HCS/385 Week 4: Working Capital Management and Capital Budgeting, sample paper

Cash Tied Up and Cash Committed: Reducing Days in Accounts Receivable to Fund an LED Lighting and Building Automation Retrofit, Evaluated With NPV, IRR and Payback

[Student Name]

University of Phoenix

HCS/385: Health Care Finance

Week 4 Assignment

[Instructor Name]

[Date]

The hospital, vendor terms and all figures are a composite written for a model paper.

A composite 140-bed hospital with net patient service revenue of $190 million spends about $2.4 million a year on electricity and natural gas. Its lighting is mostly fluorescent, and its air handlers run at full speed around the clock, including in office wings that are empty at night. The facilities director has proposed a retrofit: LED lighting throughout, variable-speed drives on the air handlers and a building automation system that sets back heating and cooling in unoccupied areas. The chief financial officer has two concerns: the hospital's days cash on hand have fallen, and the project's savings must justify its cost. The question was not only whether the retrofit was a good investment but whether the hospital could find the cash for it without borrowing. This paper addresses both concerns.

Working Capital and Accounts Receivable

Working capital management concerns current assets and liabilities, the resources an organization uses in daily operations. For hospitals, the largest working capital item is usually patient accounts receivable, the revenue earned but not yet collected (Pink & Song, 2020). The hospital's days in accounts receivable were 56, above its peer group median of about 46.

Each day of receivables represents the hospital's average daily net patient revenue: $190 million divided by 365, about $520,548. Reducing receivables from 56 to 46 days would therefore convert about 10 times $520,548, or roughly $5.2 million, from receivables into cash. That is a one-time release of cash, not new revenue, but it is real money the hospital could use for capital needs.

The revenue cycle team identified the main drivers of slow collection: claims held for missing documentation, slow follow-up on denials and patient balances not collected at the time of service. Cleverley and Cleverley (2018) note that improving the revenue cycle is often the most direct way for hospitals to improve liquidity, because it accelerates cash without reducing services. The team proposed daily review of held claims, a denial work queue with same-week follow-up and point-of-service collection of estimated patient balances.

Other Working Capital Levers

Receivables are not the only source of cash inside the balance sheet. Supply inventory ties up cash on shelves; the hospital held about 38 days of supplies, and moving high-cost implants to consignment, where the vendor owns the stock until it is used, would release a further few hundred thousand dollars. Payables work in the opposite direction: paying vendors on the agreed due date rather than early keeps cash in the hospital longer, although early-payment discounts should be taken when their implied return exceeds the hospital's cost of capital. The finance office judged these levers smaller than receivables but worth pursuing, and it cautioned against stretching payables past terms, which damages vendor relationships and can raise prices.

The Capital Project

The retrofit would cost $2.15 million: about $1.2 million for LED fixtures and $950,000 for variable-speed drives and the automation system, including installation. The local electric utility offers a $150,000 rebate for efficiency projects, paid at completion, so the net investment is $2.0 million. An engineering study estimated annual savings of $290,000 in energy and $40,000 in maintenance, since LED fixtures rarely need replacement and the drives reduce wear on motors, for total savings of $330,000 a year. The analysis uses a ten-year life, the rated life of the fixtures under the hospital's operating hours, with no salvage value. The hospital's cost of capital is 7%.

Energy projects also matter beyond the budget. Eckelman and Sherman (2016) estimated that the U.S. health care sector accounted for close to a tenth of national greenhouse gas emissions, with hospitals' energy use a leading source, so reducing energy use lowers both cost and environmental harm.

Net Present Value

Net present value equals the present value of future cash flows, discounted at the cost of capital, minus the initial investment (Brigham & Houston, 2022). Savings of $330,000 a year for ten years at 7% form an annuity; the present value annuity factor for ten years at 7% is about 7.0236, so the present value of the savings is about $2,318,000. Subtracting the $2.0 million investment gives an NPV of about $318,000. A positive NPV means the project is expected to earn more than the 7% cost of capital and add value to the hospital.

Internal Rate of Return

The internal rate of return is the discount rate at which NPV equals zero. For these cash flows, the IRR is about 10.3%, above the 7% cost of capital. The IRR and NPV agree, as they usually do for a single conventional project.

Payback

Simple payback divides the investment by the annual savings: $2.0 million divided by $330,000 is about 6.1 years. Discounted payback, which uses discounted savings, is about 8.2 years: the discounted value of the first eight years' savings is about $1.97 million, and a small part of the ninth year's discounted savings of about $179,000 closes the gap. Both fall within the fixtures' ten-year life, but discounted payback shows that the margin of safety is narrow: most of the project's value arrives in its last few years.

Sensitivity Analysis

Because savings estimates are uncertain, the analysis tested a case in which savings are 20% lower, $264,000 a year, as could happen if energy prices fall or the automation settings are overridden by staff. In that case, NPV falls to about negative $146,000. The break-even point is savings of about $285,000 a year, about 86% of the forecast. The project is therefore sensitive to the savings estimate. Pink and Song (2020) recommend such sensitivity and scenario analysis for capital projects, because a single point estimate can hide how much of the result depends on optimistic assumptions.

Non-Financial Considerations

The retrofit has benefits not captured in the cash flows. LED lighting improves light quality in patient rooms and reduces the heat that fluorescent fixtures add to spaces that must then be cooled. The automation system alerts facilities staff to equipment problems before they cause failures in temperature-sensitive areas such as operating rooms and pharmacies. And lower emissions support the hospital's commitments to its community.

Recommendation

The hospital should approve the retrofit and fund it from cash released by reducing days in accounts receivable. At the 7% cost of capital, the project has an NPV of about $318,000 and an IRR of about 10.3%. Because the result depends on achieving at least 86% of forecast savings, the hospital should ask the vendor for a performance guarantee on energy savings, have the automation settings locked against casual changes and measure savings against a weather-adjusted baseline each year.

Conclusion

Working capital and capital budgeting turned out to be two sides of one decision. Reducing receivables by ten days would free about $5.2 million, and the retrofit would add value at the hospital's cost of capital under the expected savings, with a positive NPV and an IRR above the cost of capital. Sensitivity analysis showed the investment depends on realizing most of the forecast savings, which shapes how the hospital should contract for and monitor it.

References

Brigham, E. F., & Houston, J. F. (2022). Fundamentals of financial management (16th ed.). Cengage Learning.

Cleverley, W. O., & Cleverley, J. O. (2018). Essentials of health care finance (8th ed.). Jones & Bartlett Learning.

Eckelman, M. J., & Sherman, J. D. (2016). Environmental impacts of the U.S. health care system and effects on public health. PLOS ONE, 11(6), Article e0157014. https://doi.org/10.1371/journal.pone.0157014

Pink, G. H., & Song, P. H. (2020). Gapenski's healthcare finance: An introduction to accounting and financial management (7th ed.). Health Administration Press.