Question

You have been promoted to Assistant Director of your Laboratory Department. One of your first assignments is to prepare a recommendation for the replacement of one of your Coulter Counters.

Your Department Director has asked that you work with the Financial staff in preparing this recommendation. Upon contacting the financial staff they tell you that their department has lost a number of analysts and ask if you could help in preparing the analysis since you are a recent graduate of SHU. You tell them that you are well versed in Capital Decision making and would be able to complete the analysis for them and submit to your Department Director.

You decide to prepare a Net Present Value Analysis and begin the discussions with your staff. They emphasize to you the importance of replacing the existing equipment due to quality and safety concerns for the patient. You first plan on completing a Time Line and from the discussion with the staff plan on incorporating the following assumptions in your analysis:

Assumptions to use:

Time Line for 5 years

Initial cost of equipment $3000000

Additional volume from increased efficiency 1000 test per month

Average reimbursement per test is $50

Cost of supplies will be reduced by $2000 per month

The existing equipment is fully depreciated

The only other expense is the depreciation for the new equipment and it is a non cash item

The financial staff tells you to use 5% as your Cost of Capital

What would be the NPV for your analysis?

Answer 1

NPV is the difference between the present value of cash inflows and cash outlows. It can be calculated with the use of formula given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Cost of Capital)^1 + Cash Flow Year 2/(1+Cost of Capital)^2 + Cash Flow Year 3/(1+Cost of Capital)^3 + Cash Flow Year 4/(1+Cost of Capital)^4 + Cash Flow Year 5/(1+Cost of Capital)^5

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Here,

Cash Flow Year 0 = -$3,000,000 (Cost of Equipment) and

Cash Flow from Year 1 to Year 5 = Increase in Number of Tests Per Month*Average Reimbursement Per Test*Number of Months in Year + Reduction in Cost of Supplies Per Month*Number of Months in Year = 1,000*50*12 + 2,000*12 = $624,000

Using these values in the above formula for NPV, we get,

NPV = -3,000,000 + 624,000/(1+5%)^1 + 624,000/(1+5%)^2 + 624,000/(1+5%)^3 + 624,000/(1+5%)^4 + 624,000/(1+5%)^5 = -$298,406.56

Since, the NPV is negative, the company shouldn't proceed ahead with the replacement.

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Notes:

1) As, we have not been provided with the tax rate, the tax benefit resulting from depreciation of equipment will not arise in the given case.