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PROBLEM 1. Winston Clinic is evaluating a project that costs $52,125 and has expected net cash flows of $12,000 per year for eight years. The first inflow occurs one year after the cost outflow, and the project has a cost of capital of 12 percent.

a. What is the project's payback?

b. What is the project's NPV? Its IRR?

c. Is the project financially acceptable? Explain your answer.

PROBLEM 2. Capitol Health Plans, Inc., is evaluating two different methods for providing home health services to its members. Both methods involve contracting out for services, and the health outcomes and revenues arenot affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows.

Here are the projected flows:

Year       Method A           Method B                                                                           

0              -$300,000             -$120,000                                                                            

1              -$66,000               -$96,000                                                                              

2              -$66,000               -$96,000                                                                              

3              -$66,000               -$96,000                                                                              

4              -$66,000               -$96,000                                                                              

5              -$66,000               -$96,000

a. What is each alternative's IRR?

b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why?

PROBLEM 3. Assume that you are the CFO at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments: Project X and Project Y. Each project requires a net investment outlay of $10,000, and the cost of capital for each project is 12 percent. The project's expected net cash flows are as follows:

Year       Project X              Project Y                                                                             

0              -$10,000           -$10,000                                                                              

1              $6,500               $3,000                                                                  

2              $3,000               $3,000                                                                  

3              $3,000               $3,000                                                                  

4              $1,000               $3,000

a. Calculate each project's payback period, net present value (NPV), and internal rate of return (IRR).

b. Which project (or projects) is financially acceptable? Explain your answer.

PROBLEM 4. 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

PROBLEM 5. Consider the project contained in Problem 7 in Chapter 11 (California Health Center).

a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value. Remember supplies vary with number of procedures.

b. Conduct a scenario analysis. Suppose that the hospital's staff concluded that the three most uncertain variables were number of procedures per day, average collection amount, and the equipment's salvage value. Furthermore, the following data were developed:

Equipment                                         

                                                 Number of          Average               Salvage                                

Scenario               Probability          Procedures         Collection            Value                                   

Worst                    0.25                10                        $60                $100,000                                             

Most likely          0.50                    15                       $80                 $200,000                                             

Best                 0.25                     20                      $100                 $300,000                                             

c. Finally, assume that California Health Center's average project has a coefficient of variation of NPV in the range of 1.0 - 2.0. (Hint: Coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?

d. What type of risk was measured and accounted for in Parts b. and c.? Should this be of concern to the hospital's managers?

PROBLEM 6. Allied Managed Care Company is evaluating two different computer systems for handling provider claims.There are no incremental revenues attached to the projects, so the decision will be made on the basis ofthe present value of costs. Allied's corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:

Year       System X             System Y                                                                             

0              -$500                     -$1,000                                                                

1              -$500                     -$300                                                                    

2              -$500                     -$300                                                                    

3              -$500                     -$300                                                                    

a. Assume initially that the systems both have average risk. Which one should be chosen?

b. Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its corporate cost of capital up or down by 2 percentage points. Which system should be chosen?

PROBLEM 7. Michigan Home Health is considering opening an office in a new market. The organization has identified the number of home visits, revenue per home visit, and the level of fixed costs of the new office as being the major sources of uncertainty in the investment decision. To get a better understanding of the sensitivity of the new office NPV to these variables, the following data have been assembled:

Change                 NPV                                                      

from      Number               Revenue              Level of                                               

base      of home               per home            fixed                                     

case       visits                      visit                        costs                                     

-30%      -$814                     -$57                       $82                                        

-20%      -$515                     -$11                       $82                                        

-10%      -$216                     $36                         $82                                        

0%          $82                         $82                         $82                                        

10%        $381                       $129                       $82                                        

20%        $680                       $176                       $82                                        

30%        $979                       $222                       $82                                        

Construct a graph to show the sensitivity of the new office NPV to each variable.

PROBLEM 8. Big Sky Hospital plans to obtain a new MRI that costs $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI, or it can obtain a guideline lease for the equipment. Assume that the following facts apply to the decision:

- The MRI falls into the three-year class for tax depreciation, so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively.
- Estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.
- Big Sky's marginal tax rate is 40 percent.
- The bank loan would have an interest rate of 15 percent.
- If leased, the lease payments would be $400,000 payable at the end of each of the next four years..
- The estimated residual (and salvage) value is $250,000.

a. What are the NAL and IRR of the lease? Interpret each value.

b. Assume now that the salvage value estimate is $300,000, but all other facts remain the same. What is the new NAL? The new IRR?

PROBLEM 9. Walton Nursing Home (WNH) is evaluating a guideline lease agreement on laundry equipment that costs $250,000 and falls into the MACRS three-year class. The home can borrow at an 8 percent rate on a four-year loan if WHN decided to borrow and buy rather than lease. The laundry equipment has a four-year economic life, and its estimated residual value is $50,000 at the end of Year 4. If WHN buys the equipment, it would purchase a maintenance contract which costs $5,000 per year, payable at the beginning of each year. The lease terms, which include maintenance, call for a $71,000 lease payment at the beginning of each year. WNH's tax rate is 40 percent. Should the home lease or buy?

Operation Management, Management Studies

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