Posted: May 15th, 2024

Module 7 Assignment: Merger Analysis

Module 7 Assignment: Merger Analysis

CASE 30: ST. BENEDICT’S TEACHING HOSPITAL
Directions: Fully answer each question regarding Case 30: Merger Analysis.

1. Use the data contained in the case to estimate the post-merger cash flows for 2018 through 2022 assuming that Lafayette General Hospital is acquired by St. Benedict’s Teaching Hospital. You have very limited data on which to base your forecasts. The key is to make supportable assumptions about the potential synergies that can be obtained from the merger. Also, any cost savings to St. Benedict’s that result from the merger must be included in the analysis.

2. Conceptually, what is the appropriate discount rate to apply to the cash flows? What is your actual numerical estimate? (Hint: Use CAPM)

3. What is your estimate of Lafayette General’s value to St. Benedict’s using the DCF valuation technique? What are the strengths and weaknesses of this technique both in general and as applied in this situation?

4. A major concern in any DCF valuation is the accuracy of both the terminal (long-term) growth rate and discount rate estimates. How sensitive is the acquisition value to these estimates?

5. What is your estimate of Lafayette General’s value using the market multiple valuation technique? What are the strengths and weaknesses of this technique both in general and as applied in this situation? (Remember that there are two bases for this approach—EBITDA and number of discharges.)

6. What is your final conclusion regarding the value of Lafayette General to St. Benedict’s? How much should St. Benedict’s initially offer for Lafayette General?

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Here is my attempt at answering the questions about Case 30: St. Benedict’s Teaching Hospital’s potential acquisition of Lafayette General Hospital:

1. To estimate the post-merger cash flows for 2018-2022:

Key assumptions:
– Lafayette General’s revenues grow at a conservative 3% per year post-merger, in line with overall industry trends (American Hospital Association, 2019).
– Cost savings and synergies from the merger allow expenses to be reduced by 10% initially in 2018, then grow more slowly at only 2% annually. This 10% cost reduction is achievable based on eliminating redundancies and improving operational efficiency (Blavin et al., 2020).
– Depreciation remains constant at $2.5M per year based on Lafayette’s existing assets.
– Tax rate is 25%.

Projected Post-Merger Cash Flows ($M):

Year Revenue Expenses Depreciation Pre-Tax Income Taxes (25%) After-Tax Income (+) Deprec. Free Cash Flow
2018 $92.7 $75.6 $2.5 $14.6 $3.7 $11.0 $2.5 $13.5
2019 $95.5 $77.1 $2.5 $15.9 $4.0 $11.9 $2.5 $14.4
2020 $98.3 $78.7 $2.5 $17.2 $4.3 $12.9 $2.5 $15.4
2021 $101.3 $80.2 $2.5 $18.5 $4.6 $13.9 $2.5 $16.4
2022 $104.3 $81.8 $2.5 $20.0 $5.0 $15.0 $2.5 $17.5

The projected free cash flows reflect the benefits of increased scale and cost efficiency from the merger.

2. The appropriate discount rate should reflect the risk of the merged entity. Conceptually, this is the weighted average cost of capital (WACC), incorporating the cost of equity based on CAPM and the after-tax cost of debt (Lutkevich, 2022).

For this hospital merger, key WACC inputs are:
– Risk-free rate: 3% based on long-term government bond yields
– Equity risk premium: 5% based on historical stock vs bond returns
– Beta: 0.8, assuming somewhat lower risk than overall market
– Cost of debt: 5% based on BBB-rated healthcare corporate bonds
– Debt-to-capital ratio: 30% based on industry averages
– Tax rate: 25%

WACC = [Cost of equity × (1 – Debt/Capital)] + [Cost of debt × (1 – Tax rate) × Debt/Capital]
= [8% × 70%] + [5% × (1 – 25%) × 30%] = 6.7%

Therefore, 6.7% is the estimated discount rate for the post-merger cash flows, based on the blended risk and capital structure.

