Financial valuation Applications and Models phần 8 ppt

• Annual financial statements income statements and balance sheets for the lastthree fiscal years, 1998 through 2000• Interim financial statements, year-to-date 2001 and the same period 200

Valuation Methodologies

The discounted cash flow method of the income approach typically is used as it

cap-tures estimates of future volume, reimbursement, revenue, expenses, and capital costassumptions

The guideline transaction method of the market approach often is not reliable

because the following information is usually not available:

• Assets and liabilities purchased (excluded assets such as working capital notreported)

• Consideration (cash versus stock in the buyers company)

• Modality and volume mix of the imaging center (MRI, CT, ultrasound, roscopy, mammography, X-ray, bone density, nuclear, etc.) as some modalitiesare far more profitable than others

fluo-• Volume growth

• Competition in service area

• Payer mix

• Global fee revenue versus technical fee only

• Radiology relationship and/or contract

• Maintenance agreement

• Equipment manufacturer, age, and condition

• Available capacity in the center

• Need for large capital reinvestment

The asset approach can be applied if the valuation of the business on an income

approach is similar to or less than the estimated net asset value Engagement of cialized equipment appraisers is probably necessary given the unique type and use

spe-of the assets

Specific Issues to Address

Capital expenditures as a percent of operating earnings for diagnostic imaging ters is higher than in other healthcare businesses Equipment in a diagnostic imag-ing facility is very expensive: MRI machines can cost $1.6 to $2.0 million, and CTmachines can cost as much as $1.2 million In addition, the technological obsoles-cence in imaging technology is very rapid, resulting in more frequent equipment pur-chases There has also been a continual downward pressure on reimbursement ofdiagnostic imaging procedures over the last 10 years, with that trend expecting tocontinue These major economic influences result in valuation multiples that areoften lower than those in other healthcare businesses

cen-Dialysis Centers

Background

Patients who suffer from end-stage renal disease (ESRD) are required to have ysis treatments approximately 12 to 13 times per month Regardless of age, patientESRD is the only program that is reimbursed by the Medicare program Patientswho are diagnosed with ESRD qualify for the Medicare program 24 months after

having been diagnosed As a result, Medicare is always a very large payer for ysis services.

dial-Medicare’s heavy participation in the dialysis business creates the risk thatHCFA will change reimbursement levels for a significant percentage of the business.With the government as a major payer, the regulatory requirements in the businessare significant

Purpose of the Valuation

• Sales and buy-ins

• Disputes

• Regulatory issues

• Antikickback statutes, Stark II, IRS private inurement

Valuation Methodologies

The DCF method of the income approach typically is used, as it captures estimates

of future volume, reimbursement, revenue, expenses, and capital cost assumptions

The guideline transactions method of the market approach can be utilized in

the valuation of dialysis facilities, unlike most other healthcare entities The mity of utilization (volume by patient) and payer mix (Medicare) allows careful use

unifor-of transaction data Price per patient can be used very carefully as a check on theresults established in the income approach The quality and depth of information isalso important Availability of total purchase price, consideration paid, assets andliabilities included, number of patients, and payer mix are desirable to rely on thisapproach In some cases that data can be found in the Irvin Levin Healthcare M&Adatabase and public company SEC reports

Typically the asset approach to value is not relied on in the valuation of a

dial-ysis facility unless the facility is financially underperforming Each dialdial-ysis machinecosts between $20,000 and $30,000, so for a 30-station facility, the machinescould cost almost $1 million In addition, special water purification systems used

in the dialysis process must be installed in each facility The underlying cost of thefacility, including equipment, tenant improvements, working capital, and otherintangible assets, should be considered during the valuation process To the extentthat the valuation under an income and market approach falls below that of theasset approach, the underlying net assets should be considered as an appropriateindication of value

Specific Issues to Address

The volume of patient treatments is very predictable based on the number ofpatients treated at the dialysis center However, the risk associated with competitionfrom the patients’ primary physician (the nephrologist) is very high Nephrologistswho are responsible for the patients in a dialysis center can direct patients from cen-ter to center As a result, nephrologists typically are subject to medical directorshipagreements that include strong covenants not to compete The lack of covenants not

to compete with the nephrologists treating patients in a dialysis center wouldincrease the risk of the cash flow stream dramatically The medical directorship pay-ment should also be evaluated

PUBLICLY TRADED HEALTHCARE SERVICES

COMPANIES BY NICHE

The following healthcare entities are some of the best known within their niche.Public information about these companies and information disclosed in their publicfilings can assist the analyst in understanding the dynamics influencing the economicperformance of the particular niche

Hospitals

Clarent Health Corporation (formerly Paracelcus Healthcare Corporation)

Community Health Systems, Inc

HCA The Healthcare Corporation

Health Management Associates, Inc

Iasis Healthcare Corporation (public debt)

Lifepoint Hospitals, Inc

Province Healthcare

Select Medical Corporation

Tenet Healthcare Corporation

Triad Hospitals, Inc

Universal Health Services Corporation

Surgery Center Companies

Amsurg Corp

HealthSouth Corporation

SSI Surgical Services, Inc

United Surgical Partners International, Inc

Dialysis Providers

DaVita, Inc

Dialysis Corporation of America

Fresenius Medical Care

Gambro AB

RenalCare Group, Inc

Physician Organizations

Novamed Eye Care, Inc

Pediatrix Medical Group

Phycor

Understanding the dialysis center’s relationship with the nephrologist iscritical in assessing risk

ValTip

Primedix Health Systems, Inc.

Raytel Medical Corporation

Alterra Healthcare Corporation

ARV Assisted Living, Inc

Assisted Living Concepts

Balanced Care Corporation

Beverly

Capital Senior Living Corp

Diversified Senior Services, Inc

Emeritus Corporation

Extendicare Inc

Genesis Health Ventures Group

Greenbriar Corporation

Integrated Health Services, Inc

Integrated Health Systems

InterWest Medical Corporation

Kindred Healthcare, Inc

Mariner Post Acute Care Network

National Healthcare Corporation

Regent Assisted Living Inc

Sunrise Assisted Living Facilities

Behavioral Health Companies

Integra, Inc

Horizon Health Corporation

Magellan Health Services

InterDent, Inc.

National Dentex Corporation Orthodontic Centers of America

Disease Management

American Healthways, Inc

Specialty Hospital Companies

American Kidney Stone Management

Lithotripsy Providers

MedCath

Medstone

Prime Medical Services, Inc

Home Health Care

Almost Family

Amedisys

American Home Patient

American Homepatient, Inc

Apria Healthcare Group

Contincare Corporation

Coram Healthcare Corporation

Lincare Holdings, Inc

National Home Health Corporation

New York Health Care

Option Care, Inc

Transworld Healthcare Inc

Lab Companies

American Medical Laboratories Ameripath, Inc

Dianon Systems, Inc

IMPATH, Inc.LabOne, Inc

Laboratory Corporation of America

Quest

Specialty Laboratories, Inc,

Urocor, Inc

ADDENDUM 1 — TARA SURGERY CENTER, L.P.

The Engagement

Background

It is early 2001 Tara Surgery Center (Tara or center), L.P., is a freestanding, cialty surgery center located in a metropolitan area in the southern part of the UnitedStates The center has three operating rooms and two procedure rooms and accommo-dates the following specialties: ear, nose and throat; general surgery; gastrointestinal;gynecology; neurology; orthopedic; pain management; plastic; podiatry; urology; andvascular surgery Over the past three years, Tara Surgery Center has increased its totalvolume from 2,038 cases in 1998 to 6,038 total cases in 2000 As a result, the part-nership has almost tripled its EBITDA from approximately $500,000 to $1.4 million.The center is not reliant on a hospital network or affiliation for its case vol-umes It is heavily reliant on the individual surgeons currently performing the cases

multispe-at the center Hence external forces, such as the development of a new center, cancannibalize these cases when surgeons perform their cases elsewhere

A new competing surgery center Rhett Surgery Center (Rhett) is in the finalphase of construction approximately two blocks away Rhett will have four operat-ing rooms, two treatment rooms, and will immediately become a serious competi-tor Some of the physicians currently utilizing Tara own an interest in Rhett Rhetthas attracted some of the Tara Surgery Center’s younger, nonshareholder surgeons

to perform their cases at the new facility upon completion In addition, two of theTara’s surgeons have informed the center’s administrator, Joe Scarlett, of their inten-tions to retire next year Scarlett has engaged Mission Critical Valuation (MCVal) toprovide a fair market value opinion of a 1 percent limited partnership interest in thecenter so that the partnership can transact limited partnership interests in the sur-gery center for the purpose of purchasing the two retiring surgeon’s interests andoffering units to other younger incoming surgeons

Note: Some of the numbers do not foot or tie due to rounding.

