Question

Georgia Health Center, a for profit hospital, is evaluating the purchase of a new diagnostic equipment. The equipment, which cost $600,000, has an expected life of five years and an estimated pretax salvage value of $200,000 at 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 15 x 250 x $80= $300,000

Labor and maintenance costs are expected to be $100,000 during the first year of operation, while utilities will cost another $10,000. The cost for expendable supplies is expected to average $5 per procedure during the first year. Cash overhead will increase by $5,000 in Year 1. All costs and revenues, except depreciation, are expected to increase at 5 percent inflation rate per year after the first year.

The equipment falls into the MACRS five-year class for tax depreciation and is subject to the following depreciation allowances:

Year	Allowance
1	0.20
2	0.32
3	0.19
4	0.12
5	0.11
6	0.06

The hospital’s tax rate is 40 percent, and its corporate cost of capital is 8%.

You can use Excel to complete this problem. If you do, please submit your homework document and the Excel file.

a. Estimate the project’s net cash flows over its five-year estimated life. Hint: complete the following table.

	0	1	2	3	4	5
Equipment cost
Net revenue
Less:
Labor & Maintenance
Utilities costs
Supplies
Incremental overhead
Depreciation
Income before taxes
Taxes (40%)
Project’s net income
Plus: Depreciation
Plus: Net salvage value

b. What’s the project’s NPV?

c. What’s the project’s IRR?

Answer 1

	0 $	1 $	2 $	3 $	4 $	5 $
Equipment cost	(60000)
Net revenue		300000	315000	330750	347288	364652
Less:
Labor & Maintenance		100000	105000	110250	115763	121551
Utilities costs		10000	10500	11025	11576	12155
Supplies		18750	19688	20672	21705	22791
Incremental overhead		5000	5250	5513	5788	6078
Depreciation		120000	192000	114000	72000	66000
Income before taxes		46250	(17438)	69291	120455	136078
Taxes (40%)		18500	(6975)	27716	48182	54431
Project’s net income		27750	(10463)	41574	72273	81647
Plus: Depreciation		120000	192000	114000	72000	66000
Net Cash Flow	(600000)	147750	181538	155574	144273	282047

pre tax equipment salvage value = $ 200000

MACRS equipment salvage value (600000*.06 (dep year 6)) = $ 36000

$200000 - $36000 = $ 164000

Taxes 40% = $ 65600

After tax equipment salvage value = Salvage value - tax paid on gain

= $200000 - 65600 = $134400

Projects NPV

YEAR	0	1	2	3	4	5
CASH FLOW	(600000)	147750	181538	155574	144273	282047
DISCOUNT RATE	8%
DISCOUNTED CASH FLOW = CF/(1+r)n	600000	136805	155161	123471	106083	191869
NPV(Sum of DCF)	$113389

The projects Cost of capital at 8%

NPV = PV of the cashflows - Initial investments

NPV = 147750/(1.08) + 181538/(1.08)² + 155574/(1.08)³ ....

The projects IRR

YEAR	0	1	2	3	4	5
CASH FLOW	(600000)	147750	181538	155574	144273	282047
IRR	14.40%