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Hospitals board of directors has approved of purchasing of a new equipment with

ID: 2630220 • Letter: H

Question

Hospitals board of directors has approved of purchasing of a new equipment with a capital investment of $400,000. The estimated life of the equipment is 10 years and during that period the estimated after-tax cash flows (EATCF) are given below. The investments required rate of return is 20%.

Year

0

1

2

3

4

5

6

7

8

9

10

EATCF

($1000)

-400

65

65

68

70

65

68

70

73

65

60

Evaluate this investment, in terms of:

a) Average rate of Return

b) Net Present Value

c) Profitability index

And whether or not it is acceptable and based on each method?

Year

0

1

2

3

4

5

6

7

8

9

10

EATCF

($1000)

-400

65

65

68

70

65

68

70

73

65

60

Explanation / Answer


a)

Average EATCF = (65+ 65 + 68 + 70 + 65 + 68 + 70 + 73 + 65 + 60)/10 = 66900

Average Rate of return ARR = average Income/intial investemnt

= 66900/400000 = 16.73%


Since Average Rate of return is less than required rate of return project is not accessable


sometime Average investment used in denominator

then

ARR = 66900/200000 = 33.45%

the project is acceptable


b)


NPV = -400000 + 65000/1.2 + 65000/1.2^2 + 68000/1.2^3 + 70000/1.2^4 + 65000/1.2^5 + 68000/1.2^6 + 70000/1.2^7 + 73000/1.2^8 + 65000/1.2^9 + 60000/1.2^10

= -119888.82


since NPV is negative project is not acceptable


c)

Profitibility index = PV of cash flows/intialinvetment

PV OF cash flows = 65000/1.2 + 65000/1.2^2 + 68000/1.2^3 + 70000/1.2^4 + 65000/1.2^5 + 68000/1.2^6 + 70000/1.2^7 + 73000/1.2^8 + 65000/1.2^9 + 60000/1.2^10

=280111.18


Profitability index PI = 280111.18/400000 = 0.7


since PI is less than 1 project os not acceptable