Exhibit 19.4 Case Facts

Name of Center: Tara Surgery Center, L.P.

Purpose of Valuation: Tara is planning on a sale of 1 percent limited partnership units to young

surgeon investors and buying out the interests of two retiring surgeons.

Standard of Value: Fair market value

Valuation Date: 12/31/2000

Information Request

As with most valuation consulting engagements, time is of the essence To expeditethe information-gathering process, MCVal used a preliminary information requestform that included the following:

• Descriptions of all of the competing surgery centers, including exact location,number of operating rooms, estimated number of cases performed, reputation inthe community, hospital affiliations, etc

• Annual financial statements (income statements and balance sheets) for the lastthree fiscal years, 1998 through 2000

• Interim financial statements, year-to-date 2001 and the same period 2000

• A summary of Tara’s history, including dates of formation, growth record, andaddition of specialties

• Operational reports, by specialty and physician, for the three years prior to thevaluation date and the most recent year-to-date period, including:

• Cases performed by specialty (and physician if available)

• Charges and net revenues by specialty

• Top 10 cases by specialty

• Top 10 payers by charges

• Copies of actual bills associated with the top 10 cases along with their tive explanation of benefits (EOBs) for each of the last four months and asampling of five bills per month over the last 12 months

respec-• Information regarding the current and projected status of physician-surgeonsusing the facility

• Managed care contracts and an overall discussion of payer mix by volume(Medicare, Medicaid, private insurance and managed care)

• Information regarding the average insurance reimbursement as a percentage ofMedicare

• A list and description of the outstanding accounts receivable as of the valuationdate, including an aged accounts receivable report

• A list and description of prior stock transactions and details of any offers to buyassets or interests in the center

• A detailed list of fixed assets including:

• Original acquisition cost

• Date of acquisition

• Depreciation (if available)

• A summary of any outstanding contingencies or liabilities not described in thefinancial statements

• A copy of the partnership agreement and/or operating agreement

• List of the current shareholders and number of shares owned

• A copy of the center’s relevant accreditation and licensing information (or mary)

sum-• A copy of any market research or demographic data for the center’s service area

• A copy of documents related to any future expansion plans, expected capitalexpenditures, anticipated staffing changes, or other significant change in theoperations of the center

Exhibit 19.5 Tara Surgery Center Net Charges

rev-Exhibit 19.6 Tara Surgery Center: FYE 2000

Choice of Valuation Approach

On first glance at the center’s profit and loss statement, it appears that the incomeapproach was the preferred valuation method However, MCVal considered thebenefits and determinants of each of the three approaches to value before making afinal selection

The asset approach considers the cost of replicating a comparable asset, rity, or service with the same level of utility In a general sense, the assetapproach is considered when the value derived exceeds the value generatedfrom the income or market approach To the extent that the asset approachvalue does not exceed either of the other two approaches, it is not heavilyrelied upon

secu-The market approach estimates value by comparing the value of similarassets, securities, or services (hereinafter collectively referred to as the guide-lines) traded or transacted in a free and open market The value of the subjectcan be estimated by adjusting the market value of the guidelines for qualita-tive and quantitative differences

The income approach estimates value by analyzing the historical financialinformation and estimating the future level of cash flows to be generated bythe subject company Once an appropriate rate of return is estimated for thesubject company, its benefit stream is discounted or capitalized back to pres-ent value, which represents value to an investor in the subject

Exhibit 19.7 Tara Surgery Center Partnership Agreement Clauses

Term: The term of the partnership agreement is effective from September 24, 19XX, to September 24,

20XX, unless extended or sooner liquidated in accordance with the Agreement.

Name of Partnership: Tara Surgery Center, L.P., a limited partnership.

Status of General Partner: The General Partner, a Hospital Corporation, has the exclusive authority to

manage the operations of the business of the Partnership under state law The Partnership has entered into a Management Agreement with Joe Scarlett in which Joe manages the day-to-day operations of the Center for 5.0% of gross operating revenues less allowances.

Status of Limited Partners: No limited partner is granted the right to participate in the management or

control of the Partnership’s business These powers and/or rights are reserved for the General Partner Consequently, no Limited Partner will have any personal liability, to the Partnership, another Partner or to the creditors of the Partnership.

Distributions: Except otherwise noted, available cash is distributed on a quarterly basis to the Partners

according to the percentage ownership of each Partner Available cash is defined as the excess cash, or profit, remaining after all overhead costs have been paid.

Buy/Sell Agreements: Except as otherwise provided in the agreement, no limited partner has the right to

sell or transfer units without the consent of the General Partner Before any such unit is sold or transferred, the General Partner has the first right of refusal to acquire the interest Any limited partner may sell his/her units to the General Partner at a price and terms agreed-upon by both parties The purchase price for these units shall be payable in cash to seller, or to the holder of a promissory note if one is available.

Agreed-Upon Value of Partnership Interests: The agreed upon value of an interest in the Partnership will

be determined based on a formulaic approach equaling trailing 12 months EBITDA multiplied by 4.0 less interest-bearing debt If the General Partner determines that a third-party valuation is required for regulatory purposes because of dramatic changes in the financial performance of the business, they may elect to engage a third-party valuation firm.

Ambulatory Surgery Center Industry

An ambulatory surgery center (ASC) is usually established as a freestanding pendent surgery center or as a hospital-owned facility where outpatient surgery isperformed ASCs are also referred to as freestanding outpatient surgery centers(FOSCs) or surgicenters

inde-Several factors differentiate ASCs from other businesses in the healthcare field.ASCs provide the physician and patient a location outside the hospital setting forsurgical procedures to be performed at a considerable discount As a result,Medicare, Medicaid, and private insurers now allow over 2,200 procedures to beperformed in an ASC setting

The fact that healthcare costs have increased at rates in excess of inflation isconsidered the primary factor in the development and increased utilization of sur-gery centers Procedures performed on an outpatient basis generally cost between 30percent and 60 percent less than the same procedures in a hospital setting A studydone by Blue Cross/Blue Shield of (certain state) demonstrated that a 47 percentdrop in surgery costs is attributable to ASCs

While cost containment was the initial driver in the growth of ASCs, currentgrowth in the industry also is driven by advantages to both patients and physicians

In a survey completed by the U.S Department of Health and Human Services Office

of the Inspector General (OIG), those Medicare beneficiaries who underwent cedures in ASCs strongly preferred ASCs over hospitals Reasons cited include lesspaperwork, lower cost, more convenient location, better parking, less waiting time,better organization, and friendlier staff The study also determined that the ASCprovides an environment that is as safe as a hospital and that postoperative care isalso comparable to a hospital In addition to increased patient satisfaction, physi-cians prefer performing surgeries in an ASC because they are able to achieve largervolumes and greater economies of scale Typically, ASCs provide faster operatingroom turnover time, and cases do not get transferred to emergency rooms as often

pro-as they do in acute care hospitals

Technological advances also have contributed to substantial growth in the ASCsegment Advances such as laser, endoscopy, and arthroscopic procedures haveallowed for less invasive procedures that fit well in an ASC setting Medicare paymentrates for freestanding ASC procedures are expected to undergo significant changes.These changes are expected to be implemented in 2002 Based on the 20 highest-vol-ume ASC procedures (based on national averages), these payment rates includeincreases as well as decreases and impact all surgery specialties The impact of theseprice changes will be reflected in the surgery case mixes selected by surgery centers.Due to the timing and impact of uncertain fee schedules of the proposed new paymentmethodology, MCVal decided not to adjust reimbursement for the new rules

Site Visit

By now, MCVal had gained a solid understanding of the nature of the business, theindustry, and the center’s financial and operating history A site visit came next.Fifteen of the key issues MCVal was seeking to better understand were:

1 The facility’s hours of operations to analyze scheduling issues and capacitylevels

2 Major competitors

3 Reasons why case volumes/revenues by specialty increased so dramatically overthe past two years

4 Historical and future physician practice volume patterns

5 Anticipated changes in the center’s overall payer mix (i.e., managed care tract changes, etc.)

con-6 New employee hires in the past year

7 Anticipated staffing level changes over the next year

8 Details regarding:

a Equipment lease costs

b Contract services costs

c Other operating expenses

9 Recent purchases of partnership interests by new surgeons

10 Types of services provided through the management fee

11 Copy of the management agreement

12 Estimated capital expenditures in the near future

13 Types of equipment, quantities, manufacturers’ names, manufacturers’ IDnumbers, and the dates of purchase

14 Whether to engage a machinery and equipment appraiser

15 Overall condition of the building and status of the current equipment

Interviews are conducted with the top surgeons to understand their utilizationintentions in the future and to uncover key pieces of information (e.g., retirement)that might have gone undetected during document review After the visit, the infor-mation is synthesized and used in the valuation model(s) In all likelihood, someother issues may have surfaced during the site visit that may need extra clarification

It is not uncommon for the analyst to phone the administrator to ask additionalquestions after the site visit has taken place

Performing the Valuation

Income Approach—Preparatory Analyses

At this point, MCVal had determined that the discounted cash flow (DCF) method

of the Income Approach was the appropriate method to use to value Tara SurgeryCenter MCVal performed the following important analyses as preparation forapplying the DCF to Tara

• Analysis of Specialty (Volume) Mix What specialties make up Tara’s case mix?

Has the total specialty mix noticeably changed over the past several years? Arethe cases, on a percentage basis, consistent with the historical case figures? Doesthe ASC perform pain case procedures? How many cases per day are performedper operating room? (See Exhibit 19.8.)

The total case volume for Tara has increased 49.6 percent (compoundedannually) from 2,695 cases in 1998 to 6,034 cases in 2000 Gastrointestinal (GI)and pain cases account for 3,734 (or 61.9 percent) of the total 2000 case vol-umes GI and pain cases are procedurally oriented and do not require an operat-ing room These procedures are performed in a procedure room

Based on 250 work days per year, the center performs 24.1 cases per day, or8.1 cases per day per room The average surgery case (excluding pain and GIcases) takes approximately 45 minutes to one hour to perform As a result, a sur-gery center open nine hours per day (8 a.m.–5 p.m.) can perform, on average,eight to 10 cases per day per operating room Based on a nine-hour day, it wouldappear as if Tara had excess capacity.

• Analysis of Caseloads of Top 10 Surgeons It is not uncommon for the top 10

surgeons in an ambulatory surgery center to account for a large percentage of thecenter’s caseload The top 10 Tara surgeons account for 73 percent of the totalFYE 2000 caseload (see Exhibit 19.9)

This analysis provides insight into the productivity of the top 10 physicians atTara As Exhibit 19.9 indicates, Roberts and Wilson have shown declining case

It is important to understand the underlying components in the casemix, since the reimbursement rates for each specialty are not homoge-nous

ValTip

The analysis must ascertain the likelihood that the top 10 surgeons willcontinue to perform cases at a center, which affects the specialtygrowth rates used in the projections

volumes over the past two years and have indicated their interest in retiring in

2001 As a result, Joe Scarlett has begun to consider ways to replace their lostcase volumes In the interview, Scarlett indicated that Tara did not have the capa-bility to replace the lost urology case volumes immediately Therefore, MCValdecreased total urology case volumes 50 percent for year 1 of the projectionperiod In addition, physicians who will invest in Rhett Surgery Center will alsonegatively affect case volumes

• Payer Mix Analysis What percentage of the center’s business is associated with

Medicare? Medicaid? Managed care? Self-pay? Other? Answers to such tions provided the data by which MCVal estimated future net revenue per case.(See Exhibit 19.10.)

ques-Exhibit 19.10 Tara Surgery Center Payer Mix Analysis—Expressed as a Percentage of Net Revenue

growth projected Harpert GI 731 12% 3% 753 Moderate growth in the future Peters Pain 468 8% 3% 482 Moderate growth in the future Roberts Urologist 524 9% -100% 0 Retiring

Shazo ENT 360 6% 3% 371 Moderate growth in the future Fossey ENT 50 1% 15% 58 Started performing cases in

December 2000

Keter ENT 115 2% 10% 127 Started performing cases in

August 2000 Bryan General 283 5% 3% 291 Moderate growth in the future Dallas Pain 375 6% -50% 188 Performing cases at new surgery

center

Total Cases 6,034 100% -21% 6,062

Medicare accounts for approximately half (49 percent) of the center’s payer mix.For this reason, Medicare reimbursement rates may be a good starting point for

a reasonableness check of the net Tara revenue per case amounts

Exhibit 19.11 provides an example of the detailed information extracted from

3 EOBs of Tara Surgery Center

Exhibit 19.11 Procedure Codes and Charges

iden-• Staffing Roster Analysis Since employee salaries and wages are the largest

con-trollable expense allocation for any medical practice, MCVal re-created anemployee salaries and wages schedule from the staffing roster to benchmark itagainst reported historical data as of the valuation date The staffing rosterincluded such things as names, rates of pay, hire/termination dates, and estimated(FTE) status (see Exhibit 19.12)

Exhibit 19.12 Tara Surgery Center Salary and FTE Breakdown

ValTip

FTE is the acronym for “full-time equivalent.” 1.0 FTE represents a singleindividual working 40 hours per week (full time).

a Nurse FTEs There are different classes of Nursing FTEs: PRNs (Latin,

mean-ing “pro re nata,” or “as matters are needed”), LPNs (licensed practicalnurses), and RNs (registered nurse) Typically, Nurse PRNs act as “floatingFTEs” and either work on a part-time or as-needed basis As a result, PRNsare not each represented by 1.0 FTE LPNs and RNs typically are hired on afull-time basis and are each represented by 1.0 Generally, total estimatednursing FTEs increase as cases (procedures) increase, although this is not nec-essarily a linear relationship FTEs tend to be variable with case volumes

b Technical FTEs In today’s surgery centers, there is a high demand for the use

of sophisticated equipment and the medical and technician staff to operate it.Typically, the ratio of technical FTEs to medical FTEs in any given ASC isapproximately 1:3 Generally, total estimated technical FTEs increase as cases(procedures) increase, but this is not necessarily a linear relationship FTEstend to be variable with case volumes

c Administrative FTEs Administrative FTEs consist of employees such as

administrative assistant, billing office manager, receptionist, secretary, and so

on Unlike nursing and technical FTEs, the number of administrative FTEs isnot tied directly to case volumes However, once certain case/physician vol-ume thresholds are met, additional administrative FTEs may need to beadded

d Employee Benefits Analysis The industry standard benefit package is

approx-imately 8.0 and 13.0 percent for payroll taxes and employee benefits, tively However, since each ASC has a different benefit structure, MCValvisited with Joe Scarlett in order to prepare an accurate employee benefitanalysis

respec-• Medical Supplies Analysis Aside from employee salaries and wages, medical

sup-ply expenses are probably the most important expense allocation for a per-caserate The medical supply rate will need to be adjusted to volume changes duringthe projection period (see Exhibit 19.13)

