California Health Center, a for profit hospital, is evaluating the purchase of n

Question

California Health Center, a for profit hospital, is evaluating the purchase of new diagnostic equipment. The equipment, which costs $600,000, has an expected life of 5 years and an estimated pretax salvage value of $200,000at that time. The equipment is expected to be used 15 times a day for 250 days a year for each year of the projects life. On average, each procedure is expected to generate $80 in collections, which is net of bad debt losses and contractual allowances, in its first year of use. Thus, net revenues for Year 1 are estimated at 15X250X80=$300,000.
Labor maintenance costs are expected to be $100,000 during the first year of operation, while utilities will cost another $10,000and cash overhead will increase by $5,000 in Year 1. The cost for expendable supplies is expected to average $5 per procedure during the first year. All costs and revenues, except depreciation, are expected to increase at 5% inflation rate after the first year.
The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to following deprecation allowance;
Year Allowance
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
1.00
The hospitals tax rate is 40%, and its corporate cost of capital is 10%


QUESTION

Estimate the projects net cash flows over its five-year estimated 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 salvage value                             __________________________________

Net cash flow                                               __________________________________

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

3. Assume the project is assessed to have high risk and California Imaging Center adds or subtracts 3 percentage points to adjust for project risk. Now, what is the projects NPV? Does the risk assessment change how the projects IRR is interpreted?

Explanation / Answer

1)

2)

3) project is assessed to have high risk therefore, cost of capital = 10%+3% = 13%

New NPV =

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

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

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