Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent

to evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects

of more or less risk. Currently, two mutually exclusive projects are under consideration. Both

have a cost of $200,000 and will last four years. Project A, a riskier-than-average project, will

produce annual end-of-year cash flows of $71,104. Project B, of less than average risk, will

produce cash flows of $146,411 at the end of Years 3 and 4 only. Which project should Virus

Stopper accept?

ANSWER

Here are the cash flows of both projects:

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 3 Capitol Health Plans, Inc., is evaluating two different methods for providing home health serv members. Both methods involve contracting out for services, and the health outcomes and reve not affected by the method chosen. Therefore, the incremental cash flows for the decision are a Here are the projected flows: Year Method A Method B 0 -$300,000 -$120,000 1 -$66,000 -$96,000 2 -$66,000 -$96,000 3 -$66,000 -$96,000 4 -$66,000 -$96,000 5 -$66,000 -$96,000 a. What is each alternative's IRR? b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why? ANSWER a. Years Method A Method B 0 -$300,000 -$120,000 1 ### ### 2 ### ### 3 ### ### 4 ### ### 5 ### ### IRR 3% 75% b. Years Method A Method B Discount Factor PV of Method A 0 -$300,000 -$120,000 1 -$300,000 1 ### ### 0.92 $60,550.46 2 ### ### 0.84 $55,550.88 3 ### ### 0.77 $50,964.11 4 ### ### 0.71 $46,756.06 5 ### ### 0.65 $42,895.47 NPV -$43,283 MANAGEMENT ds for providing home health services to its and the health outcomes and revenues are al cash flows for the decision are all outflows. method should be chosen? Why? PV of Method B -$120,000 $ 88,073.39 $ 80,801.28 $ 74,129.61 $ 68,008.82 $ 62,393.41 $253,407 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 11 -- Capital Budgeting PROBLEM 8 You have been asked by the president and CEO of Kidd Pharmaceuticals to evaluate the prop acquisition of a new labeling machine for one of the firm's production lines. The machine's pri $50,000, and it would cost another $10,000 for transportation and installation. The machine fa MACRS three-year class, and hence the tax depreciation allowances are 0.33, 0.45, and 0.15 in 2, and 3, respectively. The machine would be sold after three years because the production line closed at that time. The best estimate of the machine's salvage value after three years of use is The machine would have no effect on the firm's sales or revenues, but it is expected to save Kid per year in before-tax operating costs. The firm's tax rate is 40 percent and its corporate cost o 10 percent. a. What is the project's net investment outlay at Year 0? b. What are the project's operating cash flows in Years 1, 2, and 3? c. What are the terminal cash flows at the end of Year 3? d. If the project has average risk, is it expected to be profitable? ANSWER a. Initial outlay = $50,000 + $10,000 ### YR 0 b. Year 1 Save Deprecation EBIT Tax PAT Depreciation Salvage value Net cash flow Year 2 ### ### $ 200.00 $ 80.00 $ 120.00 $19,800.00 ### Year 3 ### $ 20,000.00 ### $ 9,000.00 -$ 7,000.00 $ 11,000.00 -$ 2,800.00 $ 4,400.00 -$ 4,200.00 $ 6,600.00 $27,000.00 $9,000.00 $ 12,000.00 ### $ 27,600.00 c. Salvage Value - (salvage Value - (TC of Machine - Depreciation) * Tax Rate 20,000 -(20,000-(60,000-55,800)*40% $13,680 d. If the project has average risk, the project is expected to be profitable. IAL MANAGEMENT als to evaluate the proposed lines. The machine's price is allation. The machine falls into the re 0.33, 0.45, and 0.15 in Years 1, ause the production line is being ter three years of use is $20,000. it is expected to save Kidd $20,000 and its corporate cost of capital is Tax Rate