4.0 What is “incremental cash flow”? Because the project, at least constructivel

Question

4.0

What is “incremental cash flow”? 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 project’s payback? What is the economic interpretation of payback? What type of information do decision-makers get from the payback?

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

What is the project’s 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 project’s profitability?

What is the project’s modified internal rate of return (MIRR)? How does MIRR differ from IRR? Which one is a better measure of a project’s 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 analysis—creating 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.

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INPUT DATA:          KEY OUTPUT: Land initial cost $150,000          NPV $1,408,166 Land opportunity cost (and salvage value) $200,000          IRR 14.7% Building/equipment cost $10,000,000          MIRR 12.9% Build/equipment salvage value $5,000,000          Payback 4.0 Procedures per day 20 Average net revenue per procedure $1,000 Labor costs $696,000 Utilities costs $50,000 Incremental overhead $36,000 Supply cost ($/procedure) $200 Inflation rate on charges 3.0% Inflation rate on costs 3.0% Tax rate 40.0% Revenues lost from inpatient surgeries $1,000,000 Reduction in inpatient surgery costs $500,000 Cost of capital 10.0% MODEL-GENERATED DATA: Depreciation Schedule: MACRS Deprec. End of Year Year Factor Expense Book value 1 0.20 $2,000,000 $8,000,000 2 0.32 3,200,000 4,800,000 3 0.19 1,900,000 2,900,000 4 0.12 1,200,000 1,700,000 5 0.11 1,100,000 600,000 6 0.06 600,000 0 Net Cash Flows: Project Cash Flows 0 1 2 3 4 5 Land opportunity cost ($200,000) Building/equipment cost (10,000,000) Net revenues (including inpatient loss) $4,000,000 $4,120,000 $4,243,600 $4,370,908 $4,502,035 Less: Labor costs 696,000 716,880 738,386 760,538 783,354          Cost savings on inpatients (500,000) (515,000) (530,450) (546,364) (562,754)          Utilities costs 50,000 51,500 53,045 54,636 56,275          Supplies 1,000,000 1,030,000 1,060,900 1,092,727 1,125,509          Incremental overhead 36,000 37,080 38,192 39,338 40,518          Depreciation 2,000,000 3,200,000 1,900,000 1,200,000 1,100,000 Income before taxes $718,000 ($400,460) $983,526 $1,770,032 $1,959,133 Taxes 287,200 (160,184) 393,410 708,013 783,653 Project net income $430,800 ($240,276) $590,116 $1,062,019 $1,175,480 Plus: Depreciation 2,000,000 3,200,000 1,900,000 1,200,000 1,100,000 Plus: Net land salvage value 180,000 Plus: Net building/equipment salvage value 3,240,000 Net cash flow ($10,200,000) $2,430,800 $2,959,724 $2,490,116 $2,262,019 $5,695,480 Cumulative net cash flow ($10,200,000) ($7,769,200) ($4,809,476) ($2,319,360) ($57,341) $5,638,139 (For payback calculation) Profitability and Breakeven Measures: Net present value (NPV) $1,408,166 Internal rate of return (IRR) 14.7% Modified IRR (MIRR) 12.9% Payback

4.0

(Question)

Explanation / Answer

Incremental Cash flow is the excess of cash inflow over that of cash outflows on account of expenses and taxes pertaining to the project. This is because the hospital is already operating with certain facilities. To evaluate the net benefit which can be derived from the new facility needs to be assessed from the additional cash flows (both inflows as well as outflows) associated with the operation of new facility. The net incremental cash flow will be net of incremental inflows reduced by incremental outflows and incremental taxes.

In the current case, the incremental cash flow can be calculated as

Incremental cash flow = Net Cash flow   = Net Revenues – operating costs – Taxes

Taxes are calculated as

Taxes = (Cash Inflow – cash out flow – depreciation) * tax rate

In effect we are calculating the excess cash generated by operations. Depreciation is not a cash outflow and hence it is not taken into account.

Even if the project is part financed by debt, we do not take interest into account while calculating the incremental cash flows as we are estimating the total cash available to service various financing options be they are equity, preferred stock or debt. This is the cash available to the holders or various financing options without affecting the operations of the company. Hence interest on debt financing the project is not taken into consideration while calculating incremental cash flows.

