Question

You have been promoted to Assistant Director of your Laboratory Department. One of your first assignments is to prepare a recommendation for the replacement of one of your Coulter Counters.

Your Department Director has asked that you work with the Financial staff in preparing this recommendation. Upon contacting the financial staff they tell you that their department has lost a number of analysts and ask if you could help in preparing the analysis since you are a recent graduate of SHU. You tell them that you are well versed in Capital Decision making and would be able to complete the analysis for them and submit to your Department Director.

You decide to prepare a Net Present Value Analysis and begin the discussions with your staff. They emphasize to you the importance of replacing the existing equipment due to quality and safety concerns for the patient. You first plan on completing a Time Line and from the discussion with the staff plan on incorporating the following assumptions in your analysis:

Assumptions to use:

Time Line for 5 years

Initial cost of equipment $3000000

Additional volume from increased efficiency 1000 test per month

Average reimbursement per test is $50

Cost of supplies will be reduced by $2000 per month

The existing equipment is fully depreciated

The only other expense is the depreciation for the new equipment and it is a non cash item

The financial staff tells you to use 5% as your Cost of Capital

What would be the NPV for your analysis?

What would be your recommendation to your Director based on both your quantitative analysis and also qualitative issues?

Answer 1

Answer 1:

Year 0:

Initial cost = $3000000

Year 1 to 5:

Annual cash flow = Additional revenue + Saving in cost of supplies = (1000 *12) * $50 + $2000 *12 = $624,000

As there is no tax, there is no depreciation tax shield

NPV:

NPV = Annual cash flow * PV of $1 annuity for 5 year at 5% rate - Initial investment

= 624000 * (1 - 1 / (1 + 5%) ⁵) / 5% - 3000000

= - $298,406.56

NPV = - $298,406.55

Answer 2:

Strictly based on financials presented, as NPV is negative the machine should not be replaced.

However, non-quantifiable factors like quality and safety issues of patient are critical and are of utmost importance. The existing equipment is fully depreciated and if it has quality and safety issues and if it does not meet compliance requirements, it should be retired. Else these issues could be disastrous since it deals with critical health services. Complete cost and benefit data should be collected and NPV analysis based such complete data should be done.