Dr. Christian Larson, Chief of Cardiology at Erie Hospital, was contemplating the proposal recently submitted to him by Dr. Francesca Michaels, the head of the Cardiac Cath Lab. Dr. Michaels’ request was for the purchase of some new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price was $300,000, delivered and installed.
Erie Hospital was a nonprofit, university-affiliated medical center, whose physicians practiced in a number of specialties and subspecialties. A 350-bed institution, located on the shores of Lake Erie in Cleveland, Ohio, it had been in existence for some 40 years. Although it treated patients with a variety of problems, its distinguishing speciality was cardiology, where it prided itself on having the latest in technology and up-to-date services and facilities. Because of the rapid changes taking place in the field of cardiology, maintaining the hospital’s cutting-edge position required rather constant upgrading of its facilities and equipment.
In recent years, with the advent of third-party reimbursement based on diagnosis-related groups (DRGs), i.e. a single payment to the hospital for each patient, based on that patient’s discharge diagnosis, there had been increasing pressures on the hospital’s “bottom line.” Although some of Erie’s equipment and facilities were used for research, and could be purchased with research funding, those items that were for clinical purposes had to be financed from patient care revenues only. Because of the increased financial pressures, the hospital was taking a harder and harder look at all capital equipment proposals designated for patient care purposes.
In the case of Dr. Michaels’ request, the equipment was for patient care purposes. No grant funds were available, and hence the cost would need to be financed from patient care revenues. Dr. Michaels had worked closely with the equipment manufacturer to determine the potential benefits of the new equipment, however, and she estimated that it would result in annual savings of $60,000 in labor and other direct costs, as compared with the present equipment. She also estimated that the proposed equipment’s economic life was 10 years, with zero salvage value.
The hospital had recently borrowed long-term to finance another project. Paul Hershenson, the Vice President of Fiscal Affairs, had informed Dr. Larson that, because of this, he was . . .
- What is the internal rate of return of Dr. Michaels’ proposal?
- What is the proposal’s net present value, using a discount rate of 20 percent? A discount rate of 5 percent? What is the appropriate discount rate to use? Why?
- If the hospital decides to purchase the new equipment for Dr. Michaels, a mistake has been made somewhere, because good equipment bought only two years ago is being scrapped. How did this mistake come about?
- What non-quantitative factors should the hospital consider in making this decision? How important are they? Would it make a difference if the proposal were for new technology rather than replacement of existing technology? If it were for new technology with the same dollar amounts, but in the Laundry Department? Why?