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Captial budgeting

Happy Valley is considering moving from its present location into a new 200-bed facility. The estimated construction cost for the new facility is $40 million. The hospital has no internal funds and is considering a 20-year mortgage with interest scheduled to be eight percent. The issue will be repaid over 20 years with equal annual principal payments of $2 million. Interest expense would decline each year by $160,000.

The cost of the plant and fixed equipment would be 80 percent of the total cost or $32 million, and the movable equipment would be $8 million. The movable equipment would need to be replaced in ten years, and it is estimated that the replacement cost would be $17,271,200 (inflation is assumed to be eight percent per year). The plant and fixed equipment would need to be replaced in 30 years at a cost of $322,006,400 (inflation again assumed to be eight percent per year). All costs reflect only the investment required to provide inpatient services. A separate analysis will be done for outpatient services.

Happy Valley anticipates that its operation will generate about 9700 discharges per year. The hospital anticipates that its operating costs, excluding capital costs, will be $4,000 per discharge, or $38,800,000 in the first full year of operation.

The payer mix at Happy Valley is expected to be 60 percent Medicare and Medicaid on the inpatient side. These payers will pay approximately $4,400 per discharge. This payment reflects both operating and capital cost payments. Approximately ten percent of Happy Valleyâ??s operating and capital costs will be paid by payers who reimburse the hospital on a cost-related basis for both capital and operating costs. The remaining 30 percent of Happy Valleyâ??s business will be charge-based, but it is expected that discounts to commercial insurers and bad debt and charity write-offs will average 30 percent.

Assuming that Happy Valley wishes to break even on a cash-flow basis during the first year of operation, what charge per discharge must be set? If the hospital wanted to include an element in its rate structure to reflect replacement cost of the building and movable equipment, what additional amount would that be? Assume that 50 percent of the movable equipment cost would be debt financed and 80 percent of the building and fixed equipment would be debt financed. Also assume that the hospital can earn ten percent
on any invested money, so use ten percent as your discount rate.

Solution Summary

Captial budgeting is exemplified.

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