Chapter 11 -- Capital Budgeting
PROBLEM 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 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.)
5%	inflation rate					Year
				0	1	2	3	4	5
Equipment cost				($600,000)
Net revenues					300000.00	315000.00	330750.00	347287.50	364651.88
Less:	Labor/maintenance costs				-100000.00	-105000.00	-110250.00	-115762.50	-121550.625
	Utilities costs				-10000.00	-10500.00	-11025.00	-11576.25	-12155.06
	Supplies				-18750.00	-19687.50	-20671.875	-21705.47	-22790.74
	Incremental overhead				-5,000	-5250.00	-5512.50	-5788.125	-6077.53
	Depreciation				($120,000.00)	($192,000)	($114,000)	($72,000)	($66,000)
Operating income					46250.00	-17437.50	69290.62	120455.16	136077.92
Taxes					18500	6975	27716.48	48182.06	54431.168
Net operating income					27750.00	-10462.50	41574.14	72273.10	72273.10
Plus: Depreciation					120,000.00	192,000.00	114,000.00	72,000.00	66,000.00
Plus: After-tax equipment salvage value*									120,000
Net cash flow				($600,000)	147750.00	181,537.50	155574.14	144273.10	258273.10
Discounted net CF				($600,000)	134318.18	150,030.99	116885.15	98540.47	160367.27
NPV=	$60,142.07								$60,142.07
IRR=	13.60%
Pretax equipment salvage value									200000
MACRS equipment salvage value									178000
Difference									22,000
Taxes									40%
After-tax equipment salvage value									120,000

PROBLEM 3

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?