Because of its inability to control film and personnel costs in its radiology department, Sanger General Hospital wants to replace its existing picture archive and communication (PAC) system with a newer version. The existing system, which has a current book value of $2,250,000, was purchased three years ago for $3,600,000 and is being depreciated on a straight-line basis over an eight-year life to a salvage value of $0. This system could be sold for $800,000 today. The new PAC system would reduce the need for staff by eight people per year for five years at a savings of $40,000 per person per year, and it would reduce film costs by $2,000,000 per year. The project would not affect the level of net working capital. The new PAC system would cost $9,000,000 and would be depreciated on a straight-line basis over a five-year life to a salvage value of $0. The economic life of a new system is five years, and the required rate of return on the project is 7 percent.

a) Should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision; assume the hospital is a not-for-profit facility. b) If the facility were a taxpaying entity with a tax rate of 30 percent, should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision. (Hint: see Appendix F.)

INVESTMENT DECISION dgeting CHAPTENT Appendix F: Comprehensive Capi Replacement Cost Example u replacing its man system (MIS) with cally stores EKG and ed five years ago for a salvage value of market price of $20,000 Assume that a cardiology laboratory is considering electrocardiography (EKG) management information new, more efficient product. The new system automatica stress records online. The existing system was purchased $70,000 and is being depreciated over a ten-year life to a $10,000. The old system can be sold now at a market has a book value of $40,000 ($70,000 Original cost - $30.000 depreciation). The new system can be purchased for $100 mated to have a five-year life. It can be depreciated to a $20,000. Because the organization is paid on a per procede are no new revenues directly associated with the impro Thus the focus becomes the cash savings in operational exne Jabor expenses will drop from $50,000 for the old syster for the new system, resulting in a labor cash savings of $35.000 the new system will increase net working capital by $1,000 ear pared with a $300 annual increase for the old system, starti This appendix provides comparative and incremental NPV anal situation, first assuming that the lab is not-for-profit and then that it is investor owned. In both cases the cost of capital is 5 pe 000 Accumulated $100,000 and is esti a salvage value of ocedure basis, there mproved EKG system nal expenses. Annual system to $15,000 5.000. Purchasing 000 each year, com m, starting in year 1. NPV analyses of this and then assuming f capital is 5 percent. h compares the cash Comparative Approach: Not-for-Profit Analysis As its name implies, the comparative approach compares the flows resulting from continuing with the existing alternative to those would result if the equipment were replaced. The comparative an does this by separately calculating each of these cash flows and then paring the end results (Exhibit F.1). d. The comparative approach Were the organization to continue with the existing system, there would be no investment at year 0 (it has already been made), and the oper. ating loss would be $56,000 a year (row D), which includes operating expenses (row B) and depreciation expense (row C). However, because operating loss contains depreciation, and depreciation is an expense that does not require a cash outlay, depreciation must be added back in order to derive cash flows from operations. This is done in row F by adding $6,000 (row E) back to the $56,000 operating loss (row D). Although the same result ($50,000, row F) can be derived without first subtracting and then adding back depreciation expense, this approach makes it easier compare the not-for-profit and for-profit analyses. Because the change net working capital increases by $300 each year, the resultant cash ou / Total: $133 COMPREHENSIVE CAPITAL BUDG APPENDIX E MENT COST EXAMPLE . must be accounted will be recovered ar o account for is the year 5 row H). ens (row 1). and This information for attributable to the The initial out capital effects dift FI, lower half). equipment costs $1 its existing funds ing equipment. ed for (row G). However, as explained in Appendix D. this at the end of the project (row 1). The only other cash flow the $10,000 salvage value that results in a cash inflow in . Finally, the cash flows are computed for each of the five od then discounted using the cost of capital (rows K and L). tion forms the basis for calculating the NPV of the cash flows te to the existing machine: $208,762 (row O). ial outlay, expenses, depreciation, salvage value, and working s differ for the purchase of the replacement system Exhibit af). The initial outlay is computed in row A. Although the new osts $100,000, the organization has to pay only $80,000 from funds because it can allocate $20,000 from the sale of the exist- Because net working ing cash outal steps in the red e net working capital increases by $1,000 each year, the result- outflow must be accounted for (rows G and I). The remaining the replacement analysis are the same as those in the previous and only the amounts differ. Using the comparative approach, the of the replacement alternative is -$129,683 (row O). Thus, because placement alternative has the higher NPV (-$129,683 versus 208.762), the replacement alternative should be undertaken. analysis, and only the NPV of the replace the replacemen Comparative Approach: For-Profit Analysis for-profit analysis is exactly the same as that for the not-for-profit analysis, with the two exceptions shown in Exhibit F.2, rows E and F, which arise as a result of the effects of taxes on cash flows and, ultimately, affect NPV. As in the not-for-profit analysis, earnings (or loss) before tax is cal- culated in row D. Because earnings get taxed at 40 percent, the resulting tax savings would be $22,400 for the existing alternative as compared with $12,400 for the replacement alternative, respectively (row E, both sections). Because earnings before tax is negative, the organization is losing money but will not be incurring negative taxes. However, the tax expense becomes a positive value because this tax loss can be either carried forward to offset future income or carried back to offset prior income to result in a tax refund. This has the same effect as a cash inflow: for each additional $1.00 in expenses, the organization pays $0.40 less in taxes. Therefore these tax savings get added back into the loss in row D. Taking into account the tax effects, the NPV of the existing alternative is -$111,782, and the NPV of the replacement alternative is -$67,998. Again, showing a smaller loss, or a savings of $43,784 (row R, bottom table), the replacement alternative should be undertaken, all else being equal. EXHIBIT 6.1 COMPARATIVE APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION: NOT-FOR-PROFIT ENTITY Existing equipment Givens Years 0 1 2 3 4 5 Initial outlay SO Operating expenses ($50,000) ($50,000) ($50,000) $50,000) (550,000) Depreciation expense ($6,000) ($6,000) ($6,000) ($6,000) 56,000) Change in net working capital $300 $300 5300 $300 5300 Salvage value $10,000 Cost of capital 596 5 6 Years 4 5 A Initial outlay Given 1 B Operating expenses before Given 2 ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) depreciation C Depreciation expense Given 3 (6,000) (6,000) (6,000) (6,000) (6,000) D Operating income (loss) B +C (56,000) (56,000) (56,000) (56,000) (56,000) Add: depreciation expense -Given 3 6,000 6,000 6,000 6,000 6,000 Net operating cash flow D +E (50,000) (50,000) (50,000) (50,000) (50,000) Change in net working capital -Given 4 (300) (300) (300) (300) (300) Terminal value changes H Salvage value Given 5 10,000 | Recovery of net working capital -Sum G 1,500 J Change in net cash flow F+G+H+1 ($50,300) ($50,300) ($50,300) ($50,300) ($38,800) K Cost of capital Given 6 5% 5% 5% L Present value interest factor 1/(1+0) 0.9524 0.9070 0.8638 0.8227 0.7835 M Annual PV of cash flows IXL ($47,905) ($45,624) ($43,451) ($41,382) ($30,401) N Sum of PV of cash flows Sum M ($208,762) 0 Net present value A +N ($208,762) "Present value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually. 