Dr. Whitley Avard, plastic surgeon, had just returned from a conference in which she learned of a new surgical procedure for removing wrinkles around eyes in half the usual time. Given her patient-load pressures, Dr. Avard was anxious to try out the new technique. By decreasing the time spent on eye treatments or procedures, she could perform more services within a work period and thus increase her total rev- enues. Unfortunately, in order to implement the new procedure, some special equipment costing $74,000 was needed. The equipment had an expected life of four years, with a salvage value of $6,000. Dr. Avard estimated that her cash rev- enues would increase by the following amounts:
Year
|
Revenue Increases
|
|
1
|
$19,800
|
|
2
|
27,000
|
|
3
|
32,400
|
|
4
|
32,400
|
She also expected additional cash expenses amounting to $3,000 per year. The cost of capital is 12 percent. Assume there are no income taxes.
Required
1. Compute the payback period for the new equipment.
2. Compute the accounting rate of return using both original investment and average investment.
3. Compute the NPV and IRR for the project. Should Dr. Avard purchase the new equipment? Should she be concerned about payback or the accounting rate of return in making this decision?
4. Before finalizing her decision, Dr. Avard decided to call two plastic surgeons who had been using the new procedure for the past six months. The conversa- tions revealed a somewhat less glowing report than she had received at the con- ference. The new procedure reduced the time required by about 25 percent rather than the advertised 50 percent. Dr. Avard estimated that the net operating cash flows of the procedure would be cut by one-third because of the extra time and cost involved (salvage value would be unaffected). Using this information, recompute the NPV of the project. What would you now recommend?