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 $90 in collections which is net bad debt losses and contractual allowances in its first year of use. Thus net revenues for Year 1 are estimated at 15x 250 x $80 = $300,000.
a. Perform a sensitivity analysis to see how NPV is affected by changes in number of procedures per day, average collection amount 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 were developed:
Scenario Probability # of procedure Average collection equip. salvage value
Worst 0.25 10 $60 $100,000
Most likely 0.50 15 $80 $200,000
Best 0.25 20 $100 $300,000
c. Assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0-2.0. The 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 % points to its 10% corporate cost of capital. After adjusting for differential risk is the project still profitable?
d. What type of risk was measured and accounted for in parts b and c?
e. Should this be of concern to the hospital’s managers?
8. The managers of United 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. Suppose Medtronics managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk and D has average risk. What is the firms optimal capital budget when differential risk is considered? (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).
