizee Hospital typically uses a five-year horizon in its capital budgeting analyses, and then captures the value of the cash flows beyond the horizon by valuing the new business as a going concern. Under this approach, a perpetuity model is applied to cash flows in Year 6.

The expected patient load at the center is 12 procedures a day. The average hospital charge per procedure is $8000, but charity care, bad debts, managed care plan discounts, and other allowances are expected to total 40 percent of charges. The center will be open 5 days a week, 50 weeks a year, for a total of 250 days a year. Direct labor costs to run the center are estimated at $3,000,000 per year, including fringe benefits. Utilities, including hazardous waste disposal, would add another $300,000 in annual costs.

If the surgery center is built, the hospital's cash overhead costs would increase by $250,000 annually, primarily for housekeeping and buildings and grounds maintenance. In addition, the center would be allocated $100,000 of Maizee's current $1,200,000 in administra¬tive overhead costs. On average, each procedure would require $900 in expendable medical supplies, including anesthetics. The hospital intends to carry a supplies inventory such that the inventory at the beginning of each year is equal to 30 percent of projected supplies expense for the year. The hospital's marginal federal-plus-state tax rate is 35 percent.

When the project was mentioned briefly at the last meeting of the hospital's board of directors, several questions were raised. In particular, one director wanted to make sure that complete risk analyses, including an inflation impact analysis, a sensitivity analysis, and a bad case scenario analysis, were performed prior to presenting the proposal to the board. To develop the data needed for the risk analyses, Bozo Buffoon, the hospital's director of capital budgeting, met with the surgery, marketing, and facilities department heads. After several sessions, they concluded that three variables were most uncertain: number of procedures per day, average charge per procedure, and payer mix. Currently, there are no outpatient surgery centers in Maizee's immediate service area, but if another hospital or other provider were to enter the ambulatory surgery market, the initial number of procedures per day could be as low as 10. Further, volume growth projections would have to be adjusted downward. The average charge, with a projected value of $8000, is a function of the types of procedures performed, as well as of competition. If surgery severity were lower than expected, the average charge could be as low as $6000. Revenue deductions depend on payer mix. Heavy pene¬tration by managed care plans could drive the revenue deduction percentage to as high as 50 percent. While projecting these variables for the near term was considered difficult but possible, projections into the distant future were viewed as fraught with uncertainty.

For the inflation impact analysis, Bozo used a base assumption that cash costs and charges would increase at 3 percent per year. He and the rest of the management team were particularly concerned that expense inflation might exceed revenue inflation.

Another concern is the potential effect of the ambulatory surgery facility on Maizee Hospital's inpatient business. A study of the experience of other CHAIN operating units has shown an average loss of inpatient net revenues of 20 percent of new outpatient net revenues. Avoidable costs from the reduction in inpatient volume are calculated assuming a contribution margin of 50 percent.

Buffoon also discussed the financing of the proposed project with Harold Dandy, Maizee's chief financial officer. Dandy explained that CHAIN's approach to capital financing was centralized; CHAIN arranges all financing for projects system-wide requiring capital outlays exceeding $5 million. CHAIN has a master trust indenture to support all debt financing required for the system. The current interest rate CHAIN faces on long term debt is 7 percent, net of all fees and transactions costs. CHAIN has $800 million in long-term debt outstanding. As a publicly-traded firm, CHAIN has 10 million shares outstanding. Stock price is $60 per share. Earnings per share have been steady over the past five years at about $7. In the evaluation of capital expenditures to support new business ventures (as compared to current lines of business), CHAIN requires that its hospitals impose an additional equityrisk premium of 2 percentage points.

Bozo Buffoon is characteristically unsure of his ability to complete this financial analysis correctly, so he hires you (out of his personal funds) to help him conduct a complete project analysis and to help him present the analysis in written form to Maizee Hospital's planning and finance committee.