Question

14.7-

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

1. 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                                               __________________________________

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

3. Assume the project is assessed to have high risk and California Imaging Center adds or subtracts 3 percentage points to adjust for project risk. Now, what is the project�s NPV? Does the risk assessment change how the project�s IRR is interpreted?

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Answer

1)

	0	1	2	3	4	5
Equipment Cost	-600000
Net revenues		300000	315000	330750.00	347287.50	364651.88
Less: Labor maintenance		-100000	-105000	-110250.00	-115762.50	-121550.63
Utlities Costs		-10000	-10500	-11025.00	-11576.25	-12155.06
Incremental overhead		-5000	-5250	-5512.50	-5788.13	-6077.53
Supplies		-18750	-19687.50	-20671.88	-21705.47	-22790.74
Depreciation		(120,000.00)	(192,000.00)	(114,000.00)	(72,000.00)	(66,000.00)
Operating incmoe		27750.00	-10462.50	41574.38	72273.09	81646.75
Equipment salvage value						134400
Net cash flows	-600000	147,750.00	181,537.50	155,574.38	144,273.09	282,046.75

2)

NPV	$74,903.81
IRR	14.40%

3) project is assessed to have high risk therefore, cost of capital = 10%+3% = 13%

New NPV =

NPV	$22,312.61

The cost of capital should be less than IRR. As long as that condition is satisfied, risky project can be undertaken

15.3 – Consider the project contained in Problem 14.7 in Chapter 14. a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value. b. Conduct a scenario analysis suppose that the hospital’s staff concluded that the three most uncertain variables were the number of procedures per day, average collection amount, and the equipment’s salvage value. c. Furthermore, the following data were developed:a. Finally, assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0 – 2.0. The hospital adjusts for risk by adding or subtracting 3% points to its 10% corporate cost of capital. After adjusting for differential risk, is the project still profitable? d. What type of risk was measured and accounted for in Parts B and C? Should this be of concern to the hospital’s managers?

Answer 1

	Posttax salavge	=	(200,000-wdv after 5 years)*(1-tax)
		=	[200,000-(600,000*0.06)]*91-0.4)
		=	$98400
	year	0	1	2	3	4	5
	Equipment Cost	-600000
	Net revenues		300000	315000	330750	347287.5	364651.875
	Less: Labor maintenance		-100000	-105000	-110250	-115762.5	-121550.625
	Utlities Costs		-10000	-10500	-11025	-11576.25	-12155.0625
	Incremental overhead		-5000	-5250	-5512.5	-5788.125	-6077.53125
	Supplies		-18750	-19687.5	-20671.875	-21705.46875	-22790.74219
	Depreciation		-120,000.00	-192,000.00	-114,000.00	-72,000.00	(66,000.00)
	Operating incmoe		27750	-10462.5	41574.38	72273.09	81646.75
	Equipment salvage value						98400
	Net cash flows	-600000	147,750.00	181,537.50	155,574.38	144273.00	246,046.00
	2)
	NPV	$52,547.00
	IRR	13.18%
	3) New rate	10+3=13%
	NPV	$2,453.80