CHAPTER 11 UHFM 7TH EDITION

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.)
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