Shrieves Hospital Ltd. is considering adding a new line to its diagnostic product mix, and the...

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Finance

Shrieves Hospital Ltd. is considering adding a new lineto its diagnostic product mix, and the capital
budgeting analysis is being conducted by Sidney Johnson,a recently graduated MHA. A new bone density
scanner would be set up in unused space in Shrieves'smain clinic. The machinery’s invoice price would be
approximately $200,000; another $10,000 in shippingcharges would be required; and it would cost an
additional $30,000 to install the equipment. Themachinery has an economic life of four years, andShrieves
has obtained a special tax ruling which places theequipment in the MACRS three-year class. The machinery
is expected to have a salvage value of $25,000 afterfour years of use. The new line would generate
incremental sales of 1,250 scans per year for four yearsat an incremental cost of $100 per scan in the
first year, excluding depreciation. Each scan wouldgenerate revenue of $200 in the first year. The price
and cost of each scan are expected to increase by 3percent per year due to inflation. Further, to handle
the new line, the hospital's net operating workingcapital would have to increase by an amount equal to12
**percent of sales revenues*. The hospital's tax rate is40 percent, and its corporate cost of capital is 10
percent.
a. Perform a sensitivity analysis on the corporate costof capital, number of scans, and salvage value.
    Assume that each of these variablescan vary from its base case by plus and minus 15 and 30percent.
    Include a sensitivitydiagram.
b. Perform a scenario analysis using the worst-, mostlikely, and best-case probabilities in the tablebelow:
Number of
Price
Scenario
Probability
scans
per scan
Best
25%
1,600
$240
Most likely
50%
1,250
$200
Worst
25%
900
$160
c. Assume that Shrieves's average project has acoefficient of variation of NPV in the range of0.2–0.4.
   The hospital typically adds or subtracts 3percentage points to its corporate cost of capital to adjustfor
    risk. Should the new line beaccepted?**
*
In the section entitled "Changes in Net Working Capital"in Chapter 11, Gapenski states that expansion
projects require additional inventories and accountsreceivable which must be financed, just as an increase
in fixed assets must be financed. In this situation, thehospital's net working capital would have to increase
by an amount equal to 12 percent of sales. Sales in Year1 are estimated at $250,000, so Shrieves must
**have (.12 * $250,000 =) $30,000 in net working capitalat Year 0. If sales increase to $257,500 in Year 2,
Shrieves must have (.12 * $257,500 =) $30,900 at Year 1.Because it already has $30,000 of net working
capital on hand, its net investment in working capitalat Year 1 is just ($30,900 - $30,000 =) $900. If sales
increase to $265,225 in Year 3, its net investment inworking capital in Year 2 is (.12 * 265,225 =)
$31, 827 - $30,900 = $927. If sales increase to $273,182in Year 4, its net investment in working capital
in Year 3 is (.12 * 273,182 =) $32,782 - $31,827 = $955.Shrieves will have no sales after Year 4, so it will
require no working capital at Year 4. Thus, it wouldhave a positive cash flow of $32,782 at Year 4 as
working capital is sold but not replaced.**

Answer & Explanation Solved by verified expert

4.2 Ratings (636 Votes)

Cost of Machine200000Tax rate40Shipping Cost10000Cost of Capital10installation cost30000Total Book value ofMachinery240000Life of machine4MACRSthreeyear classSalvage Value2500001234Purchase of machine240000Salvage Value25000Assuming no capital gain taxIncremental Sale1250125012501250Price per scan20000206002121821855Price increasing per year as per inflationincrease in price per See Answer