5% 5% EXHIBIT CONTINUED) Replacement equipment Givens Years ($80,000) Initial outlay Operating expenses Depreciation expense Change in net working capital Salvage value Cost of capital ($15,000) ($ 16,000) $1,000 ($15,000) $16,000) $1,000 ($15,000) ($16,000) $1,000 ($15,000) ($16,000) $1,000 4 5 6 ($15,000) $16,000) $1,000 $20,000 596 Years ($80,000) C D E Initial outlay Operating expenses before depreciation Depreciation expense Operating income (loss) Add: depreciation expense Net operating cash flow Given 1 Given 2 Given 3 B +C Given 3 DE ($15,000) (16,000) (31,000) 16,000 (15,000) ($15,000) (16,000) (31,000) 16,000 (15,000) ($15,000) (16,000) (31,000) 16,000 (15,000) ($15,000) (16,000) (31,000) 16,000 (15,000) ($15,000) (16,000) (31,000) 16,000 (15,000) -Given 4 (1,000) (1,000) (1,000) (1,000) (1,000) 20,000 5.000 $9,000 ($16,000) Change in net working capital Terminal value changes H Salvage value Recovery of net working capital Change in net cash flow Cost of capital Present value interest factor Annual PV of cash flows Sum of PV of cash flows o Net present value NPV difference Given 5 -Sum G F+G+H+1 Given 6 1/(1+i)" JxL Sum M A+N ($16,000) 5% 0.9070 ($14,512) ($16,000) 5% 0.8638 ($13,821) ($16,000) 5% 0.8227 ($13,163) 5% 0.9524 ($15,238) 0.7835 (549,683) ($129,683) $79,079 $100,000 Purchase of new equipment + $20,000 Sale of old equipment. 1-5129,683 Replacement system)-(-5208,762 Existing system) = $79,079, EXHIBIT R2 COMPARATIVE APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION:FOR-PROFIT ENTITY Existing equipment Givens Years 0 Initial outlay Operating expenses (550.000) 550.000) 550.000) Depreciation expense (56,000) (56,000) 56.000) 156.000) Change in net working capital 5300 $300 $300 SVO Salvage value Cost of capital 596 Tax rate 40% SO S300 Years O SO D Given 1 Given 2 Given 3 B+C Given 7 xD DE -Given 3 ($50,000) (6,000) (56,000) 22,400 (33,600) 6,000 (27,600) (300) ($50,000) (6,000) (56,000) 22.400 (33,600) 6,000 (27,600) (300) ($50,000) 16,000) 156,000) 22.400 (33,600) 6,000 (27,600) (300) (550.000) 16,000) 156,000) 22.400 (33,600) 6,000 (27,600) (300) $50.000) 16,000) 156,000) 22.400 33,600) 6,000 027.600) (300) H Initial outlay Operating expenses before depreciation Depreciation expense Earnings (loss) before tax Taxes at 40% Earnings after tax Add: depreciation expense Net operating cash flow Change in net working capital Terminal value changes Salvage value Recovery of net working capital Change in net cash flow Cost of capital Present value interest factor Annual PV of cash flows Sum of PV of cash flows Net present value F+G -Given 4 Given 5 - Sum! H +I+J+K Given 6 1/(1 + i)" LXN Sum o A +P (527,900) 5% 0.9524 ($26,571) ($27.900) 5% 0.9070 ($25,306) ($27,900) 5% 0.8638 ($24,101) ($27.900) 5% 0.8227 ($22,953) 10.000 1,500 ($16,400) 5% 0.7835 ($12,850) ($111,782) ($111,782) "Present value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually. EXHIBITA (CONTINUED) ($ 72,000) Replacement equipment Givens Initial outlay Operating expenses Depreciation expense Change in net working capital Salvage value Cost of capital Tax rate ($15,000) ($ 16,000) $1,000 ($15,000) ($16,000) $1,000 ($15,000) (516,000) $1,000 ($15,000) $16,000) $1,000 ($15,000) ($16,000) $1,000 $20,000 5% 40% Years ($72,000) Given 1 Given 2 Given 3 B +C Given 7 xD DE - Given 3 F+G -Given 4 ($15,000) (16,000) (31,000) 12,400 (18,600) 16,000 (2,600) (1,000) ($15,000) (16,000) (31,000) 12,400 (18,600) 16,000 (2,600) (1,000) ($15,000) (16,000) (31,000) 12,400 (18,600) 16.000 (2,600) (1,000) ($15,000) (16,000) (31,000) 12,400 (18,600) 16.000 (2,600) (1,000) ($15,000) (16,000) (31,000) 12,400 (18,600) 16,000 (2,600) (1,000) A Initial outlay B Operating