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Which project or projects should be accepted if they are independent? Which project should be accepted if they are mutually exclusive?


Module 8 Portfolio Project, Part 2

Mini Case Chapter 8

Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis’s website.

The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis’s marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

  1. What is the present value cost of owning the equipment?
  2. What is the present value cost of leasing the equipment?
  3. What is the net advantage to leasing (NAL)?
  4. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if:

– interest rate increases to 12 percent

– the tax rate falls to 34 percent

– maintenance cost increases to $25,000 per year

– residual value falls to $150,000

– the system price increases to $1,050,000

  1. Do the changes in d. make leasing more or less attractive? Explain.


Mini Case Chapter 11

James Polk Hospital has currently unused space in its lobby. In three years, the space will be required for a planned expansion, but the hospital is considering uses of the space until then. The hospital has decided that it wants to purchase at least one and maybe two fast food franchises, to take advantage of the high volume of patients and visitors that walk through the lobby all day long. The hospital plans to purchase the franchise(s), operate them for three years, and then close them down. The hospital has narrowed its selection down to two choices:

Franchise L: Lisa’s Soups, Salads, and Stuff

Franchise S: Sam’s Wonderful Fried Chicken

The net cash flows shown below include the costs of closing down the franchises in Year 3 and the forecast of how each franchise will do over the three-year period. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for the hospital to invest in both franchises. The hospital believes these franchises are perfect complements to one another: The hospital could attract both the breakfast/lunch and dinner crowds and both the health-conscious and not-so-health-conscious crowds without the franchises directly competing against one another. The corporate cost of capital is 10 percent.

            Net cash flows
Year Franchise S Franchise L
0 -$100 -$100
1 $70 $10
2 $50 $60
3 $20 $80
  1. Calculate each franchise’s payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR).
  2. Graph the NPV of each franchise at different values of the corporate cost of capital from 0 to 24 percent in 2 percent increments.

– How sensitive are the franchise NPVs to the corporate cost of capital?

– Why do the franchise NPVs differ in their sensitivity to the corporate cost of capital?

– At what cost of capital does each franchise intersect the X-axis? What are these values?

  1. Which project or projects should be accepted if they are independent? Which project should be accepted if they are mutually exclusive?
  2. Suppose the hospital could sell off the equipment for each franchise at the end of any year. Use NPV to determine the optimal economic life of each franchise when the salvage values are as follows:
            Salvage value
Year Franchise S Franchise L
0 $100 $100
1 $60 $70
2 $20 $30
3 $0 $0

Mini Case Chapter 13

Donna Jamison, a recent UNC graduate with four years of for-profit health management experience, was recently brought in as assistant to the chairman of the board of Computron Diagnostics, a manufacturer of clinical diagnostic equipment. The company had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Computron’s results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice president plus its major stockholders (who were all local business people), was most upset when directors learned how the expansion

was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the cut off credit. As a result, Al Watkins, Computron’s president, was informed that changes would have to be made, and quickly, or he would be fired. Also, at the board’s insistence, Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was Computron’s chairman and largest stockholder. Campo agreed to give up a few of his golfing days and help nurse the company back to health, with Jamison’s assistance.

Jamison began by gathering financial statements and other data, shown below. The data show the dire situation that Computron Diagnostics was in after the expansion program. Thus far, sales have not been up to the forecasted level, costs have been higher than were projected, and a large loss occurred in Year 2, rather than the expected profit. Jamison examined monthly data for Year 2 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data look somewhat worse than final monthly

data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were longer than Computron’s managers had anticipated. For these reasons, Jamison and Campo see hope for the company—provided it can survive in the short run. Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken.

Computron Diagnostics
Statement of Operations
Yr 1 Actual Yr 2 Actual Yr 3 Projected
  Net patient service revenue $3,432,000 $5,834,400 $7,035,600
  Other revenue $0 $0 $0
    Total revenues $3,432,000 $5,834,400 $7,035,600
  Salaries and benefits $2,864,000 $4,980,000 $5,800,000
  Supplies $240,000 $620,000 $512,960
  Insurance and other $50,000 $50,000 $50,000
  Drugs $50,000 $50,000 $50,000
  Depreciation $18,900 $116,960 $120,000
  Interest $62,500 $176,000 $80,000
    Total expenses $3,285,400 $5,992,960 $6,612,960
Operating income $146,600 -$158,560 $422,640
Provision for income taxes $58,640 -$63,424 $169,056
Net income $87,960 -$95,136 $253,584
Computron Diagnostics
Balance Sheet
Yr 1 Actual Yr 2 Actual Yr 3 Projected
Current assets:
  Cash $9,000 $7,282 $14,000
  Marketable securities $48,600 $20,000 $71,632
  Net accounts receivable $351,200 $632,160 $878,000
  Inventories $715,200 $1,287,360 $1,716,480
    Total current assets $1,124,000 $1,946,802 $2,680,112
Property and equipment $491,000 $1,202,950 $1,220,000
Less accumulated depreciation $146,200 $263,160 $383,160
Net property and equipment $344,800 $939,790 $836,840
Total assets $1,468,800 $2,886,592 $3,516,952
Liabilities and shareholders’ equity
Current liabilities:
  Accounts payable $145,600 $324,000 $359,800
  Accrued expenses $136,000 $284,960 $380,000
  Notes payable $120,000 $640,000 $220,000
  Current portion of long-term debt $80,000 $80,000 $80,000
    Total current liabilities $481,600 $1,328,960 $1,039,800
Long-term debt $323,432 $1,000,000 $500,000
Shareholders’ equity:
  Common stock $460,000 $460,000 $1,680,936
  Retained earnings $203,768 $97,632 $296,216
    Total shareholders’ equity $663,768 $557,632 $1,977,152
Total liabilities and shareholders’ equity $1,468,800 $2,886,592 $3,516,952
Other data:
Stock price $8.50 $6.00 $12.17
Shares outstanding 100,000 100,000 250,000
Tax rate 40% 40% 40%
Lease payments $40,000 $40,000 $40,000
Yr 1 Actual Yr 2 Actual Yr 3 Projected Average
Profitability ratios
  Total margin 3.6%
  Return on assets 9.0%
  Return on equity 17.9%
Liquidity ratios
  Current ratio 2.70
  Days cash on hand 22.0
Debt management (capital structure) ratios
  Debt ratio 50.0%
  Debt to equity ratio 2.5
  Times-interest-earned ratio 6.2
  Cash flow coverage ratio 8.00
Asset management (activity) ratios
  Fixed asset turnover 7.00
  Total asset turnover 2.50
  Days sales outstanding 32.0
Other ratios
  Average age of plant 6.1
  Earnings per share n/a
  Book value per share n/a
  Price/earnings ratio 16.20
  Market/book ratio 2.90
Computron Diagnostics
Common Size Statement of Operations
Yr 1 Actual Yr 2 Actual Yr 3 Projected Average
  Net patient service revenue 100.0%
  Other revenue       0.0%
    Total revenues 100.0%
  Salaries and benefits 84.5%
  Supplies 3.9%
  Insurance and other 0.3%
  Provision for bad debts 0.3%
  Depreciation 4.0%
  Interest       1.1%
    Total expenses 94.1%
Operating income 5.9%
Provision for income taxes 2.4%
Net income 3.5%
Computron Diagnostics
Common Size Balance Sheet Industry
Yr 1 Actual Yr 2 Actual Yr 3 Projected Average
Current assets:
  Cash 0.3%
  Marketable securities 0.3%
  Net accounts receivable 22.3%
  Inventories 41.2%
    Total current assets 64.1%
Property and equipment 53.9%
Less accumulated depreciation 18.0%
Net property and equipment       35.9%
Total assets 100.0%
Liabilities and shareholders’ equity
Current liabilities:
  Accounts payable 10.2%
  Accrued expenses 9.5%
  Notes payable 2.4%
  Current portion of long-term debt 1.6%
    Total current liabilities 23.7%
Long-term debt 26.3%
Shareholders’ equity:
  Common stock 20.0%
  Retained earnings 30.0%
    Total shareholders’ equity       50.0%
Total liabilities and shareholders’ equity 100.0%
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