Capital budgeting methods, no income taxes. City Hospital, a nonprofit organizat

Question

Capital budgeting methods, no income taxes. City Hospital, a nonprofit organization, estimates that it can save $28,000 a year in cash operating costs for the next 10 years if it buys a special-purpose eye-testing machine at a cost of $110,000. No terminal disposal value is expected. City Hospital’s required rate of return is 14%. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation.

1. Calculate the following for the special-purpose eye-testing machine: a. Net present value b. Payback period c. Internal rate of return d. Accrual accounting rate of return based on net initial investment e. Accrual accounting rate of return based on average investment

2. What other factors should City Hospital consider in deciding whether to purchase the special-purpose eye-testing machine?

Explanation / Answer

Solution 1a:

NPV = Present value of cash inflows - Initial investment

= $28,000 * Cumulative PV Factor at 14% for 10 years - $110,000

= $28,000 * 5.216116 - $110,000 = $36,051

Solution 1b:

Payback period = Initial investment / Annual cash inflows = $110,000 / $28000 = 3.93 years

Solution 1c:

At IRR Present value of cash inflows is equal to initial investment.

$28,000 * Cumulative PV Factor at IRR for 10 years = $110,000

Cumulative PV Factor at IRR for 10 years = $110,000 / $28,000 = 3.92857

The PV factor falls between 21% to 22%, on intrapolation you will get IRR = 21.96%

Solution 1d:

Annual net income = Saving in cash operating cost - depreciation = $28,000 - ($110,000/10)

= $17,000

Accounting rate of return = Average annual income / Initital investment = $17,000 / $110,000 = 15.45%

Solution 1e:

Accounting rate of return based on average investment = Average annual income / Average investment

Average investment = (Initial investment + Salvage value) / 2 = $110,000/2 = $55,000

Accounting rate of return = $17,000 / $55,000 = 30.91%

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