expenses before depreciation C Depreciation expense D Earnings before tax (loss before tax) E Taxes at 40% F Net income or earnings after tax G Add: depreciation expense H Net operating cash flow Change in net working capital Terminal value changes Salvage value K Recovery of net working capital Change in net cash flow M Cost of capital N Present value interest factor 0 Annual PV of cash flows P Sum of PV of cash flows Q Net present value R NPV difference Given 5 -Sum H+ I + J + K Given 6 1/(1 + i)" LXN Sum o A+P ($3,600) 5% 0.9524 ($3,429) ($3,600) 5% 0.9070 ($3,265) ($3,600) 5% 0.8638 (83,110) ($3,600) 5% 0.8227 ($2,962) 20,000 5,000 $21,400 5% 0.7835 $16,767 $4,002 ($67,998) 43,784 $100,000 Purchase of new equipment + 520,000 Sale of old equipment + $8,000 in Tax savings from loss on sale of existing equipment (0.40 Tax rate x $20,000 Loss) 9-567,998) - (-5111,782) = $43,784 or-Profit Analysis cision using the incre he incre thereof) for each item old EKG system with cash flows must be y reces Incremental Approach: Not-for-Profit Exhibir analyzes the same replacement decla approach It looks at the savings for lack the ir the decision were made to replace the old To make this decision, several aspects of cas into account Though the new MIS system costs $100.000 520.000 from the sale of the old system. Thus the row A). The change in operating cash flows prod. cash flow savings of $35,000 per year (row B, $15.00 ment labor expense versus $50,000 in labor 0000, the facility ree the initial outlay is $80 produces a net opera 15,000 replacement ou 000 in labor expenses for the the existing example, depre nalysis, in this nontaxpaying example equipment) As with the comparative analysis, in this ciation expense could be disregarded altogether beca cash flow. However, to compare the not-for-profit and for operating income (needed to compute taxes in the because it has no effect and for-profit examples, in the for-profit example on expense (row berating cash flows do not salvage value must apital increases by 000 for the replace ng the $10,000 in depreciation expen C) and then adding it back to show that net operating change as a result of depreciation (rows E and F). The effects of changes in working capital and the salvage be added to the analysis as well. Because net working capital in $700 annually ($300 for the existing system versus $1,000 for the ment system), cash flows decrease by $700 each year (rows 5 year 5, the year in which the investment is assumed to end, salya increases by $10,000 (row H, sale of assets), which equals the inc difference between the salvage value of the new system, $20,000. salvage value of the old system, $10,000. Because the project presuma ends at this time, it is also necessary to recapture $3,500 in net worki capital (row I: 5 Years x $700 per year). vear (rows 5 and G). In to end, salvage value equals the incremental system, $20,000, and the To determine the NPV, the cash flows each year are discounted at 5 percent and summed (rows through O), and then the initial outlay (row A) is added. Because the NPV equals $79,079, which represents a positive return due to replacement, from a financial perspective the new EKG system should be purchased. Note that this NPV is the same as the NPV difference derived in Exhibit F.1 (bottom section, row P), as it should be. Incremental Approach: For-Profit Analysis Exhibit F4 presents a similar incremental analysis, but for a for-prom taxpaying organization. In this case, the new initial outlay is still re from $100,000 to $80,000 by the additional $20,000 fron 0,000 by the additional $20,000 from the sale of the new initial outlay is still reduced EXHIBIT F.4 INCREMENTAL APPROACH TO ANALYZING A CAPITAL BUDGETING DECISION:FOR-PROFIT ENTITY Givens + taloutlay 152.000 Cost of capital New MIS 1515 15 16 Change in annual operating expenses and depreciation expense Old MIS 4 Operating expenses Labor) (550.000) 5 Depreciation expense 156,000) 6 Net working capital (5300) 7 Salvage value $10,000 75 100.000 archase of new