Internal Rate of Return; Sensitivity Analysis [LO2]

Dr. Heidi Black is the managing partner of the Crestwood Dental Clinic. Dr. Black is trying to determine whether or not the clinic should move patient files and other items out of a spare room in the clinic and use the room for dental work. She has determined that it would require an investment of $142,950 for equipment and related costs of getting the room ready for use. Based on receipts being generated from other rooms in the clinic, Dr. Black estimates that the new room would generate a net cash inflow of $37,500 per year. The equipment purchased for the room would have a seven-year estimated useful life.

Required:

(Ignore income taxes.)

1. Compute the internal rate of return on the equipment for the new room to the nearest whole percent. Verify your answer by computing the net present value of the equipment using the internal rate of return you have computed as the discount rate.

2. Assume that Dr. Black will not purchase the new equipment unless it promises a return of at least 14%. Compute the amount of annual cash inflow that would provide this return on the

$142,950 i nvestment.

3. Although seven years is the average life for dental equipment, Dr. Black knows that due to changing technology this life can vary substantially. Compute the internal rate of return to the nearest whole percent if the life of the equipment were ( a ) five years and ( b ) nine years, rather than seven years. Is there any information provided by these computations that you would be particularly anxious to show Dr. Black?

4. Dr. Black is unsure about the estimated $37,500 annual cash inflow from the room. She thinks that the actual cash inflow could be as much as 20% greater or less than this figure.

a. Assume that the actual cash inflow each year is 20% greater than estimated. Recompute the internal rate of return to the nearest whole percent.

b. Assume that the actual cash inflow each year is 20% less than estimated. Recompute the internal rate of return to the nearest whole percent.

5. Refer to the original data. Assume that the equipment is purchased and that the room is opened for dental use. However, due to an increasing number of dentists in the area, the clinic is able to generate only $30,000 per year in net cash receipts from the new room. At the end of five years, the clinic closes the room and sells the equipment to a newly licensed dentist for a cash price of $61,375. Compute the internal rate of return to the nearest whole percent that the clinic earned on its investment over the five-year period. Round all dollar amounts to the nearest whole dollar. (Hint: A useful way to proceed is to find the discount rate that will cause the net present value of the investment to be equal to, or near, zero).