Allied Managed Care Company Is Evaluating Two Different Comp

Allied Managed Care Company Is Evaluating Two Different Computer Sys

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 of the 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 a. Assume initially that the systems both have average risk. Which one should be chosen? b. 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?

Paper For Above instruction

The decision-making process for selecting between two computer systems in a corporate setting fundamentally hinges on calculating and comparing their respective present values (PV) of costs. Since Allied Managed Care Company's primary goal is cost minimization, the preferred system should be the one with the lower PV of costs over its lifespan. This paper explores the comparative analysis of System X and System Y under different risk assumptions, employing net present value (NPV) calculations to guide managerial decisions.

Part A: Choosing Between Systems with Average Risk

Under the initial scenario where both systems are considered to have average risk, the corporate cost of capital is 10%. The challenge is to determine which system has the lower PV of costs, computed by discounting each year's cash flows at 10%. Since the cash flows are negative (costs), the PV calculation involves summing the discounted cash flows over the project's duration.

For System X:

PV = -$500/(1+0.10)^1 - $500/(1+0.10)^2 - $500/(1+0.10)^3 + initial outlay

Calculating each component:

PV of Year 1 = -$500 / 1.10 ≈ -$454.55

PV of Year 2 = -$500 / (1.10)^2 ≈ -$413.22

PV of Year 3 = -$500 / (1.10)^3 ≈ -$375.66

Total PV of costs for System X:

PV_X = -($454.55 + $413.22 + $375.66) ≈ -$1,243.43

For System Y:

PV = -$1,000 / 1.10 + -$300 / (1.10)^2 + -$300 / (1.10)^3

Calculating each:

Year 0: -$1,000 (initial outlay, no discount)

Year 1: -$300 / 1.10 ≈ -$272.73

Year 2: -$300 / (1.10)^2 ≈ -$247.93

Year 3: -$300 / (1.10)^3 ≈ -$225.39

Total PV:

PV_Y = -$1,000 + (-$272.73 - $247.93 - $225.39) ≈ -$1,746.05

Decision for Part A:

Since PV_X (-$1,243.43)

Part B: Adjusting for Differential Risk

Now, System X is deemed to have high risk, prompting an adjustment in the discount rate by ±2 percentage points. Since high risk typically warrants a higher rate, the discount rate increases by 2%, making it 12%. Conversely, since System Y remains at average risk, its discount rate remains at 10%.

Calculations for System X at 12%:

PV_X_high_risk = -$500 / 1.12 + -$500 / (1.12)^2 + -$500 / (1.12)^3

Calculating:

Year 1: -$500 / 1.12 ≈ -$446.43

Year 2: -$500 / (1.12)^2 ≈ -$398.58

Year 3: -$500 / (1.12)^3 ≈ -$355.99

Total PV:

PV_X_high_risk ≈ -$446.43 - $398.58 - $355.99 ≈ -$1,201

Since the PV of System X with high risk (~$1,201) is now lower than PV_Y (~$1,746.05), which remains at 10%, System X becomes the preferable choice after risk adjustment. This demonstrates how risk perception alters investment decisions.

Implications and Recommendations

The analysis underscores the importance of considering risk perceptions and adjusting discount rates accordingly. When risk rises, future cash flows are less certain; thus, a higher discount rate is appropriate to reflect increased risk. Conversely, if a project's risk decreases, a lower discount rate can be justified. Managerial decisions should incorporate such adjustments to avoid over- or under-investing based on static assumptions. Additionally, companies should conduct sensitivity analyses to assess how variations in risk assumptions impact project desirability.

Conclusion

In the initial scenario with average risk, System X is clearly preferable based on the lower PV of costs. However, when accounting for the higher risk associated with System X, increasing the discount rate to 12% shifts the cost advantage decisively in its favor. These findings highlight the critical role of risk assessment and appropriate discount rate adjustments in capital budgeting decisions. Accurate risk valuation ensures that investments are evaluated realistically, aligning financial analysis with actual risk profiles.

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