Question

The Mayo Clinic in Rochester is evaluating two different computer systems for handling provider claims. There are no incremental revenues attached to the projects, so the decision will be made on the basis of the present value of costs. Mayo's corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:

a. Assume initially that the systems both have average risk. Which one should be chosen?
b. Assume that System X is judged to have high risk. Mayo accounts for differential risk by adjusting its
corporate cost of capital up or down by 2 percentage points. Which system should be chosen?

Year System X System Y

0 -$500 -$2,500

1 -$1,500 -$300

2 -$1,250 -$300

3 -$300 -$300

Please show work in Excel

Answer 1

a

System X
Discount rate	0.1
Year	0	1	2	3
Cash flow stream	-500	-1500	-1250	-300
Discounting factor	1	1.1	1.21	1.331
Discounted cash flows project	-500	-1363.64	-1033.06	-225.394
NPV = Sum of discounted cash flows
NPV System X =	-3122.09
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
System Y
Discount rate	0.1
Year	0	1	2	3
Cash flow stream	-2500	-300	-300	-300
Discounting factor	1	1.1	1.21	1.331
Discounted cash flows project	-2500	-272.727	-247.934	-225.394
NPV = Sum of discounted cash flows
NPV System Y =	-3246.06
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

Choose System X as it has lower cost

b

System X
Discount rate	0.08
Year	0	1	2	3
Cash flow stream	-500	-1500	-1250	-300
Discounting factor	1	1.08	1.1664	1.259712
Discounted cash flows project	-500	-1388.89	-1071.67	-238.15
NPV = Sum of discounted cash flows
NPV System X =	-3198.71
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

Choose system X as it still has lower cost compared to System Y @ 10%