Question

1. City Hospital, a nonprofit organization, estimates that it can save $28,000 a year in cash operating costs for the next 10 years if it buys a special-purpose eye-testing machine at a cost of $110,000. A $5,000 disposal value is expected. City Hospital’s required rate of return is 12%. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation. The income tax rate is 30% for all transactions that affect income taxes.

Required:

1. Calculate the following for the special-purpose eye-testing machine:

   a. Net present value
   b. Payback period
   c. Return on average investment

2. What other factors should City Hospital consider in deciding whether to purchase the special- purpose eye-testing machine?

Answer 1

Answer 1:

Year 0 Cash outflow:

Initial Investment = $110,000

Year 1 to Year 10 cash flows:

Depreciation per year = (Cost - salvage value) / Useful year = (110000 - 5000) / 10 = 105000/10 =$10,500

Net Income = (Saving in operating cost - Depreciation) * (1 - Tax rate) = (28000 - 10500) * (1 - 30%) = $12,250

Annual operating cash flow = Net Income + depreciation = 12250 + 10500 = $22,750

Terminal cash flow Year 10:

Salvage value = $5,000

NPV:

NPV = Annual operating cash flow * PV of $1 annuity for 10 years at 12% + Terminal cash flow * PV of $1 for 10 years at 12% - Initial investment

= 22750 * (1 - 1 / (1 + 12%)^10) / 12% + 5000 * 1/ (1+12%)^10 - 110000

= $20,152.44

Net present value = $20,152.44

Answer b:

Payback period = Initial investment / Annual cash flow = 110000 / 22750 = 4.84 Years

Payback period = 4.84 Years

Answer c:

Return on average investment = Average Net Income / Average investment

= 12250 / ((110000 + 5000) / 2)

= 21.30%

Return on average investment = 21.30%

Answer d:

Other factors City Hospital should consider in deciding whether to purchase the special- purpose eye-testing machine:

1. It is 10 year project. 10 years is pretty long period and technology may change.

2. Benefits to customers due to availability of services from latest special-purpose eye-testing machine. It may boost its image.

3. It may also enhance employee morale as they are working with latest machine

4. The financing sources to purchase machine.