Question

Sturgis Medical Clinic (SMC) in Sturgis, SD is considering investing in new medical imaging equipment that would increase its capacity to provide added services to treat patients. The machine will have a 5 year expected life. The projected annual cash flows related to this investment are as follows:

Investment in new medical equipment $ 450,000

Shipping cost for new equipment $ 20,000

Installation of new medical equipment 25,000

Travel and training for staff 65,000

Added customer accounts receivable fully Recovered in year 5 is 60,000

Power upgrade to handle new equipment 15,000

The projected incremental annual income statement related to the services to be provided by the new machine appear below:

Added billed revenue: $600,000

Expected uncollectibles and insurance adjustments 65,000

Operating expenses (supplies, salaries and fringe, etc.) 335,000

Depreciation (Straight line is used on the books) 80,000

Expected salvage value after 5 years 50,000

Sturgis corporate income tax rate is 35%

Sturgis uses MACRS depreciation on their tax return. The MACRS 5 year depreciation percentages multiplied by the cost of the asset using the ½ year rule are:

Year 1 20% Year 2 32% Year 3 19.2% Year 4 11.52% Year 5 11.52%.

SMC has an after-tax minimum required return on investments of 10%. At the end of 5 years SMC expects they could remove and sell the medical equipment to a smaller medical center for a net (after costs of removal) cash payment of $75,000. SMC also expects to recover the added working capital (customer accounts receivable) associated with this project.

Required (show your calculations):

a) Calculate the annual after-tax cash flow for each of the 5 years that would result from acquiring the medical equipment.

b) Calculate the Accounting Rate of Return for each of the 5 years and the five year average (ARR).

c) Calculate the Payback Period for the investment in years and months.

d) Calculate the Net Present Value (NPV) of this investment.

e) Calculate the Profitability Index of this investment.

f) Calculate the Internal Rate of Return (IRR) for this investment.

g) Based upon your calculations should SMC make this investment?

h) Justify your answer in g above.

Answer 1

Required return on Investments	10%
Cashoutflow
Investment in Medical equipment	$   450,000
Installation of New Medical equipment	$      25,000
Shipping cost for new equipment	$      20,000
Travel and Training for staff	$      65,000
Power upgrade to handle new equipment	$      15,000
Total cashoutflow	$   575,000
Income Tax rate	35%
A/Cashinflow calculation
Details	Year 1	Year 2	Year 3	Year 4	Year 5
Billed revenue	$   600,000	$   600,000	$     600,000	$   600,000	$   600,000
Uncollectibles and insurance	$   (65,000)	$   (65,000)	$     (65,000)	$   (65,000)	$   (65,000)
Operating Expenses	$ (335,000)	$ (335,000)	$   (335,000)	$ (335,000)	$ (335,000)
Revenue before tax	$   200,000	$   200,000	$     200,000	$   200,000	$   200,000
Deprication %	20.00%	32.00%	19.20%	11.52%	11.52%
Deprication	$      90,000	$   144,000	$        86,400	$      51,840	$      51,840
Net income after deprication	$   110,000	$      56,000	$     113,600	$   148,160	$   148,160
Taxes	$      38,500	$      19,600	$        39,760	$      51,856	$      51,856
Net profit	$      71,500	$      36,400	$        73,840	$      96,304	$      96,304
Net cash inflow	$   161,500	$   180,400	$     160,240	$   148,144	$   148,144

B/Calculation of accounting return
Accounting return
Details	Year 1	Year 2	Year 3	Year 4	Year 5
Billed revenue	$   600,000	$   600,000	$     600,000	$   600,000	$   600,000
Uncollectibles and insurance	$   (65,000)	$   (65,000)	$     (65,000)	$   (65,000)	$   (65,000)
Operating Expenses	$ (335,000)	$ (335,000)	$   (335,000)	$ (335,000)	$ (335,000)
Revenue before tax	$   200,000	$   200,000	$     200,000	$   200,000	$   200,000
Deprication %	20.00%	32.00%	19.20%	11.52%	11.52%
Deprication	$      80,000	$      80,000	$        80,000	$      80,000	$      80,000
Net income after deprication	$   120,000	$   120,000	$     120,000	$   120,000	$   120,000
Taxes	$      38,500	$      19,600	$        39,760	$      51,856	$      51,856
Net profit	$      81,500	$   100,400	$        80,240	$      68,144	$      68,144
Accoutning return	14%	17%	14%	12%	12%
Average cash inflow	$      79,686
Average return	14%

