The merger or acquisition of hospitals has been used as a strategy for hospitals to increase their market share, supplementing budgets, and stave off the competition. The advantage of a public hospital is that they may operate free from antitrust rules granted by the state and to dominate or monopolize its market (2006, Evans). They, however, must submit to the public authorities, city councils, or county boards for oversight of their operations and financial information which can restrict business opportunities. The merging of the not-for profit St. Jerome Teaching Hospital and not-for profit Marshland General has the potential to increase the efficiency of health care offered in the county, and decrease the over supply of beds within the community. This merger analysis will place a dollar value on Marshland General's equity capital with both the discount cash flow and market multiple approaches. The results will be used by St. Jerome's board to assess the feasibility of acquiring Marshland General.
The historical income statements of Marshland General and cash flow assumptions will be used to forecast five years of income statements necessary for the validation process (Table 1). The forecasted cash flow data will require several assumptions based on past operations. The growth in gross revenues for inpatient is estimated to be 5.8 percent and the outpatient services at 14.4 percent. The allowances and discount rate is 34.4 percent of the gross revenues. The other operating revenue growth rate has decreased almost every year and will be assumed to decrease 16.3 percent each year in the pro forma statements. The patient expense services are estimated to total 91.2 percent of the net patient revenues. The net operating cash flow retained for capital growth will total 24.3 percent. The interest paid on debt has averaged 5.5 percent
Table 1: Marshland General Hospital Income Statements.
over the past five years. The estimated interest per year is $580,000 on current debt and $2.473 million in long-term liabilities. The consolidation of services and management to be realized by St. Jerome will result in a cost savings of $16.11 million, approximately 7 percent, per year. These assumptions are based on the average changes over the past five years of Marshland General's income statements. The per forma income statement growth rate for 2015 and beyond will be estimated at 3 percent.
The market data from Provident Healthcare will be utilized to formulate the calculations for the market multiple method. The debt/asset ratio for Marshland General is approximately 50 percent so this correlates with the Provident Healthcare Company. The discount rate (cost of equity) will be adjusted by 6 percentage points for a risk premium as forecasted by three investment banking firms for a total of 16 percent. The market data of the stock price to EBITDA per share is 6.1, and the ratio of total equity market value to number of discharges is $7,000. The number of patient discharges has decreased over the last three years for Marshland General. The expected number of patient discharges is estimated at 10,842. This is a 5 percent decrease from the previous year for Marshland General.
The forecasted income statements for Marshland General estimate the cash flows to equity holders (Table 2). These cash flows and the assumptions produce the acquisition value of Marshland General. The discounted cash flow (DCF) method yields $119.595 million. The market multiple calculations applied to the 2010 EBITDA totals $153.474 million, and to the average EBITDA totals $161.331 million. The dollar estimate when applied to the expected number of discharges totals only $75.894, approximately half of the value based on the 2010 EBITDA.
Table 2: Marshland General Hospital Pro Forma Income Statements
There are several significant findings by the authors Danvoe and Lindrooth (2003) that provide guidance about the cost savings in mergers. The distance between the merging hospitals is inversely related to the costs savings, thereby the closer the facilities the greater the cost savings. The closure or conversion of one of the inpatient facilities results in a continued cost savings from 6 to 8 percent per year (2003, Danove & Lindrooth). The mergers without a closure or conversion result in savings for only two years after merger by about 5 percent and no savings beyond (2003, Danove & Lindrooth). The incentive to consolidate services between St. Jerome and Marshland General is increased due to the close proximity (one mile) of these hospitals. The complete closure or conversion of the Marshland General would significantly increase the long term cost savings to St Jerome. The current excess of hospital beds in the community would support the strategy to significantly consolidate the services at Marshland General.
The validation methods hold a great deal of dependence on the per forma estimations in equity cash flow and the market multiple from another hospital. The risk analysis can be utilized to produce a range of values by assessing the worst and best case scenario versus the most likely case. This analysis can be used to determine the degree of confidence in the final estimates (Table 3). The DCF method produces a range of estimates totaling $112.999 to $127.169 million. The resulting range is only about an 11 percent change with the adjusted risk premium for the cost of equity keeping all other assumptions about the cash flow the same. These calculations are based on St. Jerome realizing a 7 percent reduction in costs after the merger. The market multiple approach range totals $108.186 to $198.761 million with the 2010 EBITDA data and $113.725 to $208.937 million with the average EBITDA. The variation in the EBITDA multiple from different market firms produce a 45 percent change from the worst to the best case scenario. The market multiple approach produces a much more variable result by comparing Marshland General to the selected market firms. The more precise an assessment is of a comparable market firm, the more accurate the range of validation. The market value to discharges results in a range of $65.052 to $86.736 million. This range is a 25 percent change from the worst to the best case. The discharges were estimated to continue to decrease 5 percent per year; however, this may change after the merger.
Table 3: Scenario Analysis of Marshland General Business Valuation
St. Jerome may compensate for the lost discharges with the consolidation of
services. The correlation between the different methods produce a worst case scenario range that is similar ($108.168 to 113.725 million), but the best case range is much larger ($127.169 to $208.937). The most likely case calculation produces the recommendation offer range of $119.595 to $161.331 million for Marshland General.
The conversion to new service lines at Marshland General will be required for continued realization of the estimated cost reductions. The reorganization and consolidation of services should include: elimination of duplicate of services, reduction of healthcare staff FTEs, administrative staff, and board of directors. The management will find it necessary to capitalize on the strengths of each facility and shift the services to the hospital that excels in each. The institutions will have the opportunity to offer a more diverse set of services and better coordination of care with the two facilities. There should be a significant amount of planning, coordination, and continued evaluation of the integration plan. The allocation of fixed costs associated with new or updated IT for billing systems, and electronic medical records can be spread over the larger system. The centralization of certain departments will be easier to justify the costs between two facilities such as quality oversight, human resources, and patient satisfaction personnel.
