Question

You are hoping to establish a new simulation center at your hospital. Your first initiative will be offering central line placement simulations. You work with a reimbursement specialist in the finance department and estimate that, due to reductions in infection rates resulting from your simulation program, the hospital will save $2,500 per year. (These savings will come primarily through reductions in length of stay.)  

You plan to purchase 3 CVC placement mannequins for $2,000 each. The only additional cost you will have to account for is a once-annual purchase of replacement tissue for the simulation mannequins. The replacement tissue will be a $700 annual cost. You will not need to make and additional tissue purchase at the time you purchase the mannequin.

Assume the discount rate your organization uses for projects of this nature is 10%. Begin with “year 0”, which is the time at which you purchase the mannequins. Assume that at “year 0” your only financial effect is the mannequin purchase. Savings and additional tissue purchases start a year later (label this “year 1”). Make you projections for years 1-5.

1. Using the information, what is the NPV of the project?

2. What is the IRR of the project?

3. What is the payback period of the project

4. You present your findings to you director (from whom you are hoping to get approval for project funding). Your director says “this is a great project. It costs $6,000 to take on and it will return $1,800 per year ($2,500 in savings - $700 in additional tissue replacement costs) for 5 years. That’s a return of…hmm let me think…(1800*5)/6000…that’s the same as 9,000/6,000… and that’s 150%. That’s a great return!”

Do you agree with your director’s calculation of the project’s return? Does it agree with your IRR calculation? If not, what is the director forgetting about?

5. You continue conversations with your department director. Now, your director looks at your estimates and says “This looks good, but to purchase the mannequins the hospital will need additional funding. We were already planning to take out a loan at 9% interest per year for other equipment purchases. We could add $6,000 to that to fund mannequin purchases, but your calculations don’t consider the additional borrowing required and the interest this project would generate.” Is this true? Explain why or why not.

Answer 1

	Year		0	1	2	3	4	5
	Investment	3 units X $2,000	$       -6,000.00
	Revenue			$         2,500.00	$         2,500.00	$                      2,500.00	$         2,500.00	$         2,500.00
	Expenses			$           -700.00	$           -700.00	$                        -700.00	$           -700.00	$           -700.00
	Net Cash Flow		$       -6,000.00	$         1,800.00	$         1,800.00	$                      1,800.00	$         1,800.00	$         1,800.00
	Discounting Factor	= ( 1 + 10% ) ^ year	1.00	1.10	1.21	1.33	1.46	1.61
	Present Value	=Net Cash Flow / Discounting Factor	$       -6,000.00	$         1,636.36	$         1,487.60	$                      1,352.37	$         1,229.42	$         1,117.66
	Cumulative Present Value		$       -6,000.00	$       -4,363.64	$       -2,876.03	$                    -1,523.67	$           -294.24	$            823.42
1	NPV	= sum ( Present Value )	$            823.42		Excel Formula	$                         823.42
			=SUM(D8:I8)			=NPV(10%,E6:I6)+D6
2	IRR	15.24%
		=IRR(D6:I6)
3	Payback Period
	Years Before Full Recovery			4
	Unrecovered Cost at the begining of the year			$                  294
	Discounted Cash Inflow during the year			$               1,118
	Payback Period		4 Years	4.2633
			3 Months	3.160
			5 Days	5
	Payback Period			4 Years 3 months 5 days
4	The calculations made by director are partially correct, however those calculations do not matchup with IRR mainly because the calculations made by director are by ignoring the discounting rate over the years.
5	The saying of department director, which is the return of the investment doesnot cover the interest payment is true. Because while computing PV of the investment we have ignored the interest portion of such loan which would affect the profitability of the project. If we consider interest payment the NPV will be
		Year	0	1	2	3	4	5
		Net Cash Flows Before Interest	$       -6,000.00	$         1,800.00	$         1,800.00	$                      1,800.00	$         1,800.00	$         1,800.00
		Payments		₹ 1,542.55	₹ 1,542.55	₹ 1,542.55	₹ 1,542.55	₹ 1,542.55
		Interest		$            540.00	$            449.77	$                         351.42	$            244.22	$            127.37
		Balance		$         4,997.45	₹ 3,904.66	₹ 2,713.53	₹ 1,415.19	₹ 0.00
		Net Cash Flows After Interest	$       -6,000.00	$         1,260.00	$         1,350.23	$                      1,448.58	$         1,555.78	$         1,672.63
		Present Value	$       -6,000.00	$         1,145.45	$         1,115.89	$                      1,088.34	$         1,062.62	$         1,038.57
		NPV	$           -549.12