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

a. Incorporating all the given information, the cash flow table is prepared as follows:

The formula view of the above table is as follows:

The salvage value has been added to the cash flow of the last period. Please note that depreciation value has been added to the cash flow, as depreciation is a non cash expense. The depreciation value has been calculated as per MACRS depreciation table. Revenue and other expenses (other than depreciation) is projected to increase 5% each year.

b. The project's NPV can be calculated from the cash flows and the discount rate used is the cost of capital 8%.

NPV calculations are as follows:

Therefore, the NPV of the project is positive with a value of $330,650.

c. IRR of the project can be calculated using the cash flow from the project:

The IRR is calculated using the following formula:

Therefore, the IRR of this project is 24%.