California Imaging Center, a not-for-profit business, is evaluating the purchase of new diagnostic equipment. The equipment, which costs $600,000, has an expected life of five years and an estimated 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 cash collections during the first year of use. Thus, net revenues for Year 1 are estimated at 15 × 250 × $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 are expected to increase at a 5 percent inflation rate after the first year. The center's corporate cost of capital is 10 percent.
a. Estimate the project's net cash flows over its five-year estimated life. (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
Operating income
Equipment salvage value __________________________________
Net cash flow __________________________________
b. What are the project's NPV and IRR? (Assume for now that the project has average risk.)
c. Assume the project is assessed to have high risk and California Imaging Center adds or subtracts 3 percentage points to adjust for project risk. Now, what is the project's NPV? Does the risk assessment change how the project's IRR is interpreted?
5. 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 percent.
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 capital budget?
b. Now, suppose Medtronics's 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 firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)