Capital Budgeting and Investment Decisions

Assignment Details

Capital Budgeting and Investment Decisions

Unit Outcomes addressed in this Assignment:

• Explain the capital investment decision-making process.
• Conduct time-value analysis.

Course Outcome addressed in this Assignment:

HA520-4: Evaluate financial management skills of performance measurement and financial controls in organizations.

Instructions:

With the information from Case 4, Help Heidi estimate the value of Sooner Clinics to UHSC and making a recommendation on whether UHSC should make the acquisition.

Case Study 4 Unit 8 – Sooner Clinics

United Health Services Corporation

United Health Services Corporation (UHSC) is a large integrated healthcare business that serves northern and central Oklahoma. In response to healthcare reform, UHSC has been acquiring primary care practices to capture market share. The basic competitive strategy has been to select geographically well placed practices that will attract and retain patients. UHSC believes this strategy is critical in the shift to population health management.

Initial acquisitions were not entirely successful, primarily because of overvaluation of downstream revenue. In essence, UHSC overpaid for practices in anticipation of higher referrals and revenue after acquisition. Most of these practices were small with only one physician. UHSC quickly learned that, typically, these practices had insufficient patient volume to cover the substantial fixed costs of running a practice, had a payer mix of more than half from less profitable Medicare and Medicaid sources, included a physician who was not seeing an adequate number of patients per day, and paid insufficient attention to the efficient operation of the practice. On the plus side, they had a loyal patient base and were usually seen by their communities as providing an important service.

Perhaps as a result of the less-than-successful experience with small primary care practices, UHSC next acquired a much larger practice- Anderson Clinic. The large patient volume, lucrative payer mix, and busy physicians have made Anderson Clinic a financial success for UHSC. However, there have been substantial problems with this acquisition as well. Most important, changing the culture of a large practice has been difficult. Most Anderson Clinic physicians have been with the practice a long time and resisted many of the clinical and customer processes introduced by UHSC. Many implementation problems have occurred, and complaints from many physicians have required a lot of UHSC management time. One UHSC manager said, ”Anderson gives us most of our profit, but it also gives us most of our headaches.”

This less-than-successful experience with small primary care practices and a large practice prompted UHSC to review its practice acquisition strategy. After several months of study, UHSC decided that, although it can help to reduce practice costs and increase efficiency, the revenue side of the practice is most important. Thus, UHSC has established five criteria for evaluating the acquisition of a practice:

1. Adequate patient volume for the number of providers
2. Viable payer mix
3. Physician productivity
4. Effective operations, including revenue cycle management, pricing of services, coding and documentation, and service mix
5. Qualitative factors, including patient referrals from customer service, organizational culture, quality improvement, and community relations

These criteria have resulted in UHSC adopting a strategy of acquiring “not-too-big and not-too-small” primary care practices. These multi-physician practices are not as financially lucrative as larger practices such as the Anderson Clinic, but incorporation of the practices into the organization has been much easier. Thus, management has decided that this type of practice works best for UHSC and has been looking to acquire more practices of this type.

In the Sooner region of central Oklahoma, UHSC has acquired several practices in the southern end but does not yet have a practice in the northern end. UHSC practices provide general primary care services only, but UHSC is exploring provision of some specialty services, such as pain clinics. UHSC plans to try some specialty services in a few practices to determine whether there is a business case to support an extensive rollout.

Sooner Clinics

One of the primary care practices that UHSC wants to acquire is Sooner Clinics, which is located in the northern end of the Sooner region. Several years ago, UHSC had targeted Sooner Clinics for acquisition but attempts to interest the two founding partners had failed. At the time, the founders had no interest in being purchased by a larger organization.

Nevertheless, Sooner Clinics was too inviting a takeover target to be overlooked for long.  UHSC believes that acquisition of the practice would attract and retain new patients to the network; increase referrals to other UHSC services; and better prepare UHSC for new value-based payment models. Sooner would benefit from access to a larger network and greater net revenue from the UHSC expertise in boosting physician productivity.  In addition, some UHSC senior managers know the two Sooner Clinics’ founders, having served on various community committees together. “The Sooner docs see things the way we see them,” a UHSC senior manager recently said. For these reasons, UHSC has continued to follow the physicians and business activities of Sooner Clinics.

Today, Sooner Clinics operates two walk-in facilities and consists of five physicians- three are board certified in family practice and two in internal medicine. Three work full-time and two work part-time, resulting in four full-time equivalent (FTE) physicians. Sooner Clinics is organized as a for-profit corporation, but for tax purposes the business is classified as an S corporation. (In an S corporation, the business pays no taxes.  Rather, the corporation’s taxable income is constructively distributed to the owners, who pay personal taxes on the income).

