Question

Keating Hospital is considering two different low-field MRI systems: the Clearlook System and the Goodview System. The projected annual revenues, annual costs, capital outlays, and project life each system (in after-tax cash flows) are as follows:

	Clearlook	Goodview
Annual revenues	720,000	900,000
Annual operating costs	445,000	655,000
System investments	900,000	800,000
Project Life	5 years	5 years

Assume that the cost of capital for the company is 8 percent.

Required:

1. Calculate the NPV for the Clearlook System.

2. Calculate the NPV for the Goodview System. Which MRI system would be chosen?

3. What if Keating Hospital wants to know why IRR is not being used for the investment analysis? Calculate the IRR for each project and explain why it is not suitable for choosing among mutually exclusive investments.

Answer 1

Answer :

1. Calculation of NPV for the Clearlook System :

Net Present value = Present value of annual cash inflow - Initial cash outflow

Annual cash inflow = Annual revenues - Annual operating costs

= $720,000 - $445,000

= $275,000

Net Present value = $275,000 X PVAF(8%, 5years) - $900,000

= ($275,000 X 3.9927) - $900,000

= $1,097,992 - $900,000

= $197,993

2. Calculation of NPV for the Goodview System :

Net Present value = Present value of annual cash inflow - Initial cash outflow

Annual cash inflow = Annual revenues - Annual operating costs

= $900,000 - $655,000

= $245,000

Net Present value = $245,000 X PVAF(8%, 5years) - $800,000

= ($245,000 X 3.9927) - $800,000

= $978,212 - $800,000

= $178,212

Clearlook System should be choosen because it has higher NPV.

3.

IRR is not used for the investment analysis because it does not account for the project size when comparing projects. It does not consider factors like project duration, future costs, or the size of a project. It simply compares the project's cash flow to the project's existing costs, without considering the above factors.

IRR for each project is :

Clearlook System = 16.021%

Goodview System = 16.118%

For a project to be acceptable under the IRR method, the discount rate must exceed the project's cost of capital. The NPV and IRR methods gives conflicting results when mutually exclusive projects differ in size, or differences exist in the timing of cash flows.