Exhibit 19.13 Tara Surgery Center Medical Supplies Analysis

Restated Restated Normalized Projections

*Excludes Associated Drug Costs

The medical supply costs per case (excluding associated drug costs) is imately $48 in FYE 2000 The decrease in medical supply per-case rate is due tothe addition of pain cases The related medical supplies associated with paincases can be as much as 50 to 75 percent lower than the typical surgery case Thismedical supply case rate is multiplied by the forecasted case volumes to arrive at

approx-estimated medical supply expenses for year 1 of the projection period The ical supply case rates increased at CPI, or 3.0 percent, from the normalized baseyear to year 1 to accommodate for inflation.

med-• Facility Expense Analysis Does the facility own the building or pay a specified

rental expense related to a facility lease agreement? If the ASC does pay a rentexpense, the analyst can get a copy of the lease agreement from ASC manage-ment By reading the lease agreement, the analyst will understand if expensessuch as utilities and janitorial are included in the lease rates Doing this will pre-vent the analyst from double counting any of these expenses in the projections

• General and Administrative Expense Analysis Typically, general and

adminis-trative expenses account for the third largest expense allocation in the operatingexpense profile General and administrative expenses include items such asadvertising, office expenses, legal and professional fees, and the like The analystshould take note of the expenses included in the G&A operating profile to pin-point key expense levels Typically, bad debt expenses are included in G&Acosts High bad debt expenses affect the ASC’s ability to collect fees, thus, nega-tively affecting the ASC’s value

• Trends Analysis—Income Statement After the analyst has understood the

dynamics of each operating expense segment, it is important to understand theoverall operating expense profile (see Exhibit 19.14)

Exhibit 19.14 Major Operational Expenses and Percent of Revenue (1998–2000)

Major Operating Expenses:

2,695 cases in 1998 to 6,034 cases by 2000 The 14 percent decline in the netrevenue per case figures from 1999 to 2000 is primarily due to the large increase

in pain volumes from 451 to 1,163 cases over the same time frame In addition,through interviews with some of the utilizing surgeons, MCVal has learned thatover the past two years, the surgeons have become more cognizant of their ownmedical supply per case rates and have opted to use more cost-effective suppliesand instruments

• Trend Analysis—Balance Sheet (see Exhibit 19.15) Have total assets increased

or decreased based on the historical information? total liabilities? total bearing debt? working capital (current assets—current liabilities)? Does the net

interest-income as reported on the balance sheet equal the net interest-income as reported on the

Total liabilities actually have increased from $1.71 million to $2.09 millionover the same time periods The increase in total liabilities is due primarily toincreases in accrued expenses

Exhibit 19.15 Balance Sheet

Fiscal Year Ended December 31,

Income Approach—Developing the Normalized Base Year

The normalized base year is developed by adjusting the selected income statement toreflect Tara’s true operational profile for the projection period During the site visit,MCVal discussed proposed adjustments with Joe Scarlett to assess their likelihood.Some of the adjustments made to Tara include:

• Employee Salaries and Wages: Historically, the center’s accounting system

included associated contract labor costs (i.e., PRNs, etc.) with employee salariesand wages MCVal attempted to reconcile the estimated contract labor costs with

historical contract labor costs based on the employee staffing roster and sions with management.

discus-• Employee Benefits Based upon conversation with Scarlett regarding future

ben-efits, payroll taxes and employee benefits were adjusted at industry norms of 8.0percent and 13.0 percent respectively, of employee salaries and wages

• Facility Rent The center does not currently own the facility The estimated

facil-ity rent costs for Tara are based on the total square footage multiplied by thecontracted dollar per square foot cost with a CPI adjustment (3.0 percent perannum) included The CPI adjustment is added in the projection period and isbased on the analyst’s understanding of the lease agreement

• Interest Expense Since MCVal is using the invested capital method of the DCF,

the interest expense was eliminated to derive debt-free operations

• Income Taxes A blended federal and state income tax rate was calculated.

Income Approach: Development of a Discount Rate. The discount rate isoften the most contested part of the income approach (Chapter 5) The weightedaverage cost of capital (WACC) model for estimating the discount rate is a highlyregarded method of estimating an appropriate discount rate, although direct equitymethods can be used as well The discount rate needs to incorporate two factorsrelated to the projected cash flow stream:

1 Financial risk The risk inherent in the subject entity’s financial structure (i.e., the

utilization of debt versus equity financing)

2 Business risk The uncertainty associated with the economy, industry, and

inher-ent risk profile of the subject inher-entity

Some of the risks associated with Tara Surgery Center include:

• Top 10 Physicians A total of 10 physicians account for almost 75 percent of the

center’s total case volumes There are 18 investing surgeon shareholders in theASC Drs Capor and Harpert account for 33 percent of the ASC’s caseload.Therefore, a significant amount of the ASC’s value (risk) is related to these physi-cians Extenuating circumstances (i.e., development of new center that luresphysician utilizers away) can affect the ASC’s value Failure to recognize this riskcould cause an overvaluation

• New competition Tara has not been reliant on a hospital network or affiliation for

its case volumes Instead, it is heavily reliant on the individual surgeons currentlyperforming the cases Hence, external forces, such as the development of a newcenter, can tempt these surgeons to perform their cases elsewhere Rhett SurgeryCenter will be completed within the next calendar year and has already started toprey on Tara’s current surgeon base The discount rate should incorporate somefactor for the risk this introduces into the center’s projected revenue stream

• Uncertainty of APCs As mentioned earlier, the APCs for freestanding outpatient

surgery centers will not be implemented until early 2002 As a result, an tional risk factor exists since the APC fee schedules are not available and futurereimbursement prices are unknown High volatility or drastic changes in theAPCs can affect the ASC’s value For example, a sharp increase in the net reim-bursement for pain cases can positively affect the ASC’s value whereas a sharpdecrease in GI reimbursement could negatively affect the center’s value

addi-MCVal used the weighted average cost of capital (WACC) for this valuation.The basic formula for computing the WACC is:

WACC ⫽ (Ke) ⫻ (We) ⫹ (Kd(pt)[1⫺t] ⫻ Wd)Where:

WACC = Weighted average cost of capital

Ke = Company’s cost of common equity capital

Kd(pt) = Company’s cost of debt capital (pre-tax)

We = Percentage of equity capital in the capital structure

Wd = Percentage of debt capital in the capital structure

The equity portion of the WACC was calculated by using the build-up model.The basic formula is:

Ke⫽ Rf ⫹ RPm ⫹ RPs ⫹ RPuWhere:

Ke ⫽ Expected rate of return on the subject security

Rf ⫽ Rate of return on a risk free security

RPm ⫽ Risk premium associated with the market

RPs ⫽ Risk premium associated with a small company

RPu ⫽ Risk premium associated with Tara

MCVal used the 20-year Treasury bond rate as of the valuation date for its free rate The long-term market equity risk premium and small stock premiums

risk-(10th decile) were reported in the 2001 Yearbook of Stocks, Bonds, Bills, and Inflation, published by Ibbotson Associates.

A specific risk premium of 6 percent was selected for Tara to compensate forthe risks associated with the departure of the urology surgeons, the potential riskposed by Rhett Surgery Center as a new competitor, their reliance on a smaller num-ber of physicians, and the uncertainty surrounding changes in the APCs

The equity component of the WACC is as follows:

Ke ⫽ 5.6% + 7.8% + 4.63% + 6%

The capital structure used in the calculation came from a review of the average

of similar companies in the industry and the Center’s current capital structure This

is estimated at 25 percent debt and 75 percent equity The cost of debt is based uponavailable financing terms which was 7 percent.