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Transcribed Image Text

Shrieves Hospital Ltd. is considering adding a new lineto its diagnostic product mix, and the capitalbudgeting analysis is being conducted by Sidney Johnson,a recently graduated MHA. A new bone densityscanner would be set up in unused space in Shrieves'smain clinic. The machinery’s invoice price would beapproximately $200,000; another $10,000 in shippingcharges would be required; and it would cost anadditional $30,000 to install the equipment. Themachinery has an economic life of four years, andShrieveshas obtained a special tax ruling which places theequipment in the MACRS three-year class. The machineryis expected to have a salvage value of $25,000 afterfour years of use. The new line would generateincremental sales of 1,250 scans per year for four yearsat an incremental cost of $100 per scan in thefirst year, excluding depreciation. Each scan wouldgenerate revenue of $200 in the first year. The priceand cost of each scan are expected to increase by 3percent per year due to inflation. Further, to handlethe new line, the hospital's net operating workingcapital would have to increase by an amount equal to12percent of sales revenues*. The hospital's tax rate is40 percent, and its corporate cost of capital is 10percent.a. Perform a sensitivity analysis on the corporate costof capital, number of scans, and salvage value. Assume that each of these variablescan vary from its base case by plus and minus 15 and 30percent. Include a sensitivitydiagram.b. Perform a scenario analysis using the worst-, mostlikely, and best-case probabilities in the tablebelow:Number ofPriceScenarioProbabilityscansper scanBest25%1,600$240Most likely50%1,250$200Worst25%900$160c. Assume that Shrieves's average project has acoefficient of variation of NPV in the range of0.2–0.4. The hospital typically adds or subtracts 3percentage points to its corporate cost of capital to adjustfor risk. Should the new line beaccepted?*In the section entitled "Changes in Net Working Capital"in Chapter 11, Gapenski states that expansionprojects require additional inventories and accountsreceivable which must be financed, just as an increasein fixed assets must be financed. In this situation, thehospital's net working capital would have to increaseby an amount equal to 12 percent of sales. Sales in Year1 are estimated at $250,000, so Shrieves musthave (.12 * $250,000 =) $30,000 in net working capitalat Year 0. If sales increase to $257,500 in Year 2,Shrieves must have (.12 * $257,500 =) $30,900 at Year 1.Because it already has $30,000 of net workingcapital on hand, its net investment in working capitalat Year 1 is just ($30,900 - $30,000 =) $900. If salesincrease to $265,225 in Year 3, its net investment inworking capital in Year 2 is (.12 * 265,225 =)$31, 827 - $30,900 = $927. If sales increase to $273,182in Year 4, its net investment in working capitalin Year 3 is (.12 * 273,182 =) $32,782 - $31,827 = $955.Shrieves will have no sales after Year 4, so it willrequire no working capital at Year 4. Thus, it wouldhave a positive cash flow of $32,782 at Year 4 asworking capital is sold but not replaced.

Shrieves Hospital Ltd. is considering adding a new lineto its diagnostic product mix, and the capital
budgeting analysis is being conducted by Sidney Johnson,a recently graduated MHA. A new bone density
scanner would be set up in unused space in Shrieves'smain clinic. The machinery’s invoice price would be
approximately $200,000; another $10,000 in shippingcharges would be required; and it would cost an
additional $30,000 to install the equipment. Themachinery has an economic life of four years, andShrieves
has obtained a special tax ruling which places theequipment in the MACRS three-year class. The machinery
is expected to have a salvage value of $25,000 afterfour years of use. The new line would generate
incremental sales of 1,250 scans per year for four yearsat an incremental cost of $100 per scan in the
first year, excluding depreciation. Each scan wouldgenerate revenue of $200 in the first year. The price
and cost of each scan are expected to increase by 3percent per year due to inflation. Further, to handle
the new line, the hospital's net operating workingcapital would have to increase by an amount equal to12
*percent of sales revenues. The hospital's tax rate is40 percent, and its corporate cost of capital is 10**
percent.

a. Perform a sensitivity analysis on the corporate costof capital, number of scans, and salvage value.
Assume that each of these variablescan vary from its base case by plus and minus 15 and 30percent.
Include a sensitivitydiagram.
b. Perform a scenario analysis using the worst-, mostlikely, and best-case probabilities in the tablebelow:

			Number of	Price
	Scenario	Probability	scans	per scan
	Best	25%	1,600	$240
	Most likely	50%	1,250	$200
	Worst	25%	900	$160

c. Assume that Shrieves's average project has acoefficient of variation of NPV in the range of0.2–0.4.
The hospital typically adds or subtracts 3percentage points to its corporate cost of capital to adjustfor
risk. Should the new line beaccepted?

*
In the section entitled "Changes in Net Working Capital"in Chapter 11, Gapenski states that expansion
projects require additional inventories and accountsreceivable which must be financed, just as an increase
in fixed assets must be financed. In this situation, thehospital's net working capital would have to increase
by an amount equal to 12 percent of sales. Sales in Year1 are estimated at $250,000, so Shrieves must
*have (.12 $250,000 =) $30,000 in net working capitalat Year 0. If sales increase to $257,500 in Year 2,**
*Shrieves must have (.12 $257,500 =) $30,900 at Year 1.Because it already has $30,000 of net working**
capital on hand, its net investment in working capitalat Year 1 is just ($30,900 - $30,000 =) $900. If sales
*increase to $265,225 in Year 3, its net investment inworking capital in Year 2 is (.12 265,225 =)**
$31, 827 - $30,900 = $927. If sales increase to $273,182in Year 4, its net investment in working capital
*in Year 3 is (.12 273,182 =) $32,782 - $31,827 = $955.Shrieves will have no sales after Year 4, so it will**
require no working capital at Year 4. Thus, it wouldhave a positive cash flow of $32,782 at Year 4 as
working capital is sold but not replaced.