15.3 California Health Center, a not-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 5% inflation rate after the first year. The equipment falls into the MACRS five-year class for tax depreciation and is subject to the following depreciation allowances:

YEAR ALLOWANCE

1 0.20

2 0.32

3 0.19

4 0.12

5 0.11

6 0.06

7 1.00

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 5% inflation rate after the first year. The equipment falls into the MACRS five-year class for tax depreciation and is subject to the following depreciation allowances:

YEAR ALLOWANCE

1 0.20

2 0.32

3 0.19

4 0.12

5 0.11

6 0.06

7 1.00

The hospital’s tax rate is 40% and its corporate cost of capital is 10%.

a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amounts and salvage value.

b. Conduct a scenario analysis. Suppose that the hospital’s staff concluded that the three most uncertain variables were number of procedures per day, average collection amount and the equipment’s salvage value. The following data was developed:

Scenario Probability # of procedures avg collection salvage value

Worst 0.25 10 $ 60 $100,000

Most likely 0.50 15 $ 80 $200,000

Best 0.25 10 $100 $300,000

c. Finally assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0 – 2.0. The hospital adjusts for risk by adding or subtracting 3 % points to its 10% corporate cost of capital. After adjusting for differential risk, is the project still profitable?

15.4 The managers of Medtronics are evaluating the following four projects for the coming budget period. The firm’s corporate cost of capital is 14%.

PROJECT COST IRR

A $15,000 17%

B $15,000 16%

C $12,000 15%

D $20,000 13%

a. What is the firm’s optimal capital budget?

b. Now suppose Medtronic’s managers want to consider differential risk in the capital budgeting process. Project a has average risk, B has below-average risk and C has an above average risk, and D has average risk. What is the firm’s optimal capital budget when differential risk is considered? (Hint: the firm’s managers lower the IRR of high-risk projects by 3% points and raise the IRR of low risk projects by the same amount).

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