The WACC is as follows:

WACC ⫽ (24.03%) (.75) ⫹ [7% (1 ⫺ 39) (.25)]

Based on the procedures described above, a WACC of 19 percent was applied

to the cash flows

Income Approach—DCF

The top three specialties performed at Tara are GI, pain, and ear, nose, and throat(ENT) respectively GI and pain account for 62 percent of the total case volume Thecenter’s medical supply costs per case are significantly lower than industry averages

of $175 to $200 per case, due to the lower medical supply costs associated with GIand pain cases

Due to the retiring urologist, cash flow projections reflect a loss in urology umes in year 1 of the projection period Management has indicated that the urolo-gist will be hard to replace immediately; however, management believes that thedevelopment of the new competing surgery center (resulting in attracting morephysicians to the area) will assist it in recruiting a replacement urologist to the area

vol-by year 2 Note: The loss in surgeon volumes accounts for only a 4 percent decrease

in total net revenues since the departure of their cases opens up the related time slotsfor other specialties to perform their cases Exhibit 19.16 presents the projected cashflows for Tara Surgery Center for years 1 to 5, the terminal year of the projectionperiod, as well as the final estimate of value of the invested capital for Tara.Future growth was estimated at 3 percent Terminal year income was adjustedfor normalized depreciation

The exhibit illustrates the results of the 4.1 percent decrease in total net ating revenues from $4.14 million in the normalized base year to $3.97 million inyear 1 of the projection period This is primarily due to the loss in urology cases due

oper-to the retiring surgeon

DCF Analysis. After all of these steps have been performed, the final valuecreated may/may not need to be adjusted for applicable discounts (see later inreport) In addition, the value created is invested capital (total equity + interest-bear-ing debt) Depending on the agreed-on value, the related interest-bearing debtmay/may not need to be removed from invested capital value In the case of Tara,the agreed-on value was equity As a result, the analyst would need to deduct debtfrom total invested capital

Value Indication

Traditionally, the fair market value of the invested capital of ASCs has ranged from

a multiple of 3.5 to 6.5 times EBITDA This range assumes moderate growth, sonable capital expenditures, and moderate working capital needs In the case ofTara Surgery Center, the value conclusion falls within the low end of the range due

rea-to the substantial loss in urology volumes and related net revenues, and other riskfactors noted

The value conclusion is shown in Exhibit 19.17.

Market Approach: Guideline Public Company Method

The guideline public company method relies on similar publicly traded companies

as a source of market multiples Market multiples include:

Exhibit 19.16 Projected Cash Flows and DCF Value

Terminal

Cash Flow Adjustments:

Plus: Depreciation &

Sum of Present Values

Fair Market Value Indication

*Excess depreciation runs out.

Market Approach: Guideline Company Transaction Method

The guideline company transaction method involves the selection of pricing ples of individual transactions in similar companies in the marketplace Information

multi-on these transactimulti-ons and their multiples is obtained using sources such as Irvin

Levin and Associates and Pratt’s Stats If comparable data and multiples can be

found, they are applied, where appropriate, to the subject company

To apply a “reasonableness check” for the income approach value, multiplespresented in Exhibit 19.18 were applied to Tara’s year 1 net operating revenueand EBITDA These multiples were based on 10 private surgery center trans-actions that occurred over the past 12 months It is important to obtain recentpricing multiples to account for changes in the marketplace (i.e., government-imposed regulations) The use of old, or “stale,” data can cause an erroneousconclusion

Exhibit 19.17 Value Conclusion

Cash Flow Adjustments:

Plus: Depreciation &

Sum of Present Values

Fair Market Value Indication

Fair Market Value Indication

Fair Market Value Indication

(per unit assuming

The range of values generally yielded a higher value than the income approachdid Note that these multiples should be taken only at face value since they do notconsider the internal dynamics of the center (e.g., the departure of key surgeons) Bymultiplying the related year 1 revenues and EBITDA figures (Note: Multiples aretypically applied against historical revenue and income However, this would mis-represent Tara.) with their corresponding multiples, the analyst arrived at a valuerange of $2.8 million to $4.8 million

Exhibit 19.18 Guideline Company Transactions

Asset Approach

The book value of the equity portion of the business is $1.845 million To the extentthat the income approach value and the cost approach value are similar, the analystshould consider using the cost approach MCVal performed an analysis estimatingthe underlying tangible assets of the business and has determined that the book

value reasonably reflects fair market value As a result, the asset approach is deemed

relevant and MCVal considered this approach in the valuation as a “floor” value

Reconciliation

While we have considered each of the three approaches to value Tara we have marily relied on the income approach to value the surgery center Based on the facts,circumstances, and limiting conditions of the engagement, the value indication atthe equity level is $2.49 million (IC of $3,190,648 minus $698,760 in total debt).MCVal was engaged to perform a fair market value opinion of a 1 percent limitedinterest in the Tara Surgery Center, L.P As a result, assuming 225 partnership units,the analyst has arrived at an equity level, before any applicable discounts, of

pri-$11,075 per unit ($2.49 million divided by 225 units) However, the analyst must

consider the following discounts and decide their applicability to Tara

Discounts

Depending on the standard of value agreed on for the valuation, at times it is essary to consider the usage of minority and marketability discounts Each of thefollowing paragraphs briefly describes the rationale associated with each discount,and whether the discount was deemed applicable in this valuation

nec-Minority Discounts

In determining the fair market value of the equity of Tara Surgery Center, MCValconsidered the applicability of a minority discount to the estimate of value based onthe following key control factors:

• Lack of control over day-to-day operations

• Lack of control over dividends and distribution

Lack of Control Over Day-to-Day Operations. Per the operating agreement,the business, property, and affairs of the company shall be managed by or under thedirection of the management board The management board consists of 11 centermembers who supplied regular input to Joe Scarlett and the rest of his staff regard-ing management and operational issues They are also considered the center’s “cus-tomers.” This is a key issue when determining control issues related to the ASC.Since the physician-investors are free to use other ASCs in the immediate area, it is

in the best interests of the ASC to consider the physician-investor’s input regardingmanagement and operational issues As a customer and shareholder, a physician’slack of management control is often mitigated

Lack of Control over Dividends and Distributions. Per the operating ment, distributions of distributable cash and accumulated cash shall be made quar-terly It is the board’s decision and intention to pay quarterly distributions to theextent of available cash In addition, Tara has had a long history of paying distri-butions to its shareholders Available cash is defined as EBITDA less estimated cap-ital expenditures in the next quarter, less a reasonable and defined working capitalreserve The potential consequence of failure to make regular distributions couldresult in the physician choosing to sell back the units to the ASC and/or choosing touse other ASCs

agree-Based on our consideration of the above factors regarding the facts and cumstances regarding the partnership agreement, it is our opinion that a discountrelated to a minority ownership interest is not applicable

cir-Marketability Discount

A marketability discount deals with an investor’s ability to convert ownership ests into cash proceeds in a minimal amount of time Some of the key factors con-sidered are:

inter-• Restrictions on transfer of shares

• Availability of a ready market

• Determination of pricing

Restrictions on Transfer of Shares. The general partner shall have the firstoption to purchase all or any portion of the ASC interests of the selling owner If theASC and then the other limited partners do not elect to acquire all of the unitsoffered, the remaining portions may be offered to a qualified owner at a predeter-mined buyout price of approximately four times EBITDA For regulatory purposes,the board must have an independent third party perform the valuation of the ASCbefore any shares are transferred or resyndicated

Availability of a Ready Market. MCVal also considered who the most likelyinvestor for these units would be: another physician-surgeon, who would generallysatisfy the criteria noted in the above paragraph, the company itself, or a third-partyinvestor (company in the surgery facility business) MCVal concluded that a rea-sonable population of likely investors does exist.

In addition, Tara has an interest in being the market maker in its own units inorder to attract future investors and provide a ready exit for disgruntled physician-investors who could potentially harm its operations and relations with the physiciancommunity

Determination of Pricing. The operating agreement states that the center willhave the option to purchase all or any portion of the interest of the selling member

at an agreed-upon purchase price related to a “triggering event,” such as ceasing topractice medicine The provision also allows for the pricing of the units at 100 per-cent of the value upon certain “triggering events,” such as the death or retirement

of the member

Conclusion on Discounts

Based on all of the above factors, MCVal concluded that a discount for lack of ketability was not applicable to the fair market value estimate of the equity of TaraSurgery Center This opinion could be materially different if the nature of TaraSurgery Center’s business changes or if other facts and circumstances discussed

mar-above change (Note: Some analysts would apply some discounts here to reflect the

risk of future changes.)

