Every answer posted is different, how do we do this? California Health Center, a

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Every answer posted is different, how do we do this? 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.)

Explanation / Answer

(a) Computation of  the project's net cash flows over its five-year estimated life.We have,

Step1: Computation of the depreciation expenses for 5 years using MACRS five-year class.We have,

Step2: Computation of the project's net cash flows over its five year estimated life.We have,

(b-1) Computation of the net present value of the project.We have,

Step1: Computation of the present value of net cash inflow at cost of capital 10%.We have,

Step2: Computation of the net present value(NPV) of the project.We have,

NPV = Present value of net cash inflow + Salvage value x (1-tax rate)x PVIF(10%,5 year) - Cash outflow

NPV = 585,557 + 200,000(1-0.40) X 0.621 - 600,000

NPV = 585,557 + 74,520 - 600,000

NPV = $ 60,077

Hence,the net present value of the project is $ 60,077

Since,the NPV of the project have positive value,the project should be accpted. So, this project should be acceped as per NPV criteria.

(b-2) Computation of internal rate of return(IRR) of the project.We have,

Step1: Computation of the present value of cash inflow at 15% cost of capital.We have,

Step2: Computation of the IRR of the project.We have,

IRR = r - [ ( Cash outflow - PV of CFAT(15%)) / ( PV of CFAT(10%) - PV of CFAT(15%) ] x difference in interest rate

IRR = 15 - [ (600,000 - 555,821) / (660,077 -  555,821) ] (15 - 10)

IRR = 15 - [ 44,179 / 104,256 ] 5.00

IRR = 15 - 2.12 = 12.88 %

Hence,the IRR of the project is 12.88 %

If IRR of the project is greater than cost of capital. The project should be accepted.So, IRR of the project is 12.88% which is greater than cost of capital 10%, it should be acceped.

year 1 2 3 4 5 6 Cost of equipment $600,000 $600,000 $600,000 $600,000 $600,000 $600,000 Depreciation allowances 0.2 0.32 0.19 0.12 0.11 0.06 Depreciation Expenses $ 120,000 $ 192,000 $ 114,000 $ 72,000 $ 66,000 $ 36,000

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