Even if the land is already owned by the hospital for construction of the center, we need to take the opportunity cost of the land to estimate the actual profitability or net cash generation.Also the land may be used for several alternative options other than building the center. In such cases, the opportunity cost should be taken into account for arriving at the overall benefit from the project and its comparability to other options.

Overheads which are already being charged for existing facilities are already factored into profitability calculations of existing facilities. The profitability or net cash calculations of the proposed project should include only the incremental overheads associated with the new facility.

Cannibalization of inpatient surgeries denotes the closure of existing inpatient surgery facilities and merging the same with new facility.   In such cases, the reduction in costs associated with closure of old facilities needs to be taken into account while calculating the incremental cash flows. As the new facility can handle a larger number of surgeries over and above the number already being done in existing facility, the incremental revenues will be only those from the additional number of surgeries done in new facility.

Project’s Payback is 4 years. That is the future net cash flows can pay off the investment in new facility in 4 years. This provides a measure of the net cash flows required to recover the amount spent in construction of the new facility and the time the management needs to wait for the project to turn profitable.

The Net present value of the project is $ 1,408,166. This is a positive value indicating the present value of the future cash flows receivable from the project return the above amount over and above the investment in the project at a pre-determined required rate of return of the management. The required rate of return is determined based on various factors like how the project is financed – from retained earnings, by equity, by debt, or partly by all the above. Each of the sources has a cost attached it as the capital providers expect a certain rate of return on their investment. The firm needs to arrive a weighted average cost of all the sources and use the same to find the net present value to find whether they will be able to satisfy all the investment providers. A different required rate of return results in a different Net Present Value.

Internal Rate of Return is the rate of return at which the net present value of the project becomes zero. That is the sum of present values of net cash flows equals the total investment in project. Hence, this is the minimum rate at which the project breaks even.

The decision rule of NPV and IRR are not always the same. The NPV method looks whether the net present value is positive or negative to go ahead with the project while the projects with higher IRR are considered for investment while those with lower IRR are ignored. If the WACC of the firm is higher than the IRR derived for the project, then we do not invest in the project and vice versa. Upto this point both IRR and NPV give same decision. However, if there are intermediate negative cash flows i.e., there are losses in some of the periods, then IRR does not provide a correct value and the decision based on IRR will become faulty. However as NPV considers the cash flows over the total period, it provides a better measure and better decision tool.

The internal rate of return calculation does not take into account reinvestment of the intermediate flows at a specific rate. That is the net cash flow after payment of debt interest and dividends may be reinvested into operations or invested as a deposit to earn an amount which is over and above what is denoted by the net cash flows. This additional amounts are not taken into consideration while calculating IRR. Modified IRR or MIRR takes this factor into account to arrive at the internal rate of return if the intermediate flows are reinvested at a rate of interest. Based on the above, MIRR is a better measure than IRR.

The inflation adjusted net cash flow table is as follows

Year

1

2

3

4

5

Net profit

430800

-240276

590116

1062019

1175480

Inflation rate = 3%

Discount factor =1/(1.03^ year)

1

0.970874

0.942596

0.915142

0.888487

Inflation adjusted net income

430800

-233278

556240.9

971897.8

1044399

Add Depreciation

2000000

3200000

1900000

1200000

1100000

Inflation adjusted net flows

2430800

2966722

2456241

2171898

2144399

In effect we are removing the effect of inflation from the net cash flows, as the costs and revenues when calculated were done taking inflation into account.

A 10% change in number of procedures impacts the npv by 14.85% on either side

By analogy a 20% change in number of procedures per day (increase of 20% or decrease of 20%) impacts the net present value by 29.71% on either side and a 30% change in number of procedures changes the npv by 44.55%. Same is the case with the change in average cost per procedure which when changed by 10% impacts the NPV by 14.85%.

Rest of the calculation is same as above

A 10% change in Salvage value changes impacts the NPV by 15.08% as shown below. By analogy a change in NPV by 20% or 30% will impact the NPV by 30.16% and 45.24%

Year

1

2

3

4

5

Net profit

430800

-240276

590116

1062019

1175480

Inflation rate = 3%

Discount factor =1/(1.03^ year)

1

0.970874

0.942596

0.915142

0.888487

Inflation adjusted net income

430800

-233278

556240.9

971897.8

1044399

Add Depreciation

2000000

3200000

1900000

1200000

1100000

Inflation adjusted net flows

2430800

2966722

2456241

2171898

2144399

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