Key concept: Computing weighted average cost of capital, NPV, and IRR to evaluate capital investment
Rapidly Expanding Care Inc. is a chain of cardiology specialty clinics. Opal Whitson, MD, the chain's chief of cardiology, is reviewing a proposal for new 360-degree heart scanners that Edgar James, MD, the chain's leading surgeon, has requested be purchased for all ten clinics in the chain. Dr. James wants the scanners because they will permit the clinic doctors to make rapid, accurate problem diagnoses and treatment recommendations.
The scanner uses a new type of technology that allows for a detailed view of all areas of the heart without the need to inject potentially harmful dyes into the patient. It provides an especially detailed view of both heart valves and blood flow into and out of the heart. Each scan takes about one hour of total patient time, including patient education, the taking of the scan, and the use of "artificial intelligence" software to make a preliminary diagnosis.
Rapidly Expanding Care Inc. is owned by eight physicians who work at the chain. The physicians have invested almost all of their personal assets in the company, an investment totaling $10 million. Similar healthcare-related specialty chains typically provide a 20 percent return on investment for shareholders. Rapidly Expanding was previously able to borrow an additional $10 million from Bank of Big Carolina at 10 percent interest by providing the personal guarantees of the eight physicians.
Dr. Whitson thinks that the Bank of Big Carolina would agree to finance the new heart scanners but that the bank would probably charge 12 percent interest for the new loan and would again require the shareholders' personal guarantees.
Manufacturer data for the scanners indicate that they cost $1 million each and have a five-year useful life. The $1 million price includes all needed maintenance over the five-year period. The scanners would replace current equipment that has a current $100,000 net book value and $50,000 salvage value at each clinic.
Current equipment scans can only be billed at $100 per scan, but market research indicates that Medicare will pay $500 for each 360-degree heart scan. Dr. James thinks insurance companies will also pay at least that much. The scanners are highly energy intensive, and electricity costs $10 per scan. Technician labor time for each scan is estimated at $90.
Dr. Whitson's examination of patient flow at the ten clinics indicates that the annual volume for the new scanners would be 700 scans per clinic, the same as the older equipment. However, she is somewhat uncertain about this number and thinks it could be 20 percent higher or 20 percent lower.
Questions
1. Ignoring possible tax effects and rates, what is the appropriate discount rate to use in evaluating the proposed purchase? Why?
2. What is the most likely NPV for one scanner? What is the IRR for one scanner?
3. What are the NPVs and IRRs for the best- and worst-case volume estimates?
4. What are some non quantitative factors to consider in this decision?