HCM 565 Module 8 Portfolio Project Part 2 Mini Case Chapter

Hcm565module 8 Portfolio Project Part 2mini Case Chapter 8lewis Healt

HCM565 Module 8 Portfolio Project, Part 2 Mini Case Chapter 8 Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis's website. The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class.

If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40 percent.

You have been asked to analyze the lease-versus-purchase decision and answer the following questions:

a. What is the present value cost of owning the equipment?

b. What is the present value cost of leasing the equipment?

c. What is the net advantage to leasing (NAL)?

d. Answer these questions one at a time to see the effect of change on NAL:

- Interest rate increases to 12%

- Tax rate falls to 34%

- Maintenance cost increases to $25,000 per year

- Residual value falls to $150,000

- System price increases to $1,050,000

e. Do these changes make leasing more or less attractive? Explain.

Paper For Above instruction

Introduction

The decision to lease or purchase equipment is fundamental to financial management within healthcare organizations. When evaluating such choices, organizations must consider various financial metrics, including present value costs, tax implications, residual value uncertainties, and changing economic conditions. This paper analyzes the lease versus purchase decision for Lewis Health System's acquisition of a new electronic health record system, integrating key financial concepts such as net present value (NPV