Question

California Health Center, a for �profit hospital, is evaluating the purchase of new diagnostic equipment. The equipment, which costs $600,000, has an expected life of 5 years and an estimated pretax salvage value of $200,000at that time. The equipment is expected to be used 15 times a day for 250 days a year for each year of the project�s life. On average, each procedure is expected to generate $80 in collections, which is net of bad debt losses and contractual allowances, in its first year of use. Thus, net revenues for Year 1 are estimated at 15X250X80=$300,000.
Labor maintenance costs are expected to be $100,000 during the first year of operation, while utilities will cost another $10,000and cash overhead will increase by $5,000 in Year 1. The cost for expendable supplies is expected to average $5 per procedure during the first year. All costs and revenues, except depreciation, are expected to increase at 5% inflation rate after the first year.
The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to following deprecation allowance;
Year Allowance
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
1.00
The hospital�s tax rate is 40%, and its corporate cost of capital is 10%


QUESTION

A. Estimate the project�s net cash flows over its five-year estimated life. (Hint: Use the following format as a guide.)

Year

0        1       2       3       4       5

Equipment cost

Net revenues

Less: Labor/maintenance costs

Utilities costs

Supplies

Incremental overhead

Operating income

Equipment salvage value                             __________________________________

Net cash flow                                               __________________________________

B. What are the project�s NPV and IRR? (Assume for now that the project has average risk.)

Answer 1

A]		0	1	2	3	4	5
	Equipment cost	$       -6,00,000
	Net revenues		$      3,00,000	$      3,15,000	$      3,30,750	$       3,47,288	$      3,64,652
	Less: Labor/maintenance costs		$      1,00,000	$      1,05,000	$      1,10,250	$       1,15,763	$      1,21,551
	Utilities cost		$          10,000	$          10,500	$          11,025	$           11,576	$         12,155
	Supplies		$          18,750	$          19,688	$          20,672	$           21,705	$         22,791
	Incremental overhead		$            5,000	$            5,250	$            5,513	$             5,788	$            6,078
	Depreciation		$      1,20,000	$      1,92,000	$      1,14,000	$           72,000	$         66,000	$       5,64,000
	Operating income		$          46,250	$        -17,438	$          69,291	$       1,20,455	$      1,36,078
	Tax at 40%		$          18,500	$           -6,975	$          27,716	$           48,182	$         54,431
	Net operating income after tax		$          27,750	$        -10,463	$          41,574	$           72,273	$         81,647
	Add: Depreciation		$      1,20,000	$      1,92,000	$      1,14,000	$           72,000	$         66,000
	Operating cash flow		$      1,47,750	$      1,81,538	$      1,55,574	$       1,44,273	$      1,47,647
	Equipment salvage value, after tax = 200000-(200000-36000)*40% =						$      1,34,400
	Net cash flow	$       -6,00,000	$      1,47,750	$      1,81,538	$      1,55,574	$       1,44,273	$      2,82,047
B]	PVIF at 10% [PVIF = 1/1.1^t]	1	0.90909	0.82645	0.75131	0.68301	0.62092
	PV at 10%	$       -6,00,000	$      1,34,318	$      1,50,031	$      1,16,885	$           98,540	$      1,75,129
	NPV	$             74,904
	IRR is that discount rate for which NPV is 0. It is to be found out by trial and error by varying the discount rate to get 0 NPV.
	Discounting at 15%:
	PVIF at 15%	1	0.86957	0.75614	0.65752	0.57175	0.49718
	PV at 15%	$       -6,00,000	$      1,28,478	$      1,37,268	$      1,02,293	$           82,489	$      1,40,227
	NPV	$             -9,245
	Discounting at 14%:
	PVIF at 14%	1	0.87719	0.76947	0.67497	0.59208	0.51937
	PV at 14%	$       -6,00,000	$      1,29,605	$      1,39,687	$      1,05,008	$           85,421	$      1,46,486
	NPV	$               6,208
	As 0 NPV is got between discount rates of 14% and 15%, IRR lies between those rates.
	IRR by simple interpolation = 14%+1%*(6208)/(6208+9245) =	14.40%
	CONCLUSION:
	As the NPV is positive, the investment should be made.