Question

You have been asked to evaluate the proposed acquisition of a new clinical laboratory test system. The system's price is $50,000 and it will cost another $10,000 for transportation and installation. The system is expected to be sold after three years because the laboratory is being moved at that time. The best estimate of the system's salvage value after three years of use is $20,000. The system will have no impact on volume or reimbursement (and hence revenues), but it is expected to save $20,000 per year in operating costs. The not-for-profit business’s corporate cost of capital is 10 percent, and the standard risk adjustment is 4 percentage points.

a. What is the project’s net investment outlay at Year 0?

b. What are the project’s operating cash flow in Year 1,2, and 3?

c. What is the terminal cash flow at the end of Year 3?

d. If the project has average risk, is it expected to be profitable?

e. What if the project is judged to have lower-than-average risk? Higher-than-average risk?

Answer 1

A:In year 0, investment outlay =Cost of Lab + Transportation and Installation costs

= 50000+ 10000 = $60,000

B:Operating cash flows each year = $20000

C: Terminal cash flow= Operating cash flow + salvage = $40000

D: At average risk, the cost of capital = 10%

Hence NPV= -60000+ 20000/1.1^1 + 20000/1.1^2 + 40000/1.1^3 = $4763.34

Since NPV is positive, the project is profitable

E: If lower risk, the cost of capital= 10%-4% = 6%

Hence NPV= -60000+ 20000/1.06^1 + 20000/1.06^2 + 40000/1.06^3 = $10252.62

Yes it is profitable

If higher risk, cost of capital = 10%+4 = 14%

Hence NPV= -60000+ 20000/1.14^1 + 20000/1.14^2 + 40000/1.14^3 = $ - 67.9

No it is not profitable