A Discounted Cash Flow Analysis Problem

A Cancer Testing Center has been presented with a proposal to offer a new diagnostic procedure that would require the purchase of a specialized piece of equipment. This piece of equipment offers physicians the opportunity to diagnose many types of cancers. You have been asked by the Center's administrator to use the techniques of preparing a discounted cash flow analysis to evaluate it from an economic point of view by computing the Net Present Value and Internal Rate of Return.

Assumptions:

For your analysis assume that the Center uses a 6% discount rate for projects of this risk level, and that they will initially use a five-year time horizon. This is a tax-exempt not-for-profit organization so there will not be any income tax effects to consider in the calculations.

The business after buying the equipment is expected to generate gross revenues of $130,000 each year in the first two years and is expected to be $175,000 each year in the next two years, followed by $220,000 in the fifth year. The services will be paid for by third parties and there is a demand for this new service. Since the third-party payers will pay less than the full charge, assume that deductions from revenue to average 20% of gross revenues in each of the five years. The equipment cost is $375,000 and will cost $30,000 to install. After five years the equipment will be retired, and it is expected that it could be sold for $40,000.

The costs for the service include part-time staffing costs of $14,000 and supply costs of $12,000 in each of the first two years. For the following two years, salaries are expected to be $16,000 and supplies are estimated to be $14,000; and in the last year five, salaries are expected to be $25,000 and supplies are expected to be $20,000. The equipment is under warranty in the first year so there is no extra fee paid. A maintenance contract costing $7,000 per year will be paid in years 2 through 5.

Required:

1. Use the template spreadsheet and 8-step process to enter the above assumptions in the appropriate cells.

2. Compute the Net Present Value of Future Cash Flows, and the Internal Rate of Return. Highlight in yellow those two answers on your spreadsheet. Note those answers in the table below so that they are in both places.

3. Note at the bottom of the schedule whether this is an attractive project from a purely financial point of view based upon the numbers that you calculated on the spreadsheet. Why did you make that decision? Note your answers in the table below so that they are in both places.

Optional Additional Point Opportunity:

Copy your spreadsheet tab with your answer and label the new tab Years". Add a Year 6 column and assume that year six cash inflows and outflows will be the same as year 5, with the exception that the equipment will be sold for $30,000 at the end of year 6 instead of $40,000 at the end of year 5. Adjust any formulas in the cells as appropriate caused by the addition of a year 6. Compute the new Net Present value and Internal Rate of Return for this six-year project. Highlight those answers in yellow on your spreadsheet. Note those answers in the table below so that they are in both places.

Summarize your answer in the following table: