MRI Replacement: Buy, Bond-Fund, or Lease Inside a Debt Covenant Ceiling
Northgate Health is a 320-bed stand-alone hospital and the sole issuer on $46.0 million of outstanding tax-exempt revenue bonds. Net assets are $32.0 million. The indenture limits debt to 60% of total capitalization, so maximum debt is $48.0 million and existing headroom is $2.0 million. Annual operating expense is approximately $95 million and days cash on hand is 71, against a covenant floor of 65. The hospital's 11-year-old MRI is failing, and the CFO has two options. Option A is to buy a new unit for $2,400,000, depreciate it straight-line over seven years to a $200,000 salvage value, and pay $85,000 per year for a service contract. Option B is a 60-month lease at $47,000 per month with maintenance included, renewable for two additional years at the same rate, which matches the seven-year horizon. Either unit produces the same incremental net patient service revenue of $610,000 per year after contractual allowances. The hospital's weighted average cost of capital is 7.2%, new tax-exempt debt prices at 4.6%, and its incremental borrowing rate for leases is 6.0%.
1. The purchase exceeds the indenture's debt headroom by $400,000. Evaluate the financing alternatives and recommend one.
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Headroom is $48.0 million minus $46.0 million, or $2.0 million, against a $2.4 million need. A straight $2.4 million bond issue breaches the 60% test, so the hospital cannot simply issue its way to the purchase without touching the ceiling.
Four credible paths. First, fund $400,000 to $500,000 from unrestricted cash and bond the rest. Using $500,000 takes cash from about $18.5 million (71 days times an average daily expense of roughly $260,000) to about $18.0 million, or roughly 69 days, still above the 65-day floor. This is the cleanest option and preserves the covenant test on the borrowing itself. Second, buy a refurbished unit at roughly $1.1 million and stay under the ceiling; that trades image quality and useful life for covenant safety. Third, lease, but only if the indenture's definition of Debt does not capture ASC 842 lease liabilities. That is a document-reading exercise, not an assumption to make in the board packet: even where the indenture excludes operating leases, the audited balance sheet will show a liability of about $2.4 million, and rating agencies will capitalize it. Fourth, request lender consent or a waiver; that costs trustee and legal fees and takes weeks the failing scanner may not allow.
Recommend the blended approach: bond $2.0 million, apply $400,000 to $500,000 of cash, and keep the days cash cushion by phasing the remaining capital plan. Present the post-transaction debt-to-capitalization and days cash to the board with the covenant certificate.
2. What nonfinancial factors and sensitivities should the board see before approving, and what would change the recommendation?
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First, the recommendation is robust across rates but not across volume. The break-even lease is about $42,500 per month; at $47,000 the lease is roughly 10% too expensive to win. Conversely, if incremental net revenue falls about 20% to roughly $488,000, the purchase NPV turns negative, so the board should see the revenue forecast's basis: referral capture, payer mix, and the assumption that the hospital retains its imaging volume against free-standing competitors.
Second, quantify the cost of downtime. The current unit had six downtime days last quarter; if the replacement decision slips a year, the board is choosing to forgo a year of the $525,000 net cash flow while paying for interim mobile service at premium rates. That cost of delay often dominates the lease-versus-buy spread.
Third, weigh operating factors: service contract escalation clauses, technologist training on the new platform, protocol development with radiology, and the effect on referring physicians who route patients elsewhere during an outage. Then ask whether the seven-year horizon is right; the new unit's expected life is ten to twelve years, so a ten-year horizon strengthens the purchase case further and should be tested.
Finally, sensitivity to the discount rate, salvage value, and the reliability of the $610,000 revenue estimate should be presented as a small table rather than a single point estimate. Approve the purchase with the cash-and-bond structure, subject to a signed bond counsel opinion on covenant compliance and a procurement review of the refurbished alternative.