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Healthcare Financial Management and Economics Week 10 Assignment Capital Budgeting There are many options to buy capital, including cash purchases, loans, leasing, and other forms of payment. Your goal as a healthcare manager is to determine which method is best for your organization, given its financial and organizational structure (i.e., for-profit or not-for-profit). Time value of money and net present value are two techniques that may help you determine how and when to invest in new capital. For this Assignment, you examine these concepts as they pertain to the healthcare industry. To prepare for this Assignment: Review this week's Learning Resources. Reflect on concepts of time value of money, net present value, internal rate of return, and purchasing options. The Assignment: Using an Excel spreadsheet to show your work, answer the following questions: 1 If a physician deposits $24,000 today into a mutual fund that is expected to grow at an annual rate of 8%, what will be the value of this investment: a b c d 3 years from now 6 years from now 9 years from now 12 years from now 2 The Chief Financial Officer of a hospital needs to determine the present value of $120,000 investment received at the end of year 5. What is the present value if the discount rate is: a b c d 3% 6% 9% 12% 3 Calexico Hospital plans to invest $1.8 million in a new MRI machine. The MRI will be depreciated over its 5-year economic life to a $200,000 salvage value. Additional revenues attributed to the new MRI will be in the amount of $1.5 million per year for 5 years. Additional operating expenses, excluding depreciation expense, will amount to $1 million per year for 5 years. Over the life of the machine, net working capital will increase by $30,000 per year for 5 years. a Assuming that the hospital is a non-profit entity, what is the project's net present value (NPV) at a discount rate of 8%, and what is the project's 2015 Laureate Education, Inc. Page 1 of 2 IRR? b Assuming that the hospital is a for-profit entity and the tax rate is 30%, what is the project's NPV at a cost of capital of 8%, and what is the project's IRR? 4 Marshall Healthcare System, a not-for-profit hospital, is planning on opening an imaging center including MRI, x-ray, ultrasound, and CT. The new center will generate $3 million per year in revenues for 5 years. Expected operating expenses, excluding depreciation, would increase expenses by $1.2 million per year for the next 5 years. The initial capital investment outlay for the project is $5.5 million, which will be depreciated on a straight line basis to a savage value. The salvage value in year 5 is $800,000. The cost of capital for this project is 12%. a Compute the NPV in the IRR to determine the financial feasibility of the project. 5 Penn Medical Center, a for-profit hospital, is considering the purchase of a new 64-slice CT scanner. The cost of the new scanner is $4 million and will be depreciated over 10 years on a straight line basis to $0 savage value. The tax rate is 40%. The financing options include either borrowing the full cost of the scanner or leasing a scanner. The lease option is a 5-year lease with equal before-tax lease payments of $950,000 per year. The borrowing alternative is a 5-year loan covering the entire cost of the scanner at an interest rate of 5%. The after-tax cost of debt is 3%. Should Penn Medical lease the equipment or borrow the money? 