Question: Review of Basic Capital Budgeting Procedures Dr. Whitley Avard, a plastic surgeon, had just returned from a conference in which she learned of a new surgical procedure for removing wrinkles around eyes, reducing the time to perform the normal procedure by 50 percent. Given her patient-load pressures, Dr. Avard is excited to try out the new technique. By decreasing the time spent on eye treatments or procedures, she can increase her total revenues by performing more services within a work period. In order to implement the new procedure, special equipment costing $74,000 is needed. The equipment has an expected life of four years, with a salvage value of $6,000. Dr. Avard estimates that her cash revenues will increase by the following amounts:
Year Revenue Increases
1 $ 19,800
2 27,000
3 32,400
4 32,400
She also expects additional cash expenses amounting to $3,000 per year. The cost of capital is 12 percent. Assume that there are no income taxes.
Required: 1. Compute the payback period for the new equipment.
2. Compute the ARR.
3. Conceptual Connection: Compute the NPV and IRR for the project. Should Dr. Avard purchase the new equipment? Should she be concerned about payback or the ARR in making this decision?
4. Conceptual Connection: Before finalizing her decision, Dr. Avard decided to call two plastic surgeons who have been using the new procedure for the past six months. The conversations revealed a somewhat less glowing report than she received at the conference. The new procedure reduced the time required by about 25 percent rather than the advertised 50 percent. Dr. Avard estimated that the net operating cash flows of the procedure would be cut by onethird because of the extra time and cost involved (salvage value would be unaffected). Using this information, recompute the NPV of the project. What would you now recommend?