Consider the project contained in Problem 7 in Chapter 11 (California Health Center).
Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value. Remember supplies vary with number of procedures.
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. Furthermore, the following data were developed:
Number of Average Salvage
Scenario Probability Procedures Collection Value
Worst 0.25 10 $60 $100,000
Most likely 0.50 15 $80 $200,000
Best 0.25 20 $100 $300,000
Finally, assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0 – 2.0. (Hint: Coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?
What type of risk was measured and accounted for in Parts b. and c.? Should this be of concern to the hospital’s managers?
Allied Managed Care Company is evaluating two different computer systems for handling provider claims.There are no incremental revenues attached to the projects, so the decision will be made on the basis of the present value of costs. Allied’s corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:
Year System X System Y
0 -$500 -$1,000
1 -$500 -$300
2 -$500 -$300
3 -$500 -$300
Assume initially that the systems both have average risk. Which one should be chosen?
Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its corporate cost of capital up or down by 2 percentage points. Which system should be chosen?
Michigan Home Health is considering opening an office in a new market. The organization has identified the number of home visits, revenue per home visit, and the level of fixed costs of the new office as being the major sources of uncertainty in the investment decision. To get a better understanding of the sensitivity of the new office NPV to these variables, the following data have been assembled:
from Number Revenue Level of
base of home per home fixed
case visits visit costs
-30% -$814 -$57 $82
-20% -$515 -$11 $82
-10% -$216 $36 $82
0% $82 $82 $82
10% $381 $129 $82
20% $680 $176 $82
30% $979 $222 $82
Construct a graph to show the sensitivity of the new office NPV to each variable.
Big Sky Hospital plans to obtain a new MRI that costs $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI, or it can obtain a guideline lease for the equipment. Assume that the following facts apply to the decision:
– The MRI falls into the three-year class for tax depreciation, so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively.
– Estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.
– Big Sky’s marginal tax rate is 40 percent.
– The bank loan would have an interest rate of 15 percent.
– If leased, the lease payments would be $400,000 payable at the end of each of the next four years..
– The estimated residual (and salvage) value is $250,000.
What are the NAL and IRR of the lease? Interpret each value.
Assume now that the salvage value estimate is $300,000, but all other facts remain the same. What is the new NAL? The new IRR?
(Hint: Use the following format as a guide.)
Year 0 Year 1 Year 2 Year 3 Year 4
Cost of owning:
Net purchase price
Maintenance tax savings
Depreciation tax savings
Tax on residual value
Net cash flow
Cost of leasing:
Lease tax savings
Maintenance tax savings
Net cash flow
Net advantage to leasing:
PV cost of leasing
PV cost of owning
Walton Nursing Home (WNH) is evaluating a guideline lease agreement on laundry equipment that costs $250,000 and falls into the MACRS three-year class. The home can borrow at an 8 percent rate on a four-year loan if WHN decided to borrow and buy rather than lease. The laundry equipment has a four-year economic life, and its estimated residual value is $50,000 at the end of Year 4. If WHN buys the equipment, it would purchase a maintenance contract which costs $5,000 per year, payable at the beginning of each year. The lease terms, which include maintenance, call for a $71,000 lease payment at the beginning of each year. WNH’s tax rate is 40 percent. Should the home lease or buy?