**Chapter 11**

**PROBLEM 1 **

Winston Clinic is evaluating a project that costs $52,125 and has expected net cash flows of $12,000 per year for eight years. The first inflow occurs one year after the cost outflow, and the project has a cost of capital of 12 percent.

- What is the project’s payback?
- What is the project’s NPV? Its IRR?
- Is the project financially acceptable? Explain your answer.

ANSWER

**PROBLEM 3 **

Capitol Health Plans, Inc., is evaluating two different methods for providing home health services to its members. Both methods involve contracting out for services, and the health outcomes and revenues are not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows.

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

- What is each alternative’s IRR?
- If the cost of capital for both methods is 9 percent, which method should be chosen? Why?

ANSWER

**PROBLEM 5 **

Assume that you are the CFO at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments: Project X and Project Y. Each project requires a net investment outlay of $10,000, and the cost of capital for each project is 12 percent. The project’s expected net cash flows are as follows:

Year Project X Project Y

0 -$10,000 -$10,000

1 $6,500 $3,000

2 $3,000 $3,000

3 $3,000 $3,000

4 $1,000 $3,000

- Calculate each project’s payback period, net present value (NPV), and internal rate of return (IRR).
- Which project (or projects) is financially acceptable? Explain your answer.

ANSWER

**PROBLEM 7 **

California Health Center, a 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 a 5 percent inflation rate after the first year.

The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to the following depreciation allowances:

Year Allowance

1 0.2

2 0.32

3 0.19

4 0.12

5 0.11

6 0.06

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

- Estimate the project’s net cash flows over its five-year estimated life.
- What are the project’s NPV and IRR? (Assume that the project has average risk.)

(Hint: Use the following format as a guide.)

Year

0 1 2 3 4 5

Equipment cost

Net revenues

Less: Labor/maintenance costs

Utilities costs

Supplies

Incremental overhead

Depreciation

Operating income

Taxes

Net operating income

Plus: Depreciation

Plus: After-tax equipment salvage value*

Net cash flow

*

Pretax equipment salvage value

MACRS equipment salvage value

Difference

Taxes

After-tax equipment salvage value