Hell's Pass Hospital is evaluating an experimental oncology treatment. The treatment is currently under review for Medicare reimbursement and legislative experts believe the treatment has a 70% chance of receiving approval for
Medicare reimbursement. If the the procedure is approved it has an expected volume of 110 procedures per year and only 40 procedures per year if not approved. Each procedure generates $30,000 in revenues and has $10,000
in variable costs. The price does not depend on approval, just the quantity. The equipment is $5m and would last for five years but may be scrapped for $3m at the end of year 1.Hell's Pass Hospital is a not-for-profit institution with an 8% cost of capital; however, the CFO recomends using a 12% discount rate as the project is relatively risky. Note that expected volume will be 40 during year 1 and would then rise to 110 during years 2-5 only if the procedure is approved.
| Upfront costs |
$5,000,000 |
| 1-year scrap value |
$3,000,000 |
| Revenues per procedure |
$30,000 |
| Costs per procedure |
$10,000 |
| Volume | approval |
110 |
| Volume | no approval |
40 |
| Project cost of capital |
12% |
| Corporate cost of capital |
8% |
Questions
a) Evaluate whether investment now (time=0) is financially acceptable without using options.
b) Now evaluate the project allowing for abandonment at the end of year 1.
c) Can you suggest a different option that might be a better strategy for this scenario?