Final Value

Exhibit 19.19 Tara Surgery Center Final Indication of Value

(Assuming 225 Partnership units)

ADDENDUM 2 — VALUATION OF ASHLEY HOSPITAL

The Engagement

Background

It is March 15, 2002 Ashley Hospital (Ashley or Hospital) is a 225-bed acute carehospital located in an urban area in (certain state) A regional health system, WilkesHospital (Wilkes), has communicated an interest in acquiring Ashley to expand itsnetwork and gain access to the community The board of directors of Wilkes hasengaged Mission Critical Valuations (MCVal) to provide a fair market value analy-sis of Ashley The board has indicated that the facility will be acquired in an assetpurchase transaction and that certain nonoperating assets will be excluded Nointerest-bearing debt will be included

Exhibit 19.20 Case Facts

Name of Hospital: Ashley Hospital, a private not-for-profit or 501 (c)(3) hospital

Purpose of Valuation: The valuation will be used by Wilkes’ Board of Directors and Management in

assessing the potential acquisition of Ashley

Standard of Value: Fair market value

Valuation Date: 03/15/02

Information Request

MCVal provided a written information request for the following data:

• Annual financial statements (audited or compiled income statements and balancesheets) for the last five fiscal years, 1998 through 2001

• Interim financial statements, year-to-date 2002 and same period 2001

• Operational reports for the last four years and the most recent year-to-dateperiod detailing:

• Inpatient admissions

• Outpatient volume

• Patient days

• Adjusted patient days

• Other operating data for the facility

• Detailed financial statements and operational reports for the hospital

• Detailed discussion regarding services provided at the hospital

• Any detailed operating and capital budgets for the hospital

• A list and description of the outstanding accounts receivable as of the valuationdate, including an aged accounts receivable report

• A list and description of prior stock transactions and details of any offers to buyassets or interests in the hospital

• A listing of employees:

• Name

• Compensation

• Average hours worked per week

• Development projects in place

• Company budget and projections

• Company capital structure detail: debt, equity, and preferred equity

• Detailed information concerning facility leases including:

• Square footage

• Rental rates

• Terms of lease

• Details related to physician partnerships

• Service area demographic data

To gain a basic understanding as to the profitability and underlying assets andliabilities of the Hospital, MCVal reviewed the latest 12-month income statementending December 31, 2001, as well as the balance sheet dated December 31, 2001.The subject hospital generated approximately $112.7 million in net operating rev-enue and approximately $12.9 million of EBITDA The balance sheet as ofDecember 31, 2001 shows that Ashley has approximately $20.1 million in assetslimited as to use, $20.2 million in cash and investments, approximately $16.6 mil-lion of operating working capital, $3.1 of other assets, and approximately $50.5million in net plant, property and equipment Assets limited as to use, cash, andmarketable securities are nonoperating assets and as a result will not be included inthis valuation The net book value of the hospital prior to subtracting debt obliga-tions and excluding nonoperating assets is approximately $70.2 million Based on apreliminary analysis of the financial statements and based upon a basic knowledge

of the hospital operations, it appears that the valuation will utilize each of the threeapproaches to value

Reminder

The asset approach takes into consideration the cost of replicating a parable asset, security, or service with the same level of utility In a generalsense, the asset approach typically is considered in healthcare valuations whenthe value derived exceeds the value generated from the income or marketapproach To the extent that the asset approach value is significantly belowthat of the market and income approaches, it may not be heavily relied on inhealthcare valuations

com-The market approach estimates value by comparing the value of similarassets, securities or services (hereinafter collectively referred to as the guide-lines) traded or transacted in a free and open market The value of the subjectcan be estimated by adjusting the value of the guidelines for qualitative andquantitative differences

(continues)

The income approach estimates value by analyzing the historical financialinformation and to estimating the future level of cash flows to be generated bythe subject company Once an appropriate rate of return is estimated for thesubject company, the cash flow stream is discounted or capitalized back topresent value, which represents value to an investor.

Understanding the Industry

• The healthcare industry faces the challenge of continuing to provide qualitypatient care while dealing with rising costs, strong competition for patients, and

a general reduction of reimbursement rates by both private and government ers In many areas, both private and government payers have reduced the scope

pay-of what may be reimbursed and have reduced reimbursement levels for what iscovered Changes in medical technology, population demographics, existing andfuture legislation, and competitive contracting for provider services by privateand government payers may require changes in healthcare facilities, equipment,personnel, or services in the future

• Although the business outlook for hospitals has significantly improved over thelast year, the industry continues to face significant challenges Inpatient utiliza-tion, average lengths of stay, and average occupancy rates continue to be nega-tively affected by payer-required preadmission authorization, utilization review,and payer pressure to maximize outpatient and alternative healthcare deliveryservices for less acutely ill patients Increased competition, admissions con-straints, and payer pressures are expected to continue To meet these challenges,the industry has expanded many of its facilities to include outpatient centers andupgraded facilities and equipment, and has offered new programs and services.Positive industry dynamics include increased admissions growth driven by posi-tive demographic shifts, increased government reimbursement, and decreasednegotiating power of managed care companies

• Over the past several years, for-profit hospitals have begun to represent a sizableportion of the market This was due to the consolidation of or the closing ofweak not-for-profit hospitals Also increasing market share (1999) were hospi-tals with fewer beds Nearly three-fourths of hospitals have fewer than 200 beds,more than one-fifth of hospitals have between 200 and 499 beds, and 5 percent

of hospitals have more than 500 beds

• Healthcare interest groups have spent the past two years fighting to restore morethan $50 billion in Medicare and Medicaid spending growth taken away by theBalanced Budget Act (BBA) of 1997 In 2001, these interest groups will have anew fight as the Balanced Budget law approaches expiration in 2002 and 2003

A jump in healthcare spending is likely to spur another round of healthcarebudget-cutting by the federal government

• Without new legislation to extend the budget law’s tight caps, Medicare andMedicaid spending is likely to accelerate if many of the BBA’s provisions termi-nate on schedule in 2002 and 2003 The Congressional Budget Office (CBO)projects 7.2 percent average annual growth for Medicare and 8.6 percent aver-age annual growth for Medicaid from 2001 through 2011, compared with 3.2

percent and 6.3 percent for both programs, respectively, from 1996 through2000.

• Balanced Budget law brought Medicare spending growth to a near halt in 1998and 1999, including a reduction in spending in 1999, but “giveback” bills in con-secutive years have boosted Medicare growth rates The CBO estimates a growthrate for Medicare of 10.5 percent per year for 2000 and 2001, just four-tenths

of a percentage point below the spending growth rate for the six years that ceded the budget law

1 Major competitors

2 Reasons why admissions (and subsequently revenues) increased over the pasttwo years

3 Top 10 physicians in terms of both admissions and surgical cases

4 Anticipated changes in the hospital’s overall payer mix (i.e., managed care tract changes, etc.)

con-5 New employees hired in the past year

6 Staffing level changes over the next year

7 Reasons for increases/decreases in medical supplies

8 Estimated capital expenditures over the next three to five years

9 Types of equipment, quantities, manufacturer’s name and ID number, and date

of purchase

Performing the Valuation

Income Approach—Preparatory Analysis

At this point, MCVal has determined that the income approach using a DCF method

on an invested capital basis is most likely the primary method to value AshleyHospital (See Chapter 4 for more detail on the DCF method.) MCVal must under-stand certain information (Exhibit 19.21) and follow several basic yet key steps inperforming an income approach analysis on the hospital

Analyst Conclusions. Inpatient admissions increased 4 percent from FYE

2000 to FYE 2001 Similarly, the average length of stay (ALOS) increased 5 percentover the same respective time frame due to the addition of the Heart Center

Payer Mix It is important that MCVal understands the components of the

hospi-tal’s payer mix and the related revenues associated with each payer class: that is,what percentage of the hospital’s business is associated with Medicare, Medicaid,

Exhibit 19.22 Ashley Hospital Payer Mix Percentages—Expressed as a Percentage of Net Revenue

Staffing Roster The analyst may review the following key components of the

hos-pital’s staffing roster: name, rate of pay, date of hire, and estimated full-time alent (FTE) status Since employee salaries and wages are the largest controllableexpense allocation for any hospital, MCVal may review the internal dynamics of thestaffing roster to benchmark the staffing ratios to the reported historicals as of acurrent date Then the analyst will be able to understand the recent changes instaffing levels of the hospital (i.e., department overstaffing, etc.)

equiv-Exhibit 19.21 Ashley Hospital Data

An analysis of the hospital’s staffing roster (Exhibit 19.23) allows MCVal tomake assessments and groupings An FTE designates the work status of a particu-lar individual, whereby 1.0 FTE is the equivalent of an individual working 40hours per week An analysis of staffing based on activity levels in the hospital canalso be performed The standard ratio used in the hospital market is FTE peradjusted occupied bed or hours worked per adjusted patient day The inpatientdays in the hospital are adjusted to take into consideration outpatient services pro-vided by the hospital This determines adjusted bed occupancy or adjusted patientdays in a hospital facility The key driver of revenue in any healthcare facility is vol-ume For hospitals the volume is described in terms of adjusted daily census oradjusted patient days.

According to the staffing roster, the hospital employed a total of 1,015 FTEs.Although it would not prove time efficient to diagram and assess each and everyemployee’s location within the hospital, it would be important to pinpoint thosedepartments that employ the largest number of individuals Exhibit 19.23 summa-rizes this information

Exhibit 19.23 Ashley Hospital FTE by Department

Employee Benefits MCVal must obtain the appropriate benefit structure from

man-agement for projection purposes The industry standard benefit package for a pital like Ashley is approximately 7.0 and 12.0 percent for payroll taxes andemployee benefits, respectively However, each hospital is different It is important

hos-to understand the nature of this concept hos-to accurately portray hos-total employee pensation figures

com-Gross Revenue Exhibit 19.24 summarizes gross charge data com-Gross charges in a

hospital can be over two times the actual net revenue of the facility As a result,gross charges are used in an analysis to determine the percentage writeoff of con-tractual allowances (the amount of gross charges that Medicare and other payers donot reimburse for a particular procedure) For example, the gross revenue of thesubject hospital during fiscal year 2001 was approximately $230.5 million, whilecontractual allowances and charity care for that same period were approximately

$117.8 million, leaving net revenue of $112.7 million Other operating income wasapproximately $1.8 million The total net revenue for Ashley for the year endedDecember 31, 2001 was $114.5 million MCVal should notice that the pharmacydepartment accounted for the largest gross revenues (15.5 percent of revenues, or

$13.8 million) of any department in the hospital

Exhibit 19.24 Ashley Hospital Gross Revenue Analysis

Trend Analysis—Income Statement The valuation analyst must analyze net

rev-enue and operating expenses (Exhibit 19.25) The total net revrev-enues for the pital have increased 8 percent, from $105.8 million in 2000 to $114.5 million for

hos-2001 The primary determinant of this revenue increase is a 7 percent increase inadjusted patient days from 70,700 to 75,336 days The net revenue per adjustedpatient day was relatively flat from year to year Total expenses, as a percentage

of net revenues, have increased from 87 percent in 2000 to 89 percent as of 2001.This is primarily due to the increases in staffing costs over the same respectivetime frames

Trend Analysis—Balance Sheet Have total assets increased or decreased based on

the historical information? total liabilities? total interest-bearing debt? working ital? Does the net income as reported on the balance sheet equal the net income asreported on the income statement(s)? (See Exhibit 19.26.)

cap-Analyst Conclusions. The total asset base has increased from $118.0 million

to $122.4 million for FYE 2000 to FYE 2001 The primary reason for the increase

in the total asset base is due to investments

Total liabilities actually have decreased from $62.5 million to $59.7 millionover the same time period The decrease in total liabilities is due primarily todecreases in long-term debts

Exhibit 19.25 Ashley Hospital Revenue and Expenses

Major Operating Expenses:

Assets limited as to use and investments are considered here “excess

assets” and are added back to the resulting DCF value to arrive at thetotal value “Assets limited as to use” refers to those assets earmarkedfor specific activities (i.e., related future capital expenditures, etc.)

“Investments” refers to cash/marketable securities

ValTip

Normalized Base Year The purpose of the normalized base year is to adjust the

most recent income statement, or the ones MCVal utilizes, to reflect the hospital’strue operational profile for the projection period During the site visit, the analystshould discuss these adjustments with hospital management to understand theirlikelihood In addition, any related interest expense also should be removed to cal-culate the entity’s debt-free cash flow, the type of cash flow utilized here In addi-tion, an appropriate income tax rate, incorporating both state and federal taxes,should be calculated

Some of the adjustments made to Ashley Hospital include ones for:

• Bad Debts Bad debt expenses were adjusted to reflect the historical averages for

the facility, per conversations with management

• Employee Benefits Payroll taxes and employee benefits were adjusted at 7.0

per-cent and 12.0 perper-cent respectively, per industry norms This is also based on versations with management regarding future benefit offerings

con-• Interest Expense Interest expense was eliminated to derive debt-free cash flow.

• Income Taxes A blended federal and state income tax rate was calculated.

DCF Assumptions The assumptions related to the discounted cash flow model can

be projected to arrive at a value The analyst applies acquired knowledge of theoperations from the previous steps to a five-year projection of cash flow typicallyprepared by, or in some cases with, management

As mentioned previously, the hospital has experienced substantial growth overthe past year (Exhibit 19.27); however, a new center, Butler Center, will soon becompleted approximately one mile away from the hospital According to manage-ment, it is likely the new surgery center will result in lost outpatient surgical cases.Exhibit 19.27 illustrates a 3.7 percent increase in total net operating revenues,from $112.7 million in the normalized base year to $116.9 million in year 1 of theprojection period These projections are based on discussions with managementbased on the opening of the new surgery center As a result, total outpatient casesdecrease 5 and 3 percent respectively in years 1 and 2 and are flat in year 3 beforereaching standard growth levels by year 4 of the projection period The exhibit illus-trates the projection period for years 1 to 3 of the projection

Inpatient Admissions According to conversations with hospital management,

inpa-tient admissions are expected to increase at approximately 2.0 percent into the nearfuture As a reasonableness check, this assumption is confirmed by analyzing cur-rent capacity levels (i e current occupancy rate) as well as demographic projectionsfor the next three to five years According to demographics, the population growthestimates for the local area are approximately 2 percent As a result, the 2 percentinpatient admission growth rate does not seem unreasonable

Outpatient Days Total outpatient days for the hospital are expected to decrease in

year 1 due to the opening of Butler Center in the immediate area According to agement, it is expected that approximately 5 percent of its outpatient surgical case-load will depart to this new center in the upcoming year After year 1, outpatientdays decrease 3 percent and remain flat in year 2 and 3, respectively By year 4, man-agement expects that the total outpatient caseload will increase by 2 percent there-after

man-An example of the conversion factor for adjusted patient days follows: Thehypothetical calculation states that every outpatient case in the Hospital accountsfor 75 percent or 0.75 of every inpatient day.