equipment $20,000 Sale of old equipment $1.000 (0.40 $20,000) Tx savings due to sale Old MIS. $70,000 10.000 / 10 years $6.000 per year. New MIS: $100.000 $20.000) / 5 years 510.000 per year Charge - Old) $35.00 510.000 5700 $10.000 520000 ws 10.000 Years Initial outlay Given 1 (572,000) Cash savings due to decreased operating expenses Given 4 $35,000 $35.000 $35.000 $35,000 $35,000 Increase in depreciation expenses Given 5 (10,000) (10,000) (10,000) (10.000) (10,000 D Change in earnings before tax B + 25,000 25,000 25,000 25,000 25.000 Less: increased tax expense Given 3 xD 10,000 10.000 10.000 10,000 10,000 Increase in net income or earnings after tax D-E 15,000 15.000 15.000 15.000 15.000 Add: increase in depreciation expense -Given 5 10,000 10,000 10.000 10,000 Change in net operating cash flow F+G 25,000 25,000 25,000 25,000 25.000 Change in net working capital Given 6 (700) (700) (700) (700) (700) Terminal value changes Change in salvage value Given 7 10,000 Recovery of net working capital -Sum! 3,500 Change in net cash flow H+ I + J + K $24,300 $24,300 $24,300 $24,300 $37,800 Cost of capital Given 2 5% 5% 5% 5% Present value interest factor 1/(1 + i)" 0.9524 0.9070 0.8638 0.8227 0.7835 Annual PV of cash flows LXN $23,143 $22,041 $20.991 $19,992 $29,617 P Sum of PV cash flows Sum o $115,784 Q Net present value A + P $43,784 'In row C, depreciation expense increased. However, it is an expense and must be deducted from cash savings. "Present value interest factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the number displayed and that calculated manually. 5% shem, but Hect of that sale sem w Asumine 0 x $20.00 Thxes also affer B e the chan percent tax ran the change in ne $15.000) net incon require a cash our cash flow become remains the same in net work F COMTREHENSIVE CAPITAL GENE R AL is also reduced another 58,000 to 52000) by the ta Inow 1). This tax benefit arises because the ration with a $40,000 book value for 520.000, incurring $20.000 40 percent tax rate, it will pay SR.000 less in taxes 00) than it would have if it had not sold the machine affect operating income and represent a real cash outflow hange in earnings before tax is $25,00 (row D), assuming a rate, taxes will increase by $10,000 (row E), thereby reducing net income to $15.000 (row F). However, reflected in this come is the $10,000 in depreciation expense that does not h utfow. Therefore this $10.000 must be added back in, and comes $25,000 (rows G and H). The remainder of the analysis same as for the not-for-profit analysis, adjusting for the change working capital and the terminal valu counting for the sale of the new system at its termination date unting at the cost of capital, the decision to make this investment positive NPV of $43,784 (row Q). Because the NPV is positive, ment should be made. Again, this value expectedly equals that in row R in the bottom section of Exhibit E2 After accounting for and discounting at results in a positive NP the investment sho shown in towR Appendix Summary This appendix provided pendix provided both a comparative and an incremental NPV anal- of purchasing a new EKG MIS system. The analysis was conducted for ysis of purchas EXHIBIT F.5 RESULTS OF THE COMPARATIVE AND INCREMENTAL NPV ANALYSES OF REPLACING AN EXISTING EKG SYSTEM Not-for-Profit Institution For-Profit Institution Replace equipment Keep existing equipment Difference (replace - keep) Incremental approach ($129,683) ($208,762) $79,079 $79,079 ($67,998) ($111,782) $43,784 $43,784 'Exhibit F.1, comparative approach. "Exhibit F.2, comparative approach. Exhibit F.3, incremental approach. "Exhibit F.4, incremental approach. INT DE CHAP - T summary of results e and incremental the method wed final result. In this do not change the the both not for profit and for profil entity. The sur presented in Exhibit 5 shows that the comparative a approaches provide exactly the same answer. Thus the depends only on preference and has no effect on the final case, though tax effects are considerable, they do email decision