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Replacement Decision, Computing After-Tax Cash Flows, Basic NPV Analysis

Okmulgee Hospital (a large metropolitan for-profit hospital) is considering replacing its MRI equipment with a new model manufactured by a different company. The old MRI equipment was acquired three years ago, has a remaining life of five years, and will have a salvage value of $100,000. The book value is $2,000,000. Straight-line depreciation with a half-year convention is being used for tax purposes. The cash operating costs of the existing MRI equipment total $1,000,000 per year.

The new MRI equipment has an initial cost of $5,000,000 and will have cash operating costs of $500,000 per year. The new MRI will have a life of five years and a salvage value of $1,000,000 at the end of the fifth year. MACRS depreciation will be used for tax purposes. If the new MRI equipment is purchased, the old one will be sold for $500,000. The company needs to decide whether to keep the old MRI equipment or buy the new one. The cost of capital is 12 percent. The combined federal and state tax rate is 40 percent.

You must use the Exhibit 19B.1 and Exhibit 19B.2 present value tables and Exhibit 19.5 to solve the following problem.

Required:

Compute the NPV of each alternative. When required, round your computations and final answers to the nearest dollar. If the NPV is negative, enter your answer as a negative value.

Old MRI equipment $
New MRI equipment $

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Bunny Greenfelder
Bunny GreenfelderLv2
28 Sep 2019

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  1. Penn Medical Center, a for-profit hospital, is considering the purchase of a new 64-slice CT scanner. The cost of the new scanner is $5 million and will be depreciated over 10 years on a straight line basis to $0 savage value. The tax rate is 40%. The financing options include either borrowing the full cost of the scanner or leasing a scanner. The lease option is a 5-year lease with equal before-tax lease payments of $950,000 per year. The borrowing alternative is a 5-year loan covering the entire cost of the scanner at an interest rate of 5%. The after-tax cost of debt is 3%. Should Penn Medical lease the equipment or borrow the money?



    4. Marshall Healthcare System, a not-for-profit hospital, is planning on opening an imaging center including MRI, x-ray, ultrasound, and CT. The new center will generate $3 million per year in revenues for 5 years. Expected operating expenses, excluding depreciation, would increase expenses by $1.2 million per year over the life of the project. The initial capital investment outlay for the project is $5 million, which will be depreciated on a straight line basis to a savage value. The salvage value in year 5 is $800,000. The cost of capital for this project is 12%.

The Board of Trustees has decided that we should attempt to expand our service offering. They want you to evaluate the information below and determine if this is a project we should move forward with.

The MRI Trailer costs $600,000 and has an expected life of 5 years with an estimated salvage value of $200,000 at that time. After some extensive research, the numbers we have come up with look like this:

  • 15 tests per day for 250 days per year for each year of the projects life
  • Each procedure is expected to generate $80 in cash collections during the first year of use (Net revenue for year 1 is 15*250*80=$300,000)
  • Labor and Maintenance costs are expected to be $100,000 during the first year
  • Utilities will cost $10,000 in year one and there is an incremental overhead increase of $5,000 beginning in year one
  • Cost for expendable supplies is expected to be $5 per procedure
  • Costs and revenues are expected to increase at a 5% inflation rate
  • Our corporate cost of capital is 10%

In the Excel spreadsheet template:

  • estimate the project's net cash flow over the 5 year estimated life. I want you to use the properties (formulas) in Excel here.
  • determine the project's NPV and IRR (Use the excel formulas to determine this as well)
  • Is this a project we should move forward with? (Consider NPV and strategic value here)---This can be written in text into your excel sheet.

This is how is should be set up on the excel sheet:

MRI Trailer Purchase Year
0 1 2 3 4 5
Equipment Cost
Net Revenues
Less: Labor/Maintenance Costs
Utilities Costs
Supplies
Incremental Overhead
Operating Income
Equipment Salvage Value
Net Cash Flow
Net Present Value (NPV)
Internal Rate of Return (IRR)

A company wants to update their assets by buying some new machinery and selling some old equipment. The new machinery will cost $100,000 and will be depreciated using 3-year MACRS (33%, 45%, 15%, 7%). At the end of the third year, the machinery is expected to be sold for $10,000. The old equipment was bought three years ago for $60,000 and was being depreciated over four years using straight-line depreciation. It can be sold today for $10,000. If they do not buy the new machinery and replace the old equipment, then the old equipment is expected to be held for another three years at which point it will be worthless. Regardless of whether they buy the new machinery, Sales will be $500,000 for the next three years, but COGS will fall from 70% of Sales to 60% of Sales if they buy the new machinery. The tax rate is 40%.

Balance Sheet Effects ......|-----------Depreciation Expenses------------|

Today ---------------------------Year 1 Year 2 Year 3 --------------------------End

1. Buy New Assets

2. Sell Old Assets

Income Statement Effects... Year 1 Year 2 Year 3

Net Sales

-Net COGS

-Net Depreciation

= Net OEBT

- Net Taxes

= Net OEAT

+ Net Depreciation

= Net Operating CF

11. What is the Net Investment (Initial Cash Outflow or CF0) for this project?

12. What is the Depreciation Expense in year one?

13. What is the Operating Cash Flow in year two for this project?

14. What is the after tax salvage value of selling the new machinery in three years?

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