Sooner Clinics was founded ten years ago by two physicians (the part-timers) who wanted to have more free time than their solo practices allowed.  Initially, Sooner Clinics had only one location, but a second was recently added. The downtown clinic, whose patients predominantly come directly from work sites, is open Monday through Friday from 8am to 2pm The midtown clinic, whose patients mostly come from home, is open Monday through Saturday from 8am to 8pm, and also provides a few specialty services, including a diabetes care service. Both downtown and midtown clinics are open 52 weeks per year. Exhibit 4.1 provides the average number of visits by day for the two clinics, and exhibit 4.2 shows the current payer mix. With the current medical and clerical staffs, as well as clinic space, Sooner Clinic’s patient volume can grow as much as 50 percent without the need for additional personnel or facilities.

The five physicians who make up Sooner Clinics own the business.  However, the two founding partners control the business: Each has a 35 percent ownership stake. The remaining three partners each own 10 percent of the business.  Because the founding partners are looking to fully retire in the near future, they would like to sell the business.The remaining partners are less enthusiastic about selling out, but as minority owners their alternatives are limited.

The most recent income statement of the business is provided in exhibit 4.3. Note that the  statement uses the effective average tax rate applicable if Sooner Clinics were to file as a C corporation. A condensed balance sheet is contained in exhibit 4.4. If UHSC acquires Sooner Clinics, it would maintain the current debt ratio into the foreseeable future and has an agreement with a lending institution to borrow funds at a rate of 6 percent. In addition to assets used in the day-to-day operations of the business, Sooner Clinics holds non-operating assets (marketable securities and investment properties). The marketable securities represent a rainy-day fund, and the investment properties were acquired to diversify the asset holdings and revenue stream of Sooner Clinics.

Sooner Clinic’s cost structure, listed in exhibit 4.4, is expected to hold in the immediate future, with fixed costs (including depreciation) increasing at a 2 percent annual rate.  Furthermore, Sooner Clinics would have to invest roughly $25,000 each year (in Year 1 dollars) in new equipment. Inflation is expected to increase these capital investment amounts by 2 percent per year.

Wilde and Sullivan

To ensure that it did not overpay for a primary care practice again, UHSC retained the services of Wilde and Sullivan, an Oklahoma firm that specializes in physician practice valuation and appraisal. Heidi Wilde, the managing partner, had recently valued four practices in the central Oklahoma region, so she decided to use this experience as a starting point in estimating the value of Sooner Clinics to UHSC. Selected data for these acquisitions are shown in exhibit 4.5.

First, Heidi estimated the expected revenue growth rate for the short term (Years 1-5) and the long term (Years 6 and beyond). In reviewing the data in exhibit 4.5, Heidi noted that Sooner Clinics and all of the recent practice acquisitions are located in the same geographic area, so it is reasonable to assume that Sooner Clinics faces the same estimated long-term (Years 6 and beyond) revenue growth rate of 2 percent. However, Heidi has found that the short-term (Years 1- 5) revenue growth rate of a particular practice depends on the current level of physician productivity: Clinics with relatively low physician productivity have higher short-term (Years 1-5) revenue growth rates because of room for productivity increases.  Heidi also believes that there is an opportunity for improved coding and documentation, better revenue cycle management, and an updated chargemaster at Sooner Clinics.

Next, Heidi assembled the information required for the discounted cash flow (DCF) approach, including the estimated required rate of return on an equity investment in Sooner Clinics. Little market data about primary care practices are available to offer guidance, but the current yield on long-term Treasury bonds is 4 percent, and the historical risk premium on the market, which reflects the premium on an average-risk common stock investment, is about 5 percent. Of course, significant risk and liquidity differences exist between direct ownership of a relatively small group practice and ownership of the stock of a large, publicly traded corporation. UHSC also informed Heidi that it estimates its tax rate will be 20 percent for the foreseeable future.

In addition to the DCF approach, Wilde and Sullivan use three market multiple methods to value medical practices: physician FTEs, net patient revenue, and EBITDA (earnings before interest, taxes, depreciation, and amortization). In these methods, a proxy for value is multiplied by a market-determined factor that best expresses the relationship of that proxy to equity value.

Instructions

With this information, Heidi started the task of estimating the value of Sooner Clinics to UHSC and making a recommendation on whether UHSC should make the acquisition.