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 states 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 hospitals 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 firms 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 projects 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 hospitals general age and reputation will result.
Accepted: + 3

Widespread positive effect on the hospitals image a reputation will result

C. Employee Impact
Will this project have an effect on the attitude the hospitals personnel? YES
Not accepted: -3

widespread disappointment with the hospital and some negative effects on the
hospitals image among employees
Accepted: +2

A limited group of employees will be very pleased

Exhibit 3. Score Sheet

Evaluation

Instruction

Potential

Proposed

Score

Projects
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

Community Impact

0-8

Employee Impact

0-8

Total qualitative score

15

Total Score

11

Qualitative Analysis Laundry 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

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 hospitals personnel? YES
Not Accepted: -2

Limited group of employees will react negatively

The departments request for capital had been turned down in for several years
Accepted: +3

Nearly all employees will be pleased

Evaluation

Instruction

Potential Score Proposed

Projects
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

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

Physician Impact

0-8

Community Impact

0-8

Employee Impact

0-8

Total Qualitative Score

10

Total Score

14

3. Apply the Internal Rate of Return method in its capital budgeting process

Pros

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 Centers 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.