City Hospital, a nonprofit organization, estimates that it can save $28,000 a ye
ID: 2591862 • Letter: C
Question
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. A $5,000 disposal value is expected. City Hospital’s required rate of return is 12%. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation. The income tax rate is 30% for all transactions that affect income taxes.
Required:
Calculate the following for the special-purpose eye-testing machine:
Net present value
Payback period
Return on average investment
What other factors should City Hospital consider in deciding whether to purchase the special-purpose eye-testing machine?
Explanation / Answer
The cash flows:
Year 0: -110000
Year 1 to 9: Net savings after tax + Tax shield on depreciation
= 28000*(1-0.3) + (0.3*(110000-5000)/10)
= 22750
Year 10: 22750 + salvage value = 22750+5000 = 27750
NPV = -110000 + 22750/1.12 + 22750/1.12^2 + 22750/1.12^3 + +++++++ + 27750/1.12^10
= 20152.44
Payback period = 110000/22750 = 4.83 years
Return on average Investment = 22750/110000 = 20.68%
Other factors like quality of testing, ease of use etc. should also be considered.