15.3 Consider the project contained in Problem 14.7 in Chapter 14.

Problem 14.7

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 projects 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 forYear 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:

Year Allowance

• 1 0.20
• 2 0.32
• 3 0.19
• 4 0.12
• 5 0.11
• 6 0.06

The hospitals tax rate is 40 percent, and its corporate cost of capital is 10 percent.

15.3 problem continued-

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.

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

Scenario Probability Number of Procedures Average Collection Equipment Salvage 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 Centers average project has a coefficient of variation of NPV in the range of 1.02.0. (Hint: The 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 hospitals managers?