14.7-

California Health Center, a for ?profit hospital, is evaluatingthe purchase of new diagnostic equipment. The equipment, whichcosts $600,000, has an expected life of 5 years and an estimatedpretax salvage value of $200,000at that time. The equipment isexpected to be used 15 times a day for 250 days a year for eachyear of the project?s life. On average, each procedure is expectedto generate $80 in collections, which is net of bad debt losses andcontractual allowances, in its first year of use. Thus, netrevenues for Year 1 are estimated at 15X250X80=$300,000.
Labor maintenance costs are expected to be $100,000 during thefirst year of operation, while utilities will cost another$10,000and cash overhead will increase by $5,000 in Year 1. Thecost for expendable supplies is expected to average $5 perprocedure during the first year. All costs and revenues, exceptdepreciation, are expected to increase at 5% inflation rate afterthe first year.
The equipment falls into the MACRS five-year class for taxdepreciation and hence is subject to following deprecationallowance;
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 capitalis 10%


QUESTION

1. Estimate the project?s net cash flows over its five-yearestimated 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 salvagevalue                            __________________________________

Net cashflow                                             __________________________________

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

3. Assume the project is assessed to have high risk andCalifornia Imaging Center adds or subtracts 3 percentage points toadjust for project risk. Now, what is the project?s NPV? Does therisk 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 ofcapital = 10%+3% = 13%

New NPV =

NPV	$22,312.61

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

15.3 – Consider the project contained in Problem 14.7 in Chapter14. a. Perform a sensitivity analysis to see how NPV is affected bychanges in the number of procedures per day, average collectionamount, and salvage value. b. Conduct a scenario analysis supposethat the hospital’s staff concluded that the three most uncertainvariables were the number of procedures per day, average collectionamount, and the equipment’s salvage value. c. Furthermore, thefollowing data were developed:a. Finally, assume that CaliforniaHealth Center’s average project has a coefficient of variation ofNPV in the range of 1.0 – 2.0. The hospital adjusts for risk byadding or subtracting 3% points to its 10% corporate cost ofcapital. After adjusting for differential risk, is the projectstill profitable? d. What type of risk was measured and accountedfor in Parts B and C? Should this be of concern to the hospital’smanagers?