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 five years and an estimated pretax salvage value of $200,000 at that time. The equipment is expected to be used 15 times a day for 250 days a year for each year of the project's 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 15 X 250 X $80 = $300,000. Labor and maintenance costs are expected to be $100,000 during the first year of operation, while utilities will cost another $10,000 and 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 a 5 percent inflation rate after the first year. The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to the following depreciation allowances: Year Allowance 1 0.2 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06 The hospital's tax rate is 40 percent, and its corporate cost of capital is 10 percent. a. Estimate the project's net cash flows over its five-year estimated life. b. What are the project's NPV and IRR? (Assume that the project has average risk.) (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 Depreciation Operating income Taxes Net operating income Plus: Depreciation Plus: After-tax equipment salvage value* Net cash flow * Pretax equipment salvage value MACRS equipment salvage value Difference Taxes After-tax equipment salvage value

Explanation / Answer

Year 0 1 2 3 4 5 Equipment Cost------1 -600000 Net Revenue 300000 315000 330750 347287.5 364652 Less: Labor/Maintenance costs -100000 -105000 -110250 -115763 -121551 Utilities cost -10000 -10500 -11025 -11576.3 -12155.1 Incl.OH -5000 -5250 -5512.5 -5788.13 -6077.53 Supplies -18750 -19687.5 -20671.9 -21705.5 -22790.7 Depn. -120000 -192000 -114000 -72000 -66000 Operating Income 46250 -17437.5 69290.63 120455.2 136078 Taxes -18500 6975 -27716.3 -48182.1 -54431.2 Net Opg. Income 27750 -10462.5 41574.38 72273.09 81646.7 Plus :Depn. 120000 192000 114000 72000 66000 Annual Opg. Cash flow-----2 147750 181537.5 155574.4 144273.1 147647 After-tax salvage-----3 134400 (600000-564000)-200000 Net annual cash flows(1+2+3) -600000 147750 181537.5 155574.4 144273.1 282047 PV F at 10% 1 0.90909 0.82645 0.75131 0.68301 0.62092 PV at 10% -600000 134318.2 150031 116885.3 98540.46 175129 NPV 74903.81 IRR 14% Workings: After-tax salvage Cost 600000 Less:Acc. Depn. -564000 Book value 36000 Pre-tax Salvage 200000 Gain on salvage(200000-36000) 164000 Tax on gain at 40% 65600 So, after-tax salvage(200000-65600) 134400

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