Problem 13-28 Internal Rate of Return; Sensitivity Analysis [LO2] Dr. Heidi Blac
ID: 2382162 • Letter: P
Question
Problem 13-28 Internal Rate of Return; Sensitivity Analysis [LO2]
Dr. Heidi Black is the managing partner of the Crestwood Dental Clinic. Dr. Black is trying to determine whether or not the clinic should move patient files and other items out of a spare room in the clinic and use the room for dental work. She has determined that it would require an investment of $77,190 for equipment and related costs of getting the room ready for use. Based on receipts being generated from other rooms in the clinic, Dr. Black estimates that the new room would generate a net cash inflow of $15,000 per year. The equipment purchased for the room would have a eight-year estimated useful life. (Ignore income taxes.)
Click here to view Exhibit 13B-2, to determine the appropriate discount factor using tables.
Compute the internal rate of return on the equipment for the new room. (Round discount factor to 3 decimal places and final answer to the closest interest rate. Omit the "%" sign in your response.)
Assume that Dr. Black will not purchase the new equipment unless it promises a return of at least 7%. Compute the amount of annual cash inflow that would provide this return on the $77,190 investment.(Round discount factor to 3 decimal places and final answer to the nearest dollar amount. Omit the "$" sign in your response.)
Although eight years is the average life for dental equipment, Dr. Black knows that due to changing technology this life can vary substantially. Compute the internal rate of return if the life of the equipment were (a) six years and (b) ten years, rather than eight years. (Round discount factor to 3 decimal places and final answer to the closest interest rate. Omit the "%" sign in your response.)
Dr. Black is unsure about the estimated $15,000 annual cash inflow from the room. She thinks that the actual cash inflow could be as much as 20% greater or less than this figure.
Assume that the actual cash inflow each year is 20% greater than estimated. Recompute the internal rate of return. (Round discount factor to 3 decimal places and final answer to the closest interest rate. Omit the "%" sign in your response.)
Assume that the actual cash inflow each year is 20% less than estimated. Recompute the internal rate of return. (Round discount factor to 3 decimal places and final answer to the closest interest rate.Omit the "%" sign in your response.)
Dr. Heidi Black is the managing partner of the Crestwood Dental Clinic. Dr. Black is trying to determine whether or not the clinic should move patient files and other items out of a spare room in the clinic and use the room for dental work. She has determined that it would require an investment of $77,190 for equipment and related costs of getting the room ready for use. Based on receipts being generated from other rooms in the clinic, Dr. Black estimates that the new room would generate a net cash inflow of $15,000 per year. The equipment purchased for the room would have a eight-year estimated useful life. (Ignore income taxes.)
Explanation / Answer
a. Dr. Black is unsure about the estimated $15,000 annual cash inflow from the room. She thinks that the actual cash inflow could be as much as 20% greater or less than this figure.
Let Internal rate of return be r
Annual cashflow = (1+20%)*15000 =18000
At r= IRR, NPV =0
-77,190 + 18000/(1+r) + 18000/(1+r)^2 + 18000/(1+r)^3.........18000/(1+r)^8 = 0
By hit and trial, IRR = 16%
Internal rate of return = 16%
b. Assume that the actual cash inflow each year is 20% less than estimated. Recompute the internal rate of return.
Annual cashflow = (1-20%)*15000 =12000
At r= IRR, NPV =0
-77,190 + 12000/(1+r) + 12000/(1+r)^2 + 12000/(1+r)^3.........12000/(1+r)^8 = 0
By hit and trial, IRR = 5%
Internal rate of return = 5%