Question 3. Capital Investments Discounted Cash flows

The Royal Victoria Hospitals (RVH) board of trustees is considering the addition of a comprehensive medical testing laboratory. In the past, the hospital has sent all blood and tissue specimens to Acme Testing Services, an independent testing service. The hospitals current contract with the testing service is due to expire and the testing service as offered a new 5-year contract.

The decision for RVH is then:

• Establish an in-house medical testing laboratory
• Outsource testing services to Acme Testing services

Under the terms of the new contract, Royal Victoria Hospital would pay Acme Testing Services a flat fee of $80,000 per year and $20 per specimen tested.

Since Royal Victoria Hospital does not have its own comprehensive testing lab, the hospital staff is forced to refer some types of cases to nearby Trillium Hospital. If Royal Victoria Hospital had its own lab these cases could be handled in-house. Royal Victoria Hospitals administrator estimates that the hospital loses $100,000 per year in contribution margin on the cases that must be currently referred elsewhere.

The proposed new lab would require construction of a new building, since it would occupy space currently used by the hospital for storage. However, the hospital would then be forced to rent storage space in a nearby medical building at a cost of $30,000 per year. The equipment for the lab would cost $625,000 and would be purchased prior to the start of operations. Additional equipment costing $300,000 would be purchased after three years. Due to the rapid technological improvement of medical testing equipment, the equipment would have negligible salvage value after 5 year. Staffing the lab would require one supervisor and two technicians. Annual compensation would run $45,000 for the supervisor and $35,000 for each of the lab technicians. Fixed operating costs in the lab would be $40,000 each year, and variable costs would amount to $10 per medical test.

Royal Victoria Hospital requires 20,000 tests per year. The capacity of the proposed lab would be 25,000 tests per year. Royal Victoria Hospitals administrator believes that physicians in private practice would utilize the labs excess capacity, 5,000 tests, by sending their own tests to the Royal Victoria Hospital lab. The administrator has projected a charge of $20 per test for physicians in private practice. Royal Victoria Hospitals hurdle rate is 12%.

Required:

Should Royal Victoria Hospital establish an in-house testing laboratory or should it continue to outsource this activity by renewing the Acme Testing Service contract? Why or why not?