Question

Sutter Lakeside Hospital, a taxpaying entity, is considering a new ambulatory surgical center (ASC). The building and equipment for the new ASC will cost $5,500,000. The equipment and building will be depreciated on a straight-line basis over the project’s five-year life to a $2,500,000 salvage value. The new ASC’s projected net revenue and expenses are as follows. Net revenues are expected to be $5,000,000 the first year and will grow by 9 percent each year thereafter. The operating expenses, which exclude interest and depreciation expenses, will be $4,500,000 the first year and are expected to grow annually by 3 percent for every year after that. Interest expense will be $700,000 per year, and principal payments on the loan will be $1,000,000 a year. In the first year of operation, the new ASC is expected to generate additional after-tax cash flows of $600,000 from radiology and other ancillary services, which will grow at an annual rate of 5 percent per year for every year after that. Starting in year 1, net working capital will increase by $350,000 per year for the first four years, but during the last year of the project, net working capital will decrease by $250,000. The tax rate for the hospital is 40 percent, and its cost of capital is 15 percent. Use both the NPV and IRR approaches to determine if this project should be undertaken. (Hint: see Appendices C, D, and E.)

Answer 1

Formula	Year (n)	0	1	2	3	4	5
	Initial investment (II)	5500000
9% growth y-o-y	Net revenue (NR)		5000000.00	5450000.00	5940500.00	6475145.00	7057908.05
3% growth y-o-y	Operating expense (OE)		-4500000.00	-4635000.00	-4774050.00	-4917271.50	-5064789.65
(II - salvage value)/5	Depreciation (D)		-600000.00	-600000.00	-600000.00	-600000.00	-600000.00
NR-OE-D	EBIT		-100000.00	215000.00	566450.00	957873.50	1393118.41
40%*EBIT	Tax @40%		40000.00	-86000.00	-226580.00	-383149.40	-557247.36
EBIT - Tax	Net income (NI)		-60000.00	129000.00	339870.00	574724.10	835871.04
5% growth y-o-y	After-tax cash flow from ancillary services (CF1)		600000.00	630000.00	661500.00	694575.00	729303.75
NI + CF1	Operating cash flow (OCF)		540000.00	759000.00	1001370.00	1269299.10	1565174.79
	Less: Increase in net working capital (NWC)		-350000	-350000	-350000	-350000	250000
	Add: Salvage value (SV)						2500000
OCF - Inc. in NWC + SV - II	Free Cash Flow (FCF)	-5500000	190000.00	409000.00	651370.00	919299.10	4315174.79
1/(1+15%)^n	Discount factor @ 15%	1.00	0.87	0.76	0.66	0.57	0.50
FCF*Discount factor	Present Value (PV) of FCFs	-5500000.00	165217.39	309262.76	428286.35	525612.24	2145404.52
Sum of all PVs	NPV	-1926216.74

NPV = -1,926,216.74

IRR (using IRR function with FCFs calculated in the table above) = 3.88%

Project should not be accepted as it has a negative NPV and the IRR is less than the cost of capital.