Capital Healthplans, Inc., is evaluating two different methods for providing hom

Question

Capital Healthplans, Inc., is evaluating two different methods for providing home healht services to its memebers. Both methods involve contracting out for services, and the health outcomes and revenues are not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows. Here are the projected flows: year: 0, 1,2,3,4,5, Method A: $300,000, 66,000,66,000, 66,000, 66,0000,Method B: $120,000, 96,000, 96,000, 96,000, 96,000, 96,000 (a) What is each alternative's IRR? (b) If the cost of capital for both methods is 9 percent, which method should be chosen? Why?

Explanation / Answer

SOLUTION:

A. Calculation of IRR.

Using Excel to find IRR,

IRR for Method A = 3.26%

IRR for Method B = 75.15%

B. At 9% cost of capital.

Method A

DCF0 = -$300,000/ (1+0.09)^0 = -$300,000            
DCF1 = $66,000/ (1+0.09)^1 = $60,550.45
DCF2 = $66,000/ (1+0.09)^2 = $55,550.87

DCF3 = $66,000/ (1+0.09)^3 = $50964.10

DCF4 = $66,000/ (1+0.09)^4 = $46,756.06

DCF5 = $66,000/ (1+0.09)^5 = $42,895.47

NPV for Method A = -$43283.05

Method B

DCF0 = -$120,000/ (1+0.09)^0 = -$120,000            
DCF1 = $96,000/ (1+0.09)^1 = $88,073.39
DCF2 = $96,000/ (1+0.09)^2 = $80,801.27

DCF3 = $96,000/ (1+0.09)^3 = $74,129.61

DCF4 = $96,000/ (1+0.09)^4 = $68,008.82

DCF5 = $96,000/ (1+0.09)^5 = $62,393.41

NPV for Method B = $253,406.5

Method B should be chosen.

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