Question
Shrieves Hospital Ltd. is considering adding a new line to its diagnostic product mix, and the capital budgeting analysis is being conducted by Sidney Johnson,
Shrieves Hospital Ltd. is considering adding a new line to its diagnostic product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MHA. A new bone density scanner would be set up in unused space in Shrieves's main clinic. The machinerys invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of four years, and Shrieves has obtained a special tax ruling which places the equipment in the MACRS three-year class. The machinery is expected to have a salvage value of $25,000 after four years of use. The new line would generate incremental sales of 1,250 scans per year for four years at an incremental cost of $100 per scan in the first year, excluding depreciation. Each scan would generate revenue of $200 in the first year. The price and cost of each scan are expected to increase by 3 percent per year due to inflation. Further, to handle the new line, the hospital's net operating working capital would have to increase by an amount equal to 12 percent of sales revenues*. The hospital's tax rate is 40 percent, and its corporate cost of capital is 10 percent.
Perform a sensitivity analysis on the corporate cost of capital, number of scans, and salvage value. Assume that each of these variables can vary from its base case by plus and minus 15 and 30 percent. Include a sensitivity diagram.
Perform a scenario analysis using the worst-, most likely, and best-case probabilities in the table below:
Scenario | Probability | Number of Scans | Price per Scan |
Best | 25% | 1,600 | $240 |
Most-likely | 50% | 1,250 | $200 |
Worst | 25% | 900 | $160 |
Assume that Shrieves's average project has a coefficient of variation of NPV in the range of 0.20.4. The hospital typically adds or subtracts 3 percentage points to its corporate cost of capital to adjust for risk. Should the new line be accepted?
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