Question

Styles Q3) (Capital budgeting methods) (25 Marks) City Hospital, a nonprofit organization, estimates that it can save $28,000 a year in cash operating costs for the next 10 years if it buys a special purpose eye testing machine at a cost of $110,000. No terminal disposal value is expected. City Hospital's required rate of return is 14%. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation. Required: 1. Calculate the following for the special-purpose eye-testing machine: a. Net present value I b. Payback period c. Internal rate of return 2. What other factors should City Hospital consider in deciding whether to purchase the special-purpose eye-testing machine? 3. What concept must be considered when looking at cash flows over several years for a long-term investment. Explain 4. What is the weakness of the cash payback approach? tech

Answer 1

A B C D E 1 1 2 A 3 YEAR NET PRESENT VALUE CASHFLOW DISCOUNTING 14% PRESENT VALUE 0 -110000 1 -110000 1 28000 0.877 24561 2 28000 0.769 21545 3 28000 0.675 18899 4 28000 0.592 16578 5 28000 0.519 14542 6 6 28000 12756 7 8 9 12 13 14 15 16 28000 28000 28000 28000 0.456 0.400 0.351 0.308 0.270 11190 9816 8610 7553 10 NET PREESENT VALUE 36051 17

17 18 B 19 YEAR 20 21 22 23 24 25 26 27 28 3.93 YEARS PAYBACK PERIOD CASHFLOW CUMULATIVE 0 -110000 -110000 1 28000 -82000 2 28000 -54000 3 28000 -26000 PAYBACK PERIOD 4 28000 2000 5 28000 30000 6 28000 58000 7 28000 86000 8 28000 114000 9 28000 142000 10 28000 170000 29 30

31 32 C 33 YEAR YEAR 34 CASHFLOW DISCOUNTING 25% PRESENT VALUE 0 -110000 1 -110000 1 28000 0.800 22400 2 28000 0.640 17920 35 36 37 3 28000 0.512 14336 11469 38 4 28000 0.410 INTERNAL RATE OF RETURN USING TRAIL&ERROR INTERPOLATION CASHFLOW DISCOUNTING 20% PRESENT VALUE 0 -110000 1 -110000 1 28000 0.833 23333 2 28000 0.694 19444 3 28000 0.579 16204 4 28000 0.482 13503 5 28000 0.402 11253 6 28000 0.335 9377 7 28000 0.279 7814 28000 0.233 6512 9 28000 0.194 5427 10 28000 0.162 4522 PRESENT VALUE 7389 39 5 28000 0.328 40 6 41 7 9175 7340 5872 4698 3758 42 00 28000 0.262 28000 0.210 28000 0.168 28000 0.134 28000 0.107 PRESENT VALUE 00 43 9 44 10 3006 -10026 45 46 47 IRR 20+(7389/(7389+10026))*(25-20) 22.12 % IRR 48 49

other factors to consider in deciding whether to purchase an eye-testing machine

• staff required to operate
• whether training required to operate
• maintainace like repair
• whether or not the probability of the saving

concept mus be consider for the several years cashflows

• probability of the future cashflow
• inflation
• future taxes
• required rate of return in future

weakness of cash payback period

• it doenot consider the cashflow earned after the cash inflow and outflow equals
• payback period doesnot consider the time value of money