Question

1. The not-for-profit clinic Wise Care, is currently sending out all lab tests to an independent center. To generate additional revenue, the clinic is considering the purchase of new lab equipment, which will allow the services to be performed in-house. The equipment, which costs $250,000, has an expected life of five years and an estimated salvage value of $100,000 at that time. The equipment is expected to be used 12 times a day for 275 days a year for each year of the project’s life. On average, each test is expected to generate $45 in cash collections (revenues) during each year of use. Expenses for each year (do not assume an inflation adjustment) include: labor and maintenance costs ($75,000), utilities ($6,000), overhead ($4,000), and supplies of $3 per procedure. Corporate cost of capital is 10%

1. What are the cash flows for this project? (7 points)

2. What is the project’s IRR? What does it tell you? (7 points)

IRR is 12% which indicates that equipment will give return of 12% on investment during life

3. Assuming a project cost of capital of 10%, what is the project’s NPV? What does it tell you? (7 points)

The NPV is $15,278 which is a positive value and it indicated that project is profitable and should be undertaken.

4. What is your final recommendation? (4 points)

The company should buy equipment because the NPV is positive %15,278 and IRR is 12% which is higher than discount rate of 10%.

PLEASE SHOW ALL CALCULATIONS SO I CAN LEARN

Answer 1

Ans. :-

• Equipment is expected to be used for 12 times a day for 275 days each year for the life time of the equipment i.e. 5 years.
• Hence, Total number of test each year would be:- 12 * 275 = 3300 Tests.
• Each Test would earn cash flow of $45. Hence, Total cash inflow would be 3300 * $45 = $148,500 each year.
• Total Supplies cost = 3300 tests * $3 = $9900
• Initial Investment = $250,000

a. Cash flows for the Project :-

Particulars	Amount
Revenues	$ 148,500
Labor & Maintenance cost	$ (75,000)
Utilities	$ (6,000)
Overheads	$ (4,000)
Supplies	$ (9,900)
	$ 53,600
Life time of the project	5 years
Cash flow for the project	$ 268,000
Initial Investment	$ (250,000)
Salvage value	$ 100,000
Net Cash flow	$ 118,000

b. IRR of the project :-

• IRR of the project is the rate a which, the NPV of the project is NIL.
• We shall find the IRR of the project using trial & error method.

Let's Assume IRR to be 10% and find NPV using discount rate 10% :-

Year	Cash flow	PV factor @10%	Present value
1-5	$ 53,600	3.79078	$ 203,185.8
5	$ 100,000	0.62092	$ 62,092.0
			$ 265,277.8
Less : Initial investment			$ (250,000.0)
Net Present Value [NPV]			$ 15,278 (rounded off)

As 10% discount rate gives positive NPV, We shall increase the discounting rate to make NPV Zero.

Let's Assume IRR to be 11% and find NPV using discount rate 11% :-

Year	Cash flow	PV factor @11%	Present value
1-5	$ 53,600	3.69589	$ 198,099.7
5	$ 100,000	0.59345	$ 59,345.0
			$ 257,444.7
Less : Initial investment			$ (250,000.0)
Net Present Value [NPV]			$ 7,445 (rounded off)

• 1% of increase in Discount rate decreases the NPV by $7,833.[$15,278 - $7,445]
• Now, we should calculate the IRR using interpolation method as follow:-

  • to decrease NPV by	Increase Rate by
    $7,833	1%
    $15,278	?

= 2 % (rounded off)

Hence, IRR = 10% + 2% = 12%