A B C D E F G H

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5 PROBLEM 1
6 The Jim Beam Memorial Clinic is evaluating a project that costs $75,000 and has expected net cash flows of $9,000 per
7 year for ten years. The first inflow occurs one year after the cost outflow, and the project has a cost of
8 capital of 8 percent.
9 a. What is the project's payback?
10 b. What is the project's NPV? Its IRR?
11 c. Is the project financially acceptable? Explain your answer.
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13 ANSWER
14 a.
15 Here is the table of cash flows for the project:
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17 Annual Cumulative Annual Cumulative
18 Year Cash Flow Cash Flow Year Cash Flow Cash Flow
19 0 -$75,000 -$75,000 0 -$52,125 -$52,125
20 1 $9,000 -$66,000 1 $12,000 -$40,125
21 2 $9,000 -$57,000 2 $12,000 -$28,125
22 3 $9,000 -$48,000 3 $12,000 -$16,125
23 4 $9,000 -$39,000 4 $12,000 -$4,125
24 5 $9,000 -$30,000 5 $12,000 $7,875
25 6 $9,000 -$21,000 6 $12,000 $19,875
26 7 $9,000 -$12,000 7 $12,000 $31,875
27 8 $9,000 -$3,000 8 $12,000 $43,875
28 9 $9,000 $6,000
29 10 $9,000 $15,000
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31 The cumulative cash flows indicate that the project breaks even in Year 8. Note that the project has a
32 $3,000 cumulative shortfall going into Year 8. If we assume that the cash flows occur evenly during the
33 year, then breakeven will occur $3,000 / $9,000 = 0.33 of the way into Year 8. Thus, the project's
34 payback is 8.33 years.
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36 b.
37 The project's NPV (at a discount rate of 8 percent) is -$14,609.27, and its IRR is 3.46 percent.
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39 c.
40 The project has a negative NPV (and hence its IRR is lower than the cost of capital), so it is NOT financially
41 acceptable.
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43 Spreadsheet solution:
44 Payback 8.33 =B27+(-D27/C28) 8.33 years
45 NPV ($14,609.27) =NPV(0.08,C20:C29)+C19 NPV > 0
46 IRR 3.46% =IRR(C19:C29) IRR > WACC(3.46% : 8%)
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l), so it is NOT financially
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 A B C D E F G H
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5 PROBLEM 2
6 Assume that you are the CFO at J. Daniels Memorial Hospital. The CEO has asked you to
7 analyze two proposed capital investments--Project A and Project B. Each project requires a net
8 investment outlay of $20,000, and the cost of capital for each project is 10 percent. The project's expected
9 net cash flows are as follows:
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11 Year Project A Project B
12 0 -$20,000 -$20,000
13 1 $8,500 $12,250
14 2 $5,000 $4,000
15 3 $5,000 $4,000
16 4 $5,000 $4,000
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18 a. Calculate each project's payback period, net present value (NPV), and internal rate of return (IRR).
19 b. Which project (or projects) is financially acceptable? Explain your answer.
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21 ANSWER
22 a.
23 Here are the projects' cash flows, paybacks, NPVs (at 10 percent), and IRRs:
24 Spreadsheet solution:
25 Project A Project A Project B Project B
26 Annual Cumulative Annual Cumulative
27 Year Cash Flow Cash Flow Cash Flow Cash Flow Payback
28 0 $ (20,000) $ (20,000) $ (20,000) $ (20,000) NPV
29 1 $ 8,500 $ (11,500) $ 12,250 $ (7,750) IRR
30 2 $ 5,000 $ (6,500) $ 4,000 $ (3,750)
31 3 $ 5,000 $ (1,500) $ 4,000 $ 250 Payback
32 4 $ 5,000 $ 3,500 $ 4,000 $ 4,250 NPV
33 Payback 3.30 years 2.94 years IRR
34 NPV $ (968.85) No $ 179.46 Yes
35 IRR 7.51% No 10.53% Yes Payback
36 NPV
37 Project A Project A Project B Project B IRR
38 Annual Cumulative Annual Cumulative
39 Year Cash Flow Cash Flow Cash Flow Cash Flow
40 0 $ (10,000) $ (10,000) $ (10,000) $ (10,000)
41 1 $ 6,500 $ (3,500) $ 3,000 $ (7,000)
42 2 $ 3,000 $ (500) $ 3,000 $ (4,000)
43 3 $ 3,000 $ 2,500 $ 3,000 $ (1,000)
44 4 $ 1,000 $ 3,500 $ 3,000 $ 2,000
45 Payback 0.50 years 3.33 years
46 NPV $ 1,325.39 No $ (490.40) Yes
47 IRR 18.03% No 7.71% Yes
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 A B C D E F G H
49 b.
50 Project X has a negative NPV (and its IRR is less than the 10 percent cost of capital), while Project Y
51 has a positive NPV (and an IRR that is more than its cost of capital). Therefore, Project Y is financially
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Spreadsheet
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26 Project X
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28 ($969)
29 7.5%
30 Project Y
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32 $179
33 10.5%
34 Project X
35 $ 2.17
36 $ 966.01
37 18%
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Project Y is financially
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 A B C D E F G H
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5 PROBLEM 3
6 Tito's Health Plan, Inc. is evaluating two different methods for providing home health services to its
7 members. Both methods involve contracting out for services, and the health outcomes and revenues are
8 not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows.
