The director of capital budgeting for Big Sky Health Systems, Inc., has estimate
ID: 2788346 • Letter: T
Question
The director of capital budgeting for Big Sky Health Systems, Inc., has estimated the following cash flows in thousands of dollars for a proposed new service: Year Expected Net Cash Flow 0 ($100) 1 70 2 50 3 20 The project’s cost of capital is 10 percent.
Is the new service financially viable? What recommendations would you make to the board regarding this service? Would the recommendation be the same if there was an opportunity cost involved of $15,000 (total) in today’s dollars obtained by renting the space involved in the new service to an outside entity for 3 years? Why or why not?
Explanation / Answer
Calculation of the net present value of proposed service project :
Since NPV of this project is positive, The project is financially viable and it is recommended to opt this project.
Now,
If there is an opportunity cost in present value terms of $15000, the recommendation is still the same i.e, to opt for the service project and not renting. This is because the service project after considering the opportunity cost is still financially viable to the extent of $4984.97 (i.e, $19984.97-$15000).
Note
1.$15,000 is basically the NPV of the Renting alternative, Hence it can be compared directly with the NPV of the project.
Year Expected cash flow PV @ 10% 1 70000 63636.36 2 50000 41322.31 3 20000 15026.30 Present value of cash inflows 119984.97 Initial outflow 100000 Net present value 19984.97