Total Outpatient Cases ⫻ Outpatient Conversion Factor ⫽

Total Outpatient Days [33,516 ⫻ 75 ⫽ 25,137 Inpatient Days]

Adjusted Patient Days Total patient days are the sum of inpatient days and the

pro-vided (computed) outpatient days Adjusted patient days are the driving forcebehind a hospital’s core value

Average Length of Stay (ALOS) With increasing technologies and decreasing

reim-bursements, it is not uncommon for a hospital’s ALOS to decrease or, more

conser-Simply adding inpatient days plus outpatient cases would be erroneoussince patients who are treated on an outpatient basis in the hospital arenot measured in terms of days As a result, the hospital applies an out-patient conversion factor to convert the outpatient cases into outpatientdays This is necessary to arrive at adjusted patient days, the term formeasuring a hospital’s occupancy rate and capacity

Adjusted Patient Days

Net Revenue Per Adj

Patient Day $ 1,495.86 $ 1,525.77 $ 1,541.03 $ 1,556.44 Annual Growth % 1.0% 1.0% 1.0% Net 0perating Revenues

Growth $112,691,832 $116,857,615 $119,358,974 $123,087,550 Other Operating Revenue 1,796,949 1,796,949 1,796,949 1,796,949 Net Revenues 114,488,781 118,654,564 121,155,923 124,884,499

vatively, remain flat Such is the case with Ashley According to conversations withmanagement, ALOS has been projected to be flat in the projection period.

Net Revenue per Adjusted Patient Day This is calculated by dividing the hospital’s

net operating revenues by the adjusted patient day total provided by management.This calculation, coupled with adjusted patient days, drives the value under the dis-counted cash flow methodology

DCF Analysis After all of these steps have been performed, the final value created

is the Total Invested Capital (total equity + interest-bearing debt) Depending on thedeal, the related interest-bearing debt may/may not need to be removed from thetotal invested capital value indication

Discount Rate The discount rate is often the most contested part of the income

approach (Chapter 5) The weighted average cost of capital (WACC) is a highlyregarded method for estimating an appropriate discount rate, although the directequity method can be used as well Two factors must be considered in estimating thepresent value of any projected cash flow stream:

1 Financial Risk The risk inherent in an entity’s financial structure (i.e., the

uti-lization of debt versus equity financing)

2 Business Risk The uncertainty associated with the economy, industry, and the

inherent risk profile of the subject entity

The discount rate utilized for a hospital must appropriately encapsulate therisks associated with that hospital Some of the risks associated with Ashley include:

• New surgery center As management indicated, a new free-standing ambulatory

surgery center, Butler Center (the ASC), will be completed within the next dar year Management has also indicated that the new ASC has already started

calen-to recruit surgeons from the hospital pool As a result, the analyst should assumethat some of the current case volumes will depart to the ASC and the discountrate and/or projections should incorporate this inherent risk

• Nature of business The hospital is heavily reliant upon the individual surgeons

at the facility External forces, such as the development of other new centers, cantempt these surgeons to perform their cases elsewhere As a result, the discountrate should incorporate some factor to mitigate the risks associated with thebusiness

In estimating the WACC, we relied on the following formula:

WACC ⫽ (Ke ⫻ We) ⫹ (Kd(pt) ⫻ [1 ⫺ t] ⫻ Wd)Where:

WACC ⫽ Weighted average cost of capital

Ke ⫽ Company’s cost of common equity capital

Kd(pt) ⫽ Company’s cost of debt capital (pre tax)

We ⫽ Percentage of equity capital in the capital structure

Wd ⫽ Percentage of debt capital in the capital structure

The equity portion of the WACC was calculated by using the Build Up model.The basic formula is as follows:

Ke⫽ Rf ⫹ RPm ⫹ RPs ⫹ RpuWhere:

Ke ⫽ Expected rate of return on the subject security

Rf ⫽ Rate of return on a risk free security

RPm ⫽ Risk premium associated with the market

RPs ⫽ Risk premium associated with a small company

RPu ⫽ Risk premium associated with Ashley

The risk-free rate used in the calculation came from the yield of 20-yearTreasury bonds as of the valuation date The long-term market equity risk premium

and the small stock premium were reported in the 2001 Yearbook of Stocks, Bonds, Bills, and Inflation, published by Ibbotson Associates A risk premium of 2 percent

was added for Ashley due to increased competition which many other hospitals arealso experiencing

The equity component of the WACC is as follows:

Ke ⫽ 6% ⫹ 7.8% ⫹ 4.63% ⫹ 2%

The capital structure is based on an industry standard which is 25 percent debtand 75 percent equity The cost of debt is based upon available financing terms andwas 7 percent

The WACC is as follows:

WACC ⫽ (20.43%) (.75) ⫹ [7% (1⫺.40) (.25)]

Based on the procedures described above, a WACC of 16 percent was applied

to the cash flows

Value Indication

The value indication is shown in Exhibit 19.28

Value indications should incorporate the related excess assets, if applicable.Failure to recognize these assets would result in an erroneous value indication.However, in this case the valuation has been performed exclusive of excess assets

As a result, the fair market value indication at the enterprise or total invested tal level based on the DCF is approximately $77 million.

capi-Market Approach: Guideline Public Company Method

The guideline public company method relies on similar publicly traded companies

as a source of market multiples Market multiples include:

These companies had total revenues ranging from $200 million to $1.4 billion,which substantially exceeds the net revenues for Ashley Typically, hospital compa-nies trade based on their ability to grow earnings and cash flow in their business (asmost companies are valued) However, public hospital companies make use of theirmore accessible capital to grow by acquisition in addition to same-facility growth.Historically, the for-profit or proprietary hospital market has acted as a consolidator

of a very large and very fragmented business As a result, hospital companies tend totrade at multiples that reflect that acquisition growth Publicly traded hospitals havetraded at invested capital to EBITDA multiples above 9 As a result of acquisitiongrowth opportunities, size diversification, geographic diversification, and the overalllack of comparability with the subject hospital, the guideline public company method

of the market approach has not been utilized in the valuation of Ashley Hospital.Market Approach: Guideline Company Transaction Method

The guideline company transaction method includes pricing multiplies from vidual transactions of similar companies in the marketplace Information is devel-

indi-oped through various sources, such as Irvin Levin and Associates, Pratt’s Stats, and Mergerstat Review The data are then applied, where appropriate, to the subject

company (See Exhibit 19.29.)

Ten hospital transactions were utilized in the analysis In each of the 10 actions, the actual purchase terms were not included; actual historical financialstatements of the targets were also unavailable The result is that the informationreflects a purchase price in which there is no way to accurately determine assetsincluded or excluded in the transaction For example, was working capital part ofthe deal? Many transactions exclude working capital

trans-In addition, there is no way to:

• Determine the impact of special terms in the transactions including the form ofconsideration paid for the deal

• Accurately perform any financial analysis of the target hospital

• Determine overall profitability, payer mix, services provided by the target tal or the trends in those areas over the last three to four years

hospi-Facts and circumstances surrounding an individual hospital facility are cally disparate Payers in various parts of the country reimburse for services at dif-ferent levels Staffing costs in various parts of the country are different as are manyother operating costs As a result, there is less reliability of the results of the markettransactions Based on many years of research and close relationships with buyersand sellers, MCVal understands the basic range of valuation multiples that are typ-ically paid for hospitals As a result, the guideline company transaction method isutilized in the valuation However, it is given less consideration and used only as asanity check.

typi-Asset Approach

The asset approach is based on the principle of substitution, where it is assumed that

a buyer will not pay more for a particular investment than the costs to obtain aninvestment of equal worth In most cases, the asset approach assumes that the busi-ness will no longer be fully operational or is not considered a going-concern busi-ness Hence, we have encountered the following difficulties upon considering theasset approach to value Ashley Hospital It does not consider the identifiable intan-gible assets and unidentifiable intangible assets of the business—goodwill, withoutconsiderable effort and time

The net book value of Ashley Hospital prior to subtraction of debt, excludingassets limited as to use, and marketable securities, was approximately $71.7 million.This compares with the $76.6 million under the income approach to value To pro-vide a measure of accuracy to the asset approach, third-party equipment and realestate appraisers were engaged The results of that analysis indicated that bookvalue was 5 percent higher than the value of all assets of the facility as determined

pri-Exhibit 19.29 Ashley Hospital: Company Transactions

Transaction Transaction Multiples _Value Indication (TIC)