174 Chapter 15 Investment Analysis-What Should We Do Next? all relevant costs. W

Question

174 Chapter 15 Investment Analysis-What Should We Do Next? all relevant costs. WCHC uses a discournt rate of 5%. How much will wCHC need in foundation grants this year to make the purchase break-even financially? (Hint: What is the net present value of the costs of buying and operating the van over its lifetime, less the payments that will be received from the county? Are the payments from the county sufficient? If not, how much must be raised in grants before the van is purchased?) How mulch will S5.000 invested at 3% interest be worth in 4 years if it is com- pounded annually? Quarterly? How much if the interest rate is 6%? 6. 7. Suppose you were offered $10,000 every year at the same point in time for 10 years and you could earn a 5% inter- est rate every year. How much would these cash flows be worth today? 8. The Ward County Hospital Center (WCHC) wants to buy a new mobile primary care van to use in screening residents in an underserved local neigh- borhood. The van will last 5 years and costs $68,000. WCHC will pay for the acquisition and maintenance of the van partially from foundation grants and partially from receipts from the county health department. The county has agreed to reimburse WCHC $15 for each patient it screens using the new varn. They expect to have 800 patients per year with the van. It will cost $3,000 per year to maintain the vehicle, which includes 9. Community Health Center (CHC) is considering spending $50,000 on a blood analyzer. The annual cash profits fronm the machine will be $7,000 for each of the 7 years of its useful life. The board of directors wants to pursue this investment. because they think the $49,000 CHC will receive is close to the $50,000 cost. What is wrong with the board's logic? What is the IRR on the investment? 10. Why can the IRR method lead to suboptimal decision-making by organizations?

Explanation / Answer

8.

For financial breakeven the NPV should be 0. Thus amount of foundation grants - 29,034.71 = 0

Thus amount of foundation grants = $29,034.71

9.The board’s logic is wrong because it is not considering the time value of money. While $50,000 is being spent today the $49,000 is not being received today. It will be received over the period of 7 years and so the present value of cash inflows will be much lower than $49,000. This will make the investment financially unattractive.

Now IRR is the rate at which NPV becomes nil. I have computed it using a trial and error approach until the NPV becomes nil.

Thus 1+r = 0.9949747

or IRR = 0.9949747 - 1

= -0.0050253 OR -0.5025%

A B C D E F Year Purchase Reimbursement from county ($15*800) Maintenance costs Total cash flow (A+B+C) 1+R PVIF PV = (Total cash flow*PVIF) 0 -68,000.00 -68,000.00 1.05 1.0000 -68,000.00 1 12,000.00 -3,000.00 9,000.00 0.9524 8,571.43 2 12,000.00 -3,000.00 9,000.00 0.9070 8,163.27 3 12,000.00 -3,000.00 9,000.00 0.8638 7,774.54 4 12,000.00 -3,000.00 9,000.00 0.8227 7,404.32 5 12,000.00 -3,000.00 9,000.00 0.7835 7,051.74 NPV -29,034.71

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