Lowell General Physician Hospital Organization Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Lowell General Physician Hospital Organization case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lowell General Physician Hospital Organization case study is a Harvard Business School (HBR) case study written by Richard M. J. Bohmer, Natalie Kindred. The Lowell General Physician Hospital Organization (referred as “Aqc Lgpho” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Costs, Health, Innovation, Personnel policies, Supply chain.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Lowell General Physician Hospital Organization Case Study

This case focuses on the Alternative Quality Contract (AQC), a novel payment program designed to incentivize providers to deliver less costly, high quality health care. Under the AQC, offered by Blue Cross Blue Shield of Massachusetts, providers received a fixed-dollar budget to cover all care provided to a specific patient population, as well as incentive payments for quality. The AQC was piloted in 2009 by a handful of provider organizations, including a group of physicians belonging to the Lowell General Physician Hospital Organization (LGPHO). The case describes the LGPHO physicians' experience during their first two years under the AQC, allowing students to assess the group's performance as well as potential challenges in the remaining three years of the contract and future contracts and the AQC's value as part of the solution to untenably high U.S. health care costs.

Case Authors : Richard M. J. Bohmer, Natalie Kindred

Topic : Innovation & Entrepreneurship

Related Areas : Costs, Health, Innovation, Personnel policies, Supply chain

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Calculating Net Present Value (NPV) at 6% for Lowell General Physician Hospital Organization Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017426)	-10017426	-	-
Year 1	3449424	-6568002	3449424	0.9434	3254174
Year 2	3974496	-2593506	7423920	0.89	3537287
Year 3	3942636	1349130	11366556	0.8396	3310313
Year 4	3224869	4573999	14591425	0.7921	2554398
TOTAL			14591425		12656172

The Net Present Value at 6% discount rate is 2638746

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Aqc Lgpho have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Aqc Lgpho shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Lowell General Physician Hospital Organization

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Innovation & Entrepreneurship Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Aqc Lgpho often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Aqc Lgpho needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10017426)	-10017426	-	-
Year 1	3449424	-6568002	3449424	0.8696	2999499
Year 2	3974496	-2593506	7423920	0.7561	3005290
Year 3	3942636	1349130	11366556	0.6575	2592347
Year 4	3224869	4573999	14591425	0.5718	1843829
TOTAL					10440966

The Net NPV after 4 years is 423540

(10440966 - 10017426 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10017426)	-10017426	-	-
Year 1	3449424	-6568002	3449424	0.8333	2874520
Year 2	3974496	-2593506	7423920	0.6944	2760067
Year 3	3942636	1349130	11366556	0.5787	2281618
Year 4	3224869	4573999	14591425	0.4823	1555203
TOTAL					9471408

The Net NPV after 4 years is -546018

At 20% discount rate the NPV is negative (9471408 - 10017426 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Aqc Lgpho to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Aqc Lgpho has a NPV value higher than Zero then finance managers at Aqc Lgpho can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Aqc Lgpho, then the stock price of the Aqc Lgpho should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Aqc Lgpho should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Lowell General Physician Hospital Organization

References & Further Readings

Richard M. J. Bohmer, Natalie Kindred (2018), "Lowell General Physician Hospital Organization Harvard Business Review Case Study. Published by HBR Publications.