Consider the project contained in Problem 7 in Chapter 11 (California Health Center).

Consider the project contained in Problem 7 in Chapter 11 (California Health Center).

1. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value. Remember supplies vary with number of procedures.
2. Conduct a scenario analysis. Suppose that the hospital’s staff concluded that the three most uncertain variables were number of procedures per day, average collection amount, and the equipment’s salvage value. Furthermore, the following data were developed:

Equipment

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Number of          Average               Salvage

Scenario               Probability          Procedures         Collection            Value

Worst                    0.25                        10                           $60                         $100,000

Most likely          0.50                        15                           $80                         $200,000

Best                       0.25                        20                           $100                       $300,000

1. Finally, assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0 – 2.0. (Hint: Coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?
2. What type of risk was measured and accounted for in Parts b. and c.? Should this be of concern to the hospital’s managers?

ANSWER                                                                                                                                                             

PROBLEM 5                                                                                                                        

Allied Managed Care Company is evaluating two different computer systems for handling provider claims.There are no incremental revenues attached to the projects, so the decision will be made on the basis ofthe present value of costs. Allied’s corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:

Year       System X             System Y

0              -$500                     -$1,000

1              -$500                     -$300

2              -$500                     -$300

3              -$500                     -$300

1. Assume initially that the systems both have average risk. Which one should be chosen?
2. Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its corporate cost of capital up or down by 2 percentage points. Which system should be chosen?                                

ANSWER