2015 Laureate Education, Inc. Page 2 of 2 Answer 1:a. Value 3 years from Now:= $24000 (1+8%)^ 3 $ 30,233.09 b. Value 6 years from Now:= $24000 (1+8%)^ 6 $ 38,084.98 c. Value 9 years from Now:= $24000 (1+8%)^ 9 $ 47,976.11 d. Value 12 years from Now:= $24000 (1+8%)^ 12 $ 60,436.08 Answer 2:a. If the discount rate is 3% Present Value = $ 120,000 *(1/(1.03)^5) = $ 120,000 * 0.747258 $ 89,670.98 b. If the discount rate is 6% Present Value = $ 120,000 *(1/(1.06)^5) = $ 120,000 * 0.747258 $ 89,670.98 c. If the discount rate is 9% Present Value = $ 120,000 *(1/(1.09)^5) = $ 120,000 * 0.649931 $ 77,991.77 d. If the discount rate is 12% Present Value = $ 120,000 *(1/(1.12)^5) = $ 120,000 * 0.567427 $ 68,091.22 Answer 3:a. Assuming that the hospital is a non-profit entity, what is the project's net present value (NPV) at a discount rate of 8%, and what is the project's IRR? Cash flow from operation:Year Revenue From MRI Machine Operating Exp Depreciation Exp. Operating Income Net Cash Flows 1 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 2 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 3 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 4 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 5 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 Discounted Cash Flow Analysis:Particular Investment in Machine Working Capital Investment Cash Inflows Working Capital Return Salvage Value of Machine Period PVF @ 8% 0 0 1-5 Years 5 5 1 1 3.993 0.681 0.681 Discounted Discounted Cash Cash Flows Flows Cash Flows PVF @ 15% -1800000 -1800000 1 -1800000 -30000 -30000 1 -30000 500000 1996500 3.352 1676000 30000 20430 0.497 14910 200000 136200 0.497 99400 Net Cash Inflow Net Cash Outflow 2,153,130 - 1,830,000 1,790,310 - NPV of the Project @ 8%= Present Value of Inflows - Present value of Outflows = 2,153,130 - 1,830,000 NPV of the Project @ 8%= $ 323,130 NPV of the Project @ 15% Project IRR:IRR = IRR of the Project = 1,790,310 - $1,830,000 = $ -39,690 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 8% + {(323,130 / (323,130 - (-39,690)))} * (15-8) = 8% + (0.89) * (7) =8% + 6.23% = 14.23%. 1,830,000 b. Assuming that the hospital is a for-profit entity and the tax rate is 30%, what is the project's NPV at a cost of capital of 8%, and what is the project's IRR? Cash Flow Analysis:Year Revenue From MRI Machine Operating Exp Depreciation Exp. Operating Income Tax @ 30% Net Operating Income Net Cash Flows (Operating Income + Depreciation) 1 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 2 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 3 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 4 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 5 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 Discounted Cash Flow Analysis:Particular Investment in Machine Working Capital Investment Cash Inflows Working Capital Return Salvage Value of Machine after Tax Period PVF @ 8% 0 0 1-5 Years 5 5 Net Cash Inflow Net Cash Outflow 1 1 3.993 0.681 0.681 Discounted Discounted Cash Cash Flows Cash Flows PVF @ 10% Flows -1800000 -1800000 1 -1800000 -30000 -30000 1 -30000 446000 1780878 3.791 1690786 30000 20430 0.621 18630 140000 95340 0.621 86940 - 1,896,648 1,830,000 - NPV of the Project @ 8%= Present Value of Inflows - Present value of Outflows = 1,896,648 - 1,830,000 NPV of the Project @ 8%= $ 66,648 NPV of the Project @ 10% Project IRR:IRR = IRR of the Project =1796356 -1830000 = $ -33,644 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 8% + {(66,648 / (66,648 - (-33,644)))} * (10-8) = 8% + (0.66) * (2) =8% + 1.33% 9.33% 1,796,356 1,830,000 Answer 4:a. Compute the NPV in the IRR to determine the financial feasibility of the project. Cash Flow Analysis:Year Revenue Operating Exp Depreciation Exp. Net Operating Income Net Cash Flows 1 3,000,000 1,200,000 940,000 860,000 1,800,000 2 3,000,000 1,200,000 940,000 860,000 1,800,000 3 3,000,000 1,200,000 940,000 860,000 1,800,000 4 3,000,000 1,200,000 940,000 860,000 1,800,000 5 3,000,000 1,200,000 940,000 860,000 1,800,000 Discounted Cash Flow Analysis:- Particular Investment in Machine Cash Inflows Salvage Value of Machine Discounted Discounted PVF @ 12% Cash Flows Cash Flows PVF @ 22% Cash Flows 0 1.000 -5500000 -5500000 1.000 -5500000 1-5 Years 3.605 1,800,000 6489000 2.864 5155200 5 0.567 800000 453600 0.370 296000 Period Net Cash Inflow Net Cash Outflow NPV of the Project @ 12% NPV of the Project @ 12%= NPV of the Project @ 22% Project IRR:IRR = IRR of the Project 6,942,600 - 5,500,000 - 5,451,200 5,500,000 = Present Value of Inflows - Present Value of Outflows =6,942,600 - 5,500,000 $ 1,442,600 = $ 5,451,200- $ 5,500,000 $ -48,800 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 12% + {(1,442,600 / (1,442,600 - (-44,800)))} * (22-12) = 12% + (0.97) * (10) =12% + 9.67% 21.67% Answer 5:Annual Lease Payment:Tax Saving on Annual Lease Payment $ 950,000 = 950,000 *40/100 $ 380,000 Discounted Cash Flow analysis of Lease Proposal:Particular Lease Payments Tax Saving on Lease Period PVF @ 3% Cash Flow Discounted Cash Flow 4.58 -950,000.00 -4,351,000.00 4.58 380,000.00 1,740,400.00 1-5 1-5 Net Outflow of Fund -2,610,600.00 Evaluation of Proposal of Interest taken:Annual Payment to Bank = 4000000 * 1/ 4.33 $ 923,787.00 Interest Chart:Year 1 2 3 4 5 Loan Amt. 4,000,000 3,276,213 2,516,237 1,718,261 880,388 Installment 923,787 923,787 923,787 923,787 923,787 Total DCF Analysis of the Project:Particular Bank Payments Tax Savings Tax Savings Tax Savings Tax Savings Tax Savings Period Principal 723,787 759,976 797,975 837,874 880,388 4,000,000 Interest 200,000 163,811 125,812 85,913 43,399 Tax Saving 80,000 65,524 50,325 34,365 17,360 618,935 247,574 1-May 1 2 3 4 5 PVF @ 5% Cash Flow Discounted Cash Flow 4.329 - 923,787.00 3,999,073.92 0.952 80,000.00 76,160.00 0.907 65,524.26 59,430.50 0.864 50,324.73 43,480.57 0.823 34,365.23 28,282.58 0.784 17,359.78 13,610.07 Net Outflow of Fund -3,778,110.20 Net Outflow of Fund is Lower in Lease, Hence, Lease is recommended over Financing the Project. Note:- The effect of depreciation is not taken as the effect under both scenario is same. Answer 1:a. Value 3 years from Now:= $24000 (1+8%)^ 3 $ 30,233.09 b. Value 6 years from Now:= $24000 (1+8%)^ 6 $ 38,084.98 c. Value 9 years from Now:= $24000 (1+8%)^ 9 $ 47,976.11 d. Value 12 years from Now:= $24000 (1+8%)^ 12 $ 60,436.08 Answer 2:a. If the discount rate is 3% Present Value = $ 120,000 *(1/(1.03)^5) = $ 120,000 * 0.747258 $ 89,670.98 b. If the discount rate is 6% Present Value = $ 120,000 *(1/(1.06)^5) = $ 120,000 * 0.747258 $ 89,670.98 c. If the discount rate is 9% Present Value = $ 120,000 *(1/(1.09)^5) = $ 120,000 * 0.649931 $ 77,991.77 d. If the discount rate is 12% Present Value = $ 120,000 *(1/(1.12)^5) = $ 120,000 * 0.567427 $ 68,091.22 Answer 3:a. Assuming that the hospital is a non-profit entity, what is the project's net present value (NPV) at a discount rate of 8%, and what is the project's IRR? Cash flow from operation:Year Revenue From MRI Machine Operating Exp Depreciation Exp. Operating Income Net Cash Flows 1 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 2 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 3 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 4 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 5 $1,500,000 $1,000,000 $320,000 $180,000 $500,000 Discounted Cash Flow Analysis:Particular Investment in Machine Working Capital Investment Cash Inflows Working Capital Return Salvage Value of Machine Period PVF @ 8% 0 0 1-5 Years 5 5 1 1 3.993 0.681 0.681 Discounted Discounted Cash Cash Flows Flows Cash Flows PVF @ 15% -1800000 -1800000 1 -1800000 -30000 -30000 1 -30000 500000 1996500 3.352 1676000 30000 20430 0.497 14910 200000 136200 0.497 99400 Net Cash Inflow Net Cash Outflow 2,153,130 - 1,830,000 1,790,310 - NPV of the Project @ 8%= Present Value of Inflows - Present value of Outflows = 2,153,130 - 1,830,000 NPV of the Project @ 8%= $ 323,130 NPV of the Project @ 15% Project IRR:IRR = IRR of the Project = 1,790,310 - $1,830,000 = $ -39,690 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 8% + {(323,130 / (323,130 - (-39,690)))} * (15-8) = 8% + (0.89) * (7) =8% + 6.23% = 14.23%. 