Question

Dr. Julie Aardvark, 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. Aardvark 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. Unfortunately, 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. Aardvark 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. Compute the NPV and IRR for the project. Should Dr. Aardvark purchase the new equipment? Should she be concerned about payback or the ARR in making this decision?

4. Before finalizing her decision, Dr. Aardvark 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. Aardvark estimated that the net operating cash flows of the procedure would be cut by one-third because of the extra time and cost involved (salvage value would be unaffected). Using this information, re-compute the NPV of the project. What would you now recommend?

Answer 1

Answer with working is given below

Calculation of Cash inflows Cash revenues Cash expenses Cash inflow Year 1 $19,800 $3,000 $16,800 Year 2 $27,000 $3,000 $24,000 Year 3 $32,400 $3,000 $29,400 Year 4 $32,400 $3,000 $29,400 Year Year 1 Year 2 Year 3 Year 4 Cash inflow $16,800 $24,000 $29,400 $29,400 Cumulative Cash inflow $16,800 $40,800 $70,200 $3,800 Balance Payback Initial investment $74,000 3.13 years b) Accounting rate of return Year 1 $19,800 Year 2 $27,000 Year 3 $32,400 Year 4 $32,400 Total $111,600 Cash revenues Less: Cash expenses Depreciation Net Income $3,000 $17,000 -$200 $3,000 $17,000 $7,000 $3,000 $17,000 $12,400 $3,000 $17,000 $12,400 $12,000 $68,000 $31,600 Average net income | $7,900 Accounting Rate of Return Average net income Initial investment $7,900 $74,000 10.7% ARR based on average investment Accounting Rate of Return $7,900 Average investment / $40,000 19.8% c) Year 1 $19,800 $3,000 $16,800 Year 2 $27,000 $3,000 $24,000 Year 3 $32,400 $3,000 $29,400 Calculation of Net present value | Cash revenues Cash expenses Net Cash inflow Salvage value Total Cash inflow PV factor of 12% Present value of cash inflows Less Initial investment Net present value Year 4 $32,400 $3,000 $29,400 $6,000 $35,400 0.6355 $22,497 Total $111,600 $12,000 $99,600 $6,000 $105,600 $16,800 0.8929 $15,000 $24,000 0.7972 $19,133 $29,400 0.7118 $20,926 $77,556 $74,000 $3,556 Calculation of IRR Year o Year 1 Year 2 Year 3 Year 4 IRR -$74,000 $16,800 $24,000 $29,400 $35,400 14.0% New Equipment should be purchased since the NPV is positive and IRR rate is above cost of capital Dr Aardvark should not be concerned about payback and ARR d) Calculation of Net present value Year 1 $13,200 $3,000 $10,200 Year 2 $18,000 $3,000 $15,000 Year 3 $21,600 $3,000 $18,600 Cash revenues Cash expenses Net Cash inflow Salvage value Total Cash inflow PV factor of 12% Present value of cash inflows Less Initial investment Net present value Year 4 $21,600 $3,000 $18,600 $6,000 $24,600 0.6355 $15,634 Total $74,400 $12,000 $62,400 $6,000 $68,400 $10,200 0.8929 $9,107 $15,000 0.7972 $11,958 $18,600 0.7118 $13,239 $49,938 $74,000 -$24,062 Since NPV is negative the project is not recommended