Question

Because of its inability to control film and personnel costs in its radiology department, Sanger General Hospital wants to replace its existing picture archive and communication (PAC) system with a newer version. The existing system, which has a current book value of $2,250,000, was purchased three years ago for $3,600,000 and is being depreciated on a straight-line basis over an eight-year life to a salvage value of $0. This system could be sold for $800,000 today. The new PAC system would reduce the need for staff by eight people per year for five years at a savings of $40,000 per person per year, and it would reduce film costs by $2,000,000 per year. The project would not affect the level of net working capital. The new PAC system would cost $9,000,000 and would be depreciated on a straight-line basis over a five-year life to a salvage value of $0. The economic life of a new system is five years, and the required rate of return on the project is 7 percent.

a) Should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision; assume the hospital is a not-for-profit facility.
b) If the facility were a taxpaying entity with a tax rate of 30 percent, should the existing PAC system be replaced? Use the incremental NPV approach to evaluate the decision. (Hint: see Appendix F.)

INVESTMENT DECISION dgeting CHAPTENT Appendix F: Comprehensive Capi Replacement Cost Example u replacing its man system (MIS) with cally stores EKG and ed five years ago for a salvage value of market price of $20,000 Assume that a cardiology laboratory is considering electrocardiography (EKG) management information new, more efficient product. The new system automatica stress records online. The existing system was purchased $70,000 and is being depreciated over a ten-year life to a $10,000. The old system can be sold now at a market has a book value of $40,000 ($70,000 Original cost - $30.000 depreciation). The new system can be purchased for $100 mated to have a five-year life. It can be depreciated to a $20,000. Because the organization is paid on a per procede are no new revenues directly associated with the impro Thus the focus becomes the cash savings in operational exne Jabor expenses will drop from $50,000 for the old syster for the new system, resulting in a labor cash savings of $35.000 the new system will increase net working capital by $1,000 ear pared with a $300 annual increase for the old system, starti This appendix provides comparative and incremental NPV anal situation, first assuming that the lab is not-for-profit and then that it is investor owned. In both cases the cost of capital is 5 pe 000 Accumulated $100,000 and is esti a salvage value of ocedure basis, there mproved EKG system nal expenses. Annual system to $15,000 5.000. Purchasing 000 each year, com m, starting in year 1. NPV analyses of this and then assuming f capital is 5 percent. h compares the cash Comparative Approach: Not-for-Profit Analysis As its name implies, the comparative approach compares the flows resulting from continuing with the existing alternative to those would result if the equipment were replaced. The comparative an does this by separately calculating each of these cash flows and then paring the end results (Exhibit F.1). d. The comparative approach Were the organization to continue with the existing system, there would be no investment at year 0 (it has already been made), and the oper. ating loss would be $56,000 a year (row D), which includes operating expenses (row B) and depreciation expense (row C). However, because operating loss contains depreciation, and depreciation is an expense that does not require a cash outlay, depreciation must be added back in order to derive cash flows from operations. This is done in row F by adding $6,000 (row E) back to the $56,000 operating loss (row D). Although the same result ($50,000, row F) can be derived without first subtracting and then adding back depreciation expense, this approach makes it easier compare the not-for-profit and for-profit analyses. Because the change net working capital increases by $300 each year, the resultant cash ou

Answer 1

Given, the current book value of Old system= $2,250,000

Price at which the old system is sold= $800,000

Savings in staff by replacement of old system= $40,000*8= $320,000

Reduction in film costs= $2,000,000

Price of new PAC system= $9,000,000

Life of the new PAC system= 5 years

a. It is given that the hospital is a not-for-profit facility. So, neither it would get an tax advantage at selling the old PAC system below its book value or have to pay any taxes for any increase in income.

Initial cash flow due to replacement of old system= -Price of new system is bought+ Price at which old system is sold= -$9,000,000+$800,000 = -$8,200,000

Increase in cash flow per year by replacing the old system= Savings in terms of staff+ Savings in film costs

=$320,000+$2,000,000= $2,320,000

Discounting the yearly incremental cash flow for the next 5 years at the required rate of return of 7% we have,

=$2,320,000/(1.07)+$2,320,000/(1.07^2)+$2,320,000/(1.07^3)+$2,320,000/(1.07^4)+$2,320,000/(1.07^5)

=$9,512,458.05

So, net incremental cash flow in buying the new machine= -$8,200,000+$9,512,458.05 = $1,312,458.05

Therefore, the hospital should buy the new PAC machine if it doesn't pay any taxes.

b. Given, tax rate= 30%

Tax advantage due to selling the old PAC machine at a price below the book value = 30%* ($2,250,000-$800,000)= $435,000

The old machine was bought at $3,600,000 and depreciated over 8 years while the new machine is being bought at $9,000,000 and is being depreciated over the next 5 years.

So change in depreciation costs= 9,000,000/5 - 3,600,000/8 = $1,800,000-450,000 = $1,350,000

Yearly incremental profit by buying the new machine= Savings in terms of staff+ Savings in film costs- Increase in depreciation costs

=$320,000+$2,000,000-$1,350,000

=$970,000

So, income tax paid on the incremental profit= 30%*$970,000= $291,000

Now, taking the incremental cash flow from the above part a and adjusting it for the yearly income tax paid we have,

=Savings in terms of staff+ Savings in film costs- Incremental income tax paid

=$320,000+$2,000,000-$291,000

=$2,029,000

Discounting the yearly incremental cash flow for the next 5 years at the required rate of return of 7% we have,

=$2,029,000/(1.07)+$2,029,000/(1.07^2)+$2,029,000/(1.07^3)+$2,029,000/(1.07^4)+$2,029,000/(1.07^5)

=$8,319,300.60

So, incremental cash flow in buying the machine= -Cost of buying the new machine+After tax Proceeds from the selling the old machine+ Present value of future cash flows due to buying the new machine

=-$9,000,000 + ($800,000+$435,000) + $8,319,300.60

=$554300.60

Therefore, the hospital should buy the new machine as there is a net positive cash flow.