C.Payback period calculation
	Cashinflow	Cum cashinflow
Year 1	$   161,500	$   161,500
Year 2	$   180,400	$   341,900
Year 3	$   160,240	$   502,140
Year 4	$   148,144	$   650,284
Year 5	$   148,144	$   798,428
Cashflow required to achieve 575000 lies in between year 3 and year 4
Payback period	3+(575000-502140/(650000-502140))
Payback period in years	3.49276342
Payback period in years and months	3 year and 6 months

D.NPV calculation
	Cashinflow	Discount fact	Discount cashflow
Year 1	$     161,500	0.91	$                   146,818
Year 2	$     180,400	0.83	$                   149,091
Year 3	$     160,240	0.75	$                   120,391
Year 4	$     148,144	0.68	$                   101,184
Year 5	$     148,144	0.62	$                     91,986
Cashinflow in year 5 due to collection	$        60,000	0.62	$                     37,255
Cashinflow in year 5 due to sale of Medical equipment	$        75,000	0.62	$                     46,569
Total Cashinflow			$                   693,294
Cashoutflow
Cashoutflow at the project	$     575,000
cashoutflow due increase in receivable	$        60,000
	$     635,000		$                   635,000
NPV calculation at 10%			$                     58,294

E.Profitability index calculation
Profitability Index	Discounted value of cashinflows/ Discounted value of Cashoutflows
	693294/635000	1.09

F IRR calculation
IRR calculation at 13%		1.1
	Cashinflow	Discount fact	Discount cashflow
Year 1	$                                                  161,500	0.88	$                   142,920
Year 2	$                                                  180,400	0.78	$                   141,280
Year 3	$                                                  160,240	0.69	$                   111,054
Year 4	$                                                  148,144	0.61	$                     90,859
Year 5	$                                                  148,144	0.54	$                     80,407
Cashinflow in year 5 due to collection	$                                                    60,000	0.48	$                     28,819
Cashinflow in year 5 due to sale of Medical equipment	$                                                    75,000	0.43	$                     31,880
Total Cashinflow			$                   627,219
Cashoutflow
Cashoutflow at the project	$                                                  575,000
cashoutflow due increase in receivable	$                                                    60,000
	$                                                  635,000		$                   635,000
NPV calculation at 13%			$                     (7,781)
IRR calculation at 12%		1.1
	Cashinflow	Discount fact	Discount cashflow
Year 1	$                                                  161,500	0.89	$                   144,196
Year 2	$                                                  180,400	0.80	$                   143,814
Year 3	$                                                  160,240	0.71	$                   114,056
Year 4	$                                                  148,144	0.64	$                     94,148
Year 5	$                                                  148,144	0.57	$                     84,061
Cashinflow in year 5 due to collection	$                                                    60,000	0.51	$                     30,398
Cashinflow in year 5 due to sale of Medical equipment	$                                                    75,000	0.45	$                     33,926
Total Cashinflow			$                   644,599
Cashoutflow
Cashoutflow at the project	$                                                  575,000
cashoutflow due increase in receivable	$                                                    60,000
	$                                                  635,000		$                   635,000
NPV calculation at 12%			$                       9,599
To calculate IRR the NPV of the project should be zero which lies between 12% and 13%
IRR	12% +	9599/(9599+7781)
IRR %	12.55%

G/ SMC SHOULD MAKE THIS INVESTMENT

H/ SMC SHOULD MAKE THIS INVESTMENT AS THE NPV IS POSTIVE AND IRR IS > 10 %