Assume You Are The Chief Financial Officer At Porter Me
Assume That You Are The Chief Financial Officer At Porter Memorial Hos
Assume that you are the chief financial officer at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments – Project X and Project Y. Each project requires a net investment outlay of $10,000, and the cost of capital for each project is 12%. The project’s expected net cash flows are as follows:
Year | Project X | Project Y
0 | ($10,000) | ($10,000)
1 | $6,500 | $3,000
2 | $3,000 | $3,000
3 | $3,000 | $3,000
4 | $1,000 | $3,000
a. Calculate each project’s payback period.
b. Calculate net present value (NPV).
c. Calculate internal rate of return (IRR).
d. Which project (or projects) is financially acceptable?
e. Explain your answer.
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Paper For Above instruction
Introduction
Capital investment analysis is essential for healthcare organizations seeking to determine the most financially viable projects that align with their strategic goals. Porter Memorial Hospital's CEO has requested an evaluation of two potential projects—Project X and Project Y—using standard investment appraisal techniques: payback period, net present value (NPV), and internal rate of return (IRR). This paper aims to perform these financial analyses to guide decision-making, assess project feasibility, and determine future investments' viability considering risk adjustments.
Payback Period Analysis
The payback period measures the time required for an investment to recover its initial cost, providing a simple indicator of liquidity and risk. For Project X, the initial outlay is $10,000. The project generates cash flows of $6,500 in Year 1, which reduces the outstanding balance to $3,500 ($10,000 - $6,500). In Year 2, cash inflows of $3,000 decrease the remaining amount to $500 ($3,500 - $3,000). Since the project does not fully recover the initial investment within Year 2, part of Year 3 cash flow is needed. Year 3 adds another $3,000, which exceeds the remaining $500. Therefore, the exact payback period is calculated as follows:
\[
\text{Payback Period} = 2 + \frac{\text{Remaining amount at end of Year 2}}{\text{Year 3 cash flow}} = 2 + \frac{500}{3,000} \approx 2.17 \text{ years}
\]
Similarly, Project Y receives $3,000 annually, allowing recovery of $10,000 over approximately 3.33 years:
\[
\text{Payback Period} = \frac{\text{Initial investment}}{\text{Annual cash flow}} = \frac{10,000}{3,000} \approx 3.33 \text{ years}
\]
Thus, Project X has a faster payback period (≈2.17 years) compared to Project Y (≈3.33 years), implying quicker recovery of investment and potentially lower risk.
Net Present Value (NPV) Calculation
NPV evaluates the profitability by discounting future cash flows to their present value at the hospital's cost of capital (12%). The formula is:
\[
NPV = \sum_{t=1}^{n} \frac{C_t}{(1 + r)^t} - C_0
\]
Where \( C_t \) = cash flow in year t, \( r \) = discount rate, \( C_0 \) = initial investment.
Calculating for Project X:
\[
NPV_X = \frac{6,500}{(1.12)^1} + \frac{3,000}{(1.12)^2} + \frac{3,000}{(1.12)^3} + \frac{1,000}{(1.12)^4} - 10,000
\]
\[
NPV_X = 5,803.57 + 2,391.53 + 2,134.78 + 635.50 - 10,000 = 1,865.38
\]
For Project Y:
\[
NPV_Y = \frac{3,000}{(1.12)^1} + \frac{3,000}{(1.12)^2} + \frac{3,000}{(1.12)^3} + \frac{3,000}{(1.12)^4} - 10,000
\]
\[
NPV_Y = 2,678.57 + 2,392.77 + 2,136.03 + 1,907.33 - 10,000 = -965.30
\]
In conclusion, Project X yields a positive NPV of approximately $1,865, indicating it is likely profitable, while Project Y yields a negative NPV, suggesting it may not be financially justifiable under current assumptions.
Internal Rate of Return (IRR) Calculation
IRR is the discount rate that makes the NPV zero. Using iterative methods or financial software:
- For Project X, IRR is approximately 17.2%. Since 17.2% > 12%, the project exceeds the required hurdle rate.
- For Project Y, IRR is approximately 8.5%. Since this is less than the 12% hurdle rate, it is not acceptable from a financial perspective.
These IRRs reinforce the NPV findings—Project X is financially attractive, and Project Y is not.
Project Acceptability and Decision
Based on the calculations, Project X is financially acceptable given its positive NPV, acceptable payback period within the hospital's investment horizon, and IRR exceeding the cost of capital. Conversely, Project Y does not meet the financial viability criteria, marked by negative NPV and IRR below the target threshold.
While financial metrics are crucial, other considerations such as strategic alignment, operational impact, and risk exposure play vital roles. In this case, Project X’s ability to recover funds faster and its higher return make it the preferable investment, aligning with prudent hospital financial management.
Risk Analysis and Adjustments
Financial analysis must account for uncertainties inherent in hospital projects. Sensitivity analysis helps evaluate how NPV responds to variations in key variables, like cash flows and salvage value. For example, decreasing annual cash flows in Project X would diminish its NPV, raising questions on robustness. Similarly, scenario analysis, which combines multiple variable changes, reveals possible worst-case outcomes and helps assess project resilience.
Furthermore, adjusting for risk involves modifying the discount rate based on the project's risk profile. According to the problem statement, the hospital increases or decreases its weighted average cost of capital (WACC) by 3 percentage points. In a higher-risk scenario, the discount rate would increase to 15%, potentially decreasing NPV and affecting project acceptability. Under this adjustment, Project X’s NPV would decrease but might still remain positive, confirming its viability, whereas Project Y’s negative NPV would likely worsen.
The coefficient of variation (CV) of NPV, ranging from 1.0 to 2.0, quantifies the variability relative to the expected NPV, offering insight into risk exposure. An average CV of 1.0-2.0 indicates significant uncertainty, necessitating cautious decision-making, especially for risky projects like Y.
Conclusion
In conclusion, financial analysis indicates that Project X is a sound investment, with positive NPV, a quick payback period, and an IRR exceeding the hurdle rate. Project Y, under the current assumptions, does not appear financially viable. Adjustments for risk further reinforce Project X’s acceptability, even under adverse conditions. It is vital for hospital management to consider both quantitative metrics and qualitative factors such as strategic fit and operational capacity when making final decisions. Proper risk assessment ensures sustainable investments that contribute positively to hospital growth and patient care.
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