9 Here are the projected flows:
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11 Year Method A Method B
12 0 -$500,000 -$750,000
13 1 -$95,000 -$35,000
14 2 -$95,000 -$35,000
15 3 -$95,000 -$35,000
16 4 -$95,000 -$35,000
17 5 -$95,000 -$35,000
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19 a. What is each alternative's IRR?
20 b. If the cost of capital for both methods is 7.5 percent, which method should be chosen? Why?
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22 ANSWER
23 a.
24 If you use a spreadsheet to obtain the IRR, you will receive an error (no solution) message. Because there
25 are no inflows associated with the projects, they do not have IRRs.
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27 b.
28 At a 7.5 percent discount rate, the PV of costs for Method A is -$884,359, while the PV of costs for Method
29 B is -$891,606. Because Method A is the lower cost alternative, it should be chosen.
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31 Spreadsheet solution:
32 Method A
33 IRR Err:523 =IRR(C12:C17)
34 NPV ($884,359) =NPV(0.075,C13:C17)+C12
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36 Method B
37 IRR Err:523 =IRR(D12:D17)
38 NPV ($891,606) =NPV(0.075,D13:D17)+D12
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tcomes and revenues7 are
he decision are all outflows.
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on) message. Because 24there
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 A B C D E F G H
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5 PROBLEM 4
6 The Deep Eddy Health Center, a for-profit hospital, is evaluating the purchase of new diagnostic equipment.
7 The equipment, which costs $800,000, has an expected life of five years and an estimated pre-tax salvage
8 value of $300,000 at that time. The equipment is expected to be used 20 times a day for 250 days a year
9 for each year of the project's life. On average, each procedure is expected to generate $100 in collections,
10 which is net of bad debt losses and contractual allowances, in its first year of use. Thus, net revenues for
11 Year 1 are estimated at 20 X 250 X $100 = $500,000.
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13 Labor and maintenance costs are expected to be $125,000 during the first year of operation, while utilities
14 will cost another $15,000 and cash overhead will increase by $7,500 in Year 1. The cost for expendable
15 supplies is expected to average $10 per procedure during the first year. All costs and revenues, except
16 depreciation, are expected to increase at a 3 percent inflation rate after the first year.
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18 The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to the
19 following depreciation allowances:
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21 Year Allowance
22 1 20%
23 2 32%
24 3 19%
25 4 12%
26 5 11%
27 6 6%
28 100%
29 The hospital's tax rate is 35 percent, and its corporate cost of capital is 8 percent.
30 a. Estimate the project's net cash flows over its five-year estimated life.
31 b. What are the project's NPV and IRR? (Assume that the project has average risk.)
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 A B C D E F G H
33 ANSWER
34 a.
35 Here are the project's cash flows:
36 0 1 2 3 4
37 Equipment cost -$600,000
38 Net revenues $500,000 $515,000 $530,450 $546,364
39 Less: Labor/maintenance costs -$125,000 -$128,750 -$132,613 -$136,591
40 Utilities costs -$15,000 -$15,450 -$15,914 -$16,391
41 Supplies -$18,750 -$19,313 -$19,892 -$20,489
42 Incremental overhead -$5,000 -$5,150 -$5,305 -$5,464
43 Depreciation -$120,000 -$192,000 -$114,000 -$72,000
44 Operating income $216,250 $154,338 $242,728 $295,429
45 Taxes -$75,688 -$54,018 -$84,955 -$103,400
46 Net operating income $140,563 $100,319 $157,773 $192,029
47 Plus: Depreciation $120,000 $192,000 $114,000 $72,000
48 Plus: After-tax equipment salvage value*
49 Net cash flow -$600,000 $260,563 $292,319 $271,773 $264,029
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51 Here are the project's cash flows:
52 0 1 2 3 4
53 Equipment cost -$800,000
54 Net revenues $300,000 $309,000 $318,270 $327,818
55 Less: Labor/maintenance costs -$100,000 -$103,000 -$106,090 -$109,273
56 Utilities costs -$10,000 -$10,300 -$10,609 -$10,927
57 Supplies -$50,000 -$51,500 -$53,045 -$54,636
58 Incremental overhead -$7,500 -$7,725 -$7,957 -$8,195
59 Depreciation $0 -$256,000 -$152,000 -$96,000
60 Operating income $132,500 -$119,525 -$11,431 $48,786
61 Taxes -$46,375 $41,834 $4,001 -$17,075
62 Net operating income $86,125 -$77,691 -$7,430 $31,711
63 Plus: Depreciation $0 $256,000 $152,000 $96,000
64 Plus: After-tax equipment salvage value*
65 Net cash flow -$800,000 $86,125 $178,309 $144,570 $127,711
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38 $562,754
39 -$140,689
40 -$16,883
41 -$21,103
42 -$5,628
43 -$66,000
44 $312,452
45 -$109,358
46 $203,094
47 $66,000
48 $207,600
49 $476,694
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54 $337,653
55 -$112,551
56 -$11,255
57 -$56,275
58 -$8,441
59 -$88,000
60 $61,130
61 -$21,395
62 $39,734
63 $88,000
64 $0
65 $127,734
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