Question

Capital Budgeting

California Health Center, a for-profit hospital, is evaluating the purchase of a new diagnostic equipment, which costs $600,000 and has an expected life of five years.   Average investments in inventory and accounts receivable will be $50,000 and $200,000 respectively, while the average accounts payable balance will be $30,000. The expected before-tax salvage value of the equipment after five years’ use is $200,000. The equipment will produce an annual revenue of $300,000 each year in years 1-3, and $350,000 in years 4 and 5.

All costs excluding depreciation: 22% of revenue

Depreciation method: MACRS

Year    Depreciation

1          20%

2          32%

3          19%

4          12%

5          11%

6          6%

You will multiply the depreciation percentage for each year by the purchase price to get the depreciation expense in dollars for that year.

Tax rate: 21%

Estimate the project’s cash flows for the next five years and calculate the project’s payback period, NPV and IRR.   The cost of capital is 11% and the required payback is three years. Indicate whether the project will be acceptable by each of the three techniques.

Answer 1

Solution is as under: