- If variable costs change from 30% of revenues to 40% of revenues, project B
- Becomes more appealing
- Becomes less appealing
- If the initial fixed cost amount changed to $30,000,000, the NPV of the poor scenario will
- Increase and make project B more desirable
- Increase and make project B less desirable
- Decrease and make project B more desirable
- Decrease and make project B less desirable
- True or False: If cash flow in year 8 for medium demand changes to 200,000,000, the expected NPV of the project increases
- True or False: A good stage 1 and high demand in stage two results in a positive NPV
- True or False: A firm can capitalize operating expenses but not expenses related to an asset
- The low demand scenario arises. If the best estimate for the year 8 cash flow changes to $300 million, the value of the abandonment option
- Increases which is a good thing
- Increases which is a bad thing
- Decreases which is a good thing
- Decreases which is a bad thing
- True or False: A good stage 1 and medium demand in stage two results in positive NPV
- True or False: Capitalizing expenses means to take the expenses over the life of the asset
NATIONAL REHABILITATION CENTERS (NRC) is one of the nation's leading providers of outpatient rehabilitative medicine. It was founded in 1988 in Phoenix, Arizona, by a group of five individuals who recognized the need for cost-effective alternatives to traditional hospital-based rehabilitative services. This vision has become the hallmark of NRC, which continues to provide the highest-quality, most cost-effective care available. (For more information on rehabilitative medicine, see the American Academy of Physical Medicine and Rehabilitation website at www.aapmr.org.) To keep the costs of rehabilitative services low, NRC uses the latest in noninvasive treatment procedures, which reduces direct costs and results in quicker recoveries. In addition, the company encourages patients to begin aggressive rehabilitation as early as possible, which helps them return to nor- mal functioning more quickly than under conventional treatment protocols. In spite of NRC's relatively short history, its strategy has worked wonders, and it quickly expanded from a local to a regional to a national company. Today, NRC is a multibillion-dollar publicly traded company with nearly 750 locations in all 50 states, Puerto Rico, the United Kingdom, and Australia. For several years, NRC's board of directors has been considering expand- ing its service line to include sports medicine. The American College of Sports Medicine defines this field as the physiological, biomechanical, psy- chological, and pathological phenomena associated with exercise and sports. (For more information on sports medicine, see the American College of Sports Medicine website at http://acsm.org.) Because rehabilitative and sports medicine services have much in common, expansion into this rapidly growing area of healthcare seems natural.One of the most important advantages of staged entry is that new information will become available throughout the investment period. NRC's managers recognize the value of this feature and believe that they will have a better estimate of the Stage 2 probabilities and cash ows before mak ing the Year 6 investment. Even if Stage 2 is undertaken, there is some possibility that the project could be abandoned at the end of Year 8 if the low-demand scenario materializes. Ifthe project is terminated at that point, the best estimate for the Year 8 abandonment cash ow is $420 million'he uncertainty of whether abandonment would occur lies more in the politics than in the economics of the decision. In the past, NRC's managers have not been inclined to admit mistakes and cut losses, so some doubt lingers about whether the abandonment decision would be made even if it is the nancially right thing to do at the time. You have been hired as a consultant to analyze the sports medicine pro gram and to make a remmmendation to NRC's board of directors regarding the best course of action. In addition to a detailed analysis of Proposal B, you have been asked to Subjectivcly compare the relative merits of Proposal A with those of Proposal B. Recovery tear MACHS Class I 2 3 4 5 7-year 14.3% 24.5% 17.5% 12.5% 8.9% MACHS: modified accelerated cost recovery system Note: For ease. these allomnces were rounded to the nearest one-tenth of 1 percent. In actual applications. the allowances would not be re unded. .__._______ EXHIBIT 22.1 MACHS Depreciation Rates As shown in the following table, the net cash inflows forecasted for Stage 2 depend on the demand scenario: Net Cash Flow End of Year High Demand Medium Demand Low Demand ($240,000,000) ($240,000,000) ($240,000,000) (240,000,000) (240,000,000) (240,000,000) 210,000,000 160,000,000 70,000,000 9 228,000,000 170,000,000 75,000,000 10 241,000,000 175,000,000 75,000,000 11 256,000,000 180,000,000 75,000,000 12 500,000,000 350,000,000 150,000,000 Note that the net cash flows have been "bumped up" in Year 9 to reflect the cash flows from those facilities in the test region. In addition, note that the project is expected to last beyond Year 12, and an allowance for the value of these future cash flows is embedded in the Year 12 cash flows. The estimated probabilities of the Stage 2 demand scenarios are related to the response to the Stage 1 trial program. If acceptance is poor in Stage 1, there is a 10 percent probability that demand will be high during Stage 2, a 40 percent probability that demand will be medium, and a 50 percent probability that demand will be low. However, if acceptance during Stage 1 is good, there is a 50 percent probability that demand will be high during Stage 2, a 40 percent probability that demand will be medium, and a 10 percent probability that demand will be low. Of course, these expectations may change over time as new information becomes available. Furthermore, the actual demand scenario for Stage 2 is not expected to be known until midway through Year 8, after the program has been operational nationally for six months. NRC's current effective income tax rate is 30 percent, and this rate is projected to remain roughly constant into the future. The firm's corporate cost of capital is 9 percent, a percentage NRC adjusts up or down by 3 percentage points to adjust for project risk. NRC defines low-risk projects as those that have a coefficient of variation (CV) of net present value of less than 0.8, average-risk projects as those that have CVs in the range of 0.8 to 1.2, and high-risk projects as those that have CVs of more than 1.2.identied for the sports medicine program could be staffed. The next step would be to buy the land needed at locations where totall)r new facilities are required. In total, land acquisition costs, which are assumed to occur at the end of Year 1, are expected to be $10 million. New construction and renovations at the chosen locations would take place during Year 2 and Year 3, and equipment would be installed during the last quarter of Year 3. Additional personnel would be hired as needed at the end of Year 3. The total amount required for new buildings, renovations to existing buildings, and equipment (plus a relatively small amount for recruitment) is estimated to be $50 million. For planning purposes, half this amount is assumed to be spent at the end of Year 2 and the other half at the end of Year 3. Any new buildings would fall into the MACRS (modied accelerated cost recovery system) 39-year tax depreciation class for tax purposes, but (for simplicity) both the buildings and equipment needed are assumed to fall into the MACRS 7year class. Appropriate depreciation allowances are given in exhibit 22.1. NRC would begin to depreciate the buildings and equipment during Year 4, the year in which the trial sports medicine program would be initiated. The trial program would be evaluated at the beginning of Year 6. If the results are satisfactory, the program would be expanded to the other eight regions. If the program does not meet expectations, it would be terminated at the end of Year 3. If terminated, the land would have an estimated market value of $10 million at that time, and the buildings and equipment would have a market value of $30 million. NRC's marketing department has projected two demand scenarios for Stage 1. If demand for the sports medicine program is poor, total revenues are forecasted to be $40 million for Year 4, the rst year of operations. However, if demand is good, revenues are expected to be $60 million. At this point, the best guess is that there is a 50 percent chance of poor demand and a 50 percent chance of good demand. If demand is good, revenues are expected to increase by 6 percent each year after Year 4. If demand is poor, revenue growth is expected to be only 3 percent. In terms of operating costs,variable costs are expected to be 30 percent of revenues. Fixed costs (other than depreciation), which are expected to total 325 million in Year 4, are forecasted to increase after the initial year of operations at the anticipated overall rate of ination, 2 percent. If the board approves Stage 2, NRC would spend an additional $480 million on land, buildings, and equipment to expand into the other eight regions. This expenditure would be evenly split between Year 6 and Year 7. NRC's board is examining two proposals related to the expansion. Pro- posal A involves a single, large investment that would immediately give the company a national presence in sports medicine. In essence, all the current rehabilitation facilities deemed suitable to offer sports medicinehservices would be renovated, equipped, and staffed as required to offer sports medi- cine services. The amount of' capital investment at each earmarked location would vary signicantiy, but the average cost is estimated at about $800,000 per facility. With roughly 500 locations identied as being suitable for the sports medicine service line, the estimated cost of Proposal A is in the vicinity of $400 million. Although the protability analysis of Proposal A is only preliminary, its internal rate of return is thought to be in the range of 20 to 25 percent. Proposal B, on the other hand, involves a more deliberate, two-stage approach to the expansion. Stage 1 of Proposal B calls for a trial program in which only one ofNRC's nine regions would offer sports medicine services. If the results of Stage 1 meet the company's prot targets, Stage 2, which calls for the expansion of sports medicine services into the remaining eight regions, would be implemented. Proposal A requires a much iarger capital investment than does Stage 1 of Proposal B. However, overall, Proposal B is more costly than Proposal A, even when the time value of money is considered, because Proposal A's large up-front investment leads to greater efciencies in contracting, construction, recruitment, and marketing. In spite of Proposal A's cost advantage, several board members are concerned about the wisdom of Proposal A because it requires a large investment in a service line that is new to NRC. Other board members, however, see no difference between rehabilitation and sports medicine services; one board member even said, \"Healthcare is healthcare." The primary task at band now is to evaluate Proposal B, which includes the trial program and possible expansion into all regions. To date, NRC has spent $7 million to develop a sports medicine concept that matches its approach to rehabilitative medicine. Of the $7 million, $2 million has been expensed for tax purposes, and the remaining $5 million has been capitalized and will be amortized Over the ve-year operating life of Stage 1. According to a specic Internal Revenue Service ruling requested by NRC, if neither Proposal A not B is implemented, the $5 million couid be immediately expenscd. If NRC decides to go ahead with Stage 1, it would immediately spend $2 million to perform local labor-market studies to ensure that the locations
