Reference no: EM132813986
Students will estimate the firm's cash flows from a capital acquisition in new diagnostic equipment. This particular exercise, will illustrate the importance of identifying and factoring all relevant costs associated with a potential acquisition including the building in of the depreciation experience, the inflationary effect over time, and the salvage value once the asset has reached the end of its' economic life. Furthermore, the students will be computing the net present value (NPV) and internal rate of return (IRR) to determine is a capital investment should be made.
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 × 250 × $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 is subject to the following depreciation allowances:
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. (Hint: Use the following format as a guide.)
b. What are the project's NPV and IRR? (Assume for now that the project has average risk.)
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