1,830,000 b. Assuming that the hospital is a for-profit entity and the tax rate is 30%, what is the project's NPV at a cost of capital of 8%, and what is the project's IRR? Cash Flow Analysis:Year Revenue From MRI Machine Operating Exp Depreciation Exp. Operating Income Tax @ 30% Net Operating Income Net Cash Flows (Operating Income + Depreciation) 1 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 2 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 3 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 4 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 5 1,500,000 1,000,000 320,000 180,000 54,000 126,000 446,000 Discounted Cash Flow Analysis:Particular Investment in Machine Working Capital Investment Cash Inflows Working Capital Return Salvage Value of Machine after Tax Period PVF @ 8% 0 0 1-5 Years 5 5 Net Cash Inflow Net Cash Outflow 1 1 3.993 0.681 0.681 Discounted Discounted Cash Cash Flows Cash Flows PVF @ 10% Flows -1800000 -1800000 1 -1800000 -30000 -30000 1 -30000 446000 1780878 3.791 1690786 30000 20430 0.621 18630 140000 95340 0.621 86940 - 1,896,648 1,830,000 - NPV of the Project @ 8%= Present Value of Inflows - Present value of Outflows = 1,896,648 - 1,830,000 NPV of the Project @ 8%= $ 66,648 NPV of the Project @ 10% Project IRR:IRR = IRR of the Project =1796356 -1830000 = $ -33,644 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 8% + {(66,648 / (66,648 - (-33,644)))} * (10-8) = 8% + (0.66) * (2) =8% + 1.33% 9.33% 1,796,356 1,830,000 Answer 4:a. Compute the NPV in the IRR to determine the financial feasibility of the project. Cash Flow Analysis:Year Revenue Operating Exp Depreciation Exp. Net Operating Income Net Cash Flows 1 3,000,000 1,200,000 940,000 860,000 1,800,000 2 3,000,000 1,200,000 940,000 860,000 1,800,000 3 3,000,000 1,200,000 940,000 860,000 1,800,000 4 3,000,000 1,200,000 940,000 860,000 1,800,000 5 3,000,000 1,200,000 940,000 860,000 1,800,000 Discounted Cash Flow Analysis:- Particular Investment in Machine Cash Inflows Salvage Value of Machine Discounted Discounted PVF @ 12% Cash Flows Cash Flows PVF @ 22% Cash Flows 0 1.000 -5500000 -5500000 1.000 -5500000 1-5 Years 3.605 1,800,000 6489000 2.864 5155200 5 0.567 800000 453600 0.370 296000 Period Net Cash Inflow Net Cash Outflow NPV of the Project @ 12% NPV of the Project @ 12%= NPV of the Project @ 22% Project IRR:IRR = IRR of the Project 6,942,600 - 5,500,000 - 5,451,200 5,500,000 = Present Value of Inflows - Present Value of Outflows =6,942,600 - 5,500,000 $ 1,442,600 = $ 5,451,200- $ 5,500,000 $ -48,800 Lower Rate + {(Lower Rate NPV / (Lower Rate NPV - Higher Rate NPV))} * (Difference in Rates) = 12% + {(1,442,600 / (1,442,600 - (-44,800)))} * (22-12) = 12% + (0.97) * (10) =12% + 9.67% 21.67% Answer 5:Annual Lease Payment:Tax Saving on Annual Lease Payment $ 950,000 = 950,000 *40/100 $ 380,000 Discounted Cash Flow analysis of Lease Proposal:Particular Lease Payments Tax Saving on Lease Period PVF @ 3% Cash Flow Discounted Cash Flow 4.58 -950,000.00 -4,351,000.00 4.58 380,000.00 1,740,400.00 1-5 1-5 Net Outflow of Fund -2,610,600.00 Evaluation of Proposal of Interest taken:Annual Payment to Bank = 4000000 * 1/ 4.33 $ 923,787.00 Interest Chart:Year 1 2 3 4 5 Loan Amt. 4,000,000 3,276,213 2,516,237 1,718,261 880,388 Installment 923,787 923,787 923,787 923,787 923,787 Total DCF Analysis of the Project:Particular Bank Payments Tax Savings Tax Savings Tax Savings Tax Savings Tax Savings Period Principal 723,787 759,976 797,975 837,874 880,388 4,000,000 Interest 200,000 163,811 125,812 85,913 43,399 Tax Saving 80,000 65,524 50,325 34,365 17,360 618,935 247,574 1-May 1 2 3 4 5 PVF @ 5% Cash Flow Discounted Cash Flow 4.329 - 923,787.00 3,999,073.92 0.952 80,000.00 76,160.00 0.907 65,524.26 59,430.50 0.864 50,324.73 43,480.57 0.823 34,365.23 28,282.58 0.784 17,359.78 13,610.07 Net Outflow of Fund -3,778,110.20 Net Outflow of Fund is Lower in Lease, Hence, Lease is recommended over Financing the Project. Note:- The effect of depreciation is not taken as the effect under both scenario is same