3. To estimate Lafayette General’s value using discounted cash flow (DCF):

Present Value of 2018-2022 Free Cash Flows at 6.7% = $66.1M
+ Terminal value in 2022, assuming 2% perpetuity growth rate = $385.9M
= Enterprise value of $452M

Subtracting Lafayette’s $45M debt = $407M equity value

Key strengths of DCF:
– Intrinsic valuation based on cash flow fundamentals
– Explicitly considers growth, margin, investment needs
– Time value of money via discounting

Key weaknesses of DCF:
– Highly sensitive to assumptions, especially in terminal value
– Difficult to estimate distant cash flows
– WACC not directly observable, just estimated

However, DCF provides a useful valuation starting point based on conservative post-merger cash flow projections.

4. Sensitivity analysis shows Lafayette’s value to St. Benedict’s is highly dependent on long-term growth and WACC assumptions:

Terminal growth rate | 1% 2% 3%
———————-|——————-
5.7% WACC | $483M $559M $663M
6.7% WACC (base case) | $384M $432M $495M
7.7% WACC | $311M $343M $384M

A 1% change in perpetuity growth rate or WACC shifts the valuation by over 10%, demonstrating the importance of these inputs. The analysis should consider a reasonable valuation range rather than a single DCF value.

5. The market multiple valuation approach values Lafayette based on recent acquisition multiples for comparable hospitals.

EBITDA Multiple Method:
– Lafayette’s EBITDA = $17.1M
– Comparable hospital acquisition EV/EBITDA multiples average 9.5x (BDO, 2021)
– Implied enterprise value = 9.5 × $17.1M = $162M
– Less $45M debt = $117M equity value

Discharge Multiple Method:
– Lafayette discharges = 55,000
– Comparable price per discharge in acquisitions averages $8,500 (Melnick et al., 2018)
– Implied enterprise value = 55,000 × $8,500 = $468M
– Less $45M debt = $423M equity value

Key strengths of market multiples:
– Based on actual comparable transactions
– Captures current valuation environment
– Simple and understandable benchmarking

Key weaknesses of market multiples:
– Depends on availability of truly comparable deals
– Doesn’t explicitly consider Lafayette’s specific growth potential
– Multiples may reflect short-term market conditions vs long-term value

The EBITDA and discharges imply a wide $117-423M equity value range, but provide cross-checks vs the DCF.

6. Considering the DCF valuation of $407M, the EBITDA multiple valuation of $117M, and the discharge multiple valuation of $423M, a reasonable estimate of Lafayette’s equity value to St. Benedict’s appears to be around $300-450M.

The DCF is the most robust valuation approach, as it is based on Lafayette/St. Benedict’s projected financials and the WACC. The EBITDA multiple likely understates the value by ignoring Lafayette’s growth potential. The discharge multiple provides a useful data point but should be adjusted for Lafayette’s profitability.

As such, St. Benedict’s should consider an initial offer for Lafayette in the $350-400M range, around the midpoint of the DCF value. This would represent a fair value for the target while leaving some room for negotiation. St. Benedict’s could justify paying up to ~$450M, the high end of the DCF, if needed to close the deal, given the strategic benefits.

The ultimate price will depend on St. Benedict’s other alternatives, Lafayette’s willingness to sell, and any competing bids. But a DCF-based valuation of $350-450M provides a strong framework to guide St. Benedict’s acquisition of Lafayette General.

References:

American Hospital Association. (2019). 2019 AHA Hospital Statistics. https://www.aha.org/statistics/2019-01-01-aha-hospital-statistics-2019

BDO. (2021). BDO Healthcare RX: Q3 2021 Deal Insights Report. https://www.bdo.com/BDO/media/Report-PDFs/HC_Q3_2021_Deal-Insights_WEB.pdf

Blavin, F., Arnos, D., & Ramos, C. (2020). The Effect of Hospital Acquisitions on Quality, Costs, and Patient Outcomes. JAMA Internal Medicine, 180(6), 952-954. https://doi.org/10.1001/jamainternmed.2020.0797

Lutkevich, B. (2022). WACC (weighted average cost of capital). TechTarget. https://www.techtarget.com/whatis/definition/weighted-average-cost-of-capital-WACC

Melnick, G., Ong, S., & Chung, V. (2018). Hospital Prices and Market Structure in the Hospital and Insurance Industries. RAND Corporation. https://www.rand.org/pubs/research_reports/RR3033.html

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Study Notes & Homework Samples: Module 3 Assignment: Financial Risk and Required Return »Module 6 Assignment: Traditional Project Analysis