Because of its inability to control film and personnel costs in its radiology de
ID: 2785842 • Letter: B
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 eyars 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 the new system is five years, and the required rate of return on the project is 7%.
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%, should the existing PAC system to replaced? Use the incremental NPV approach to evaluate the decision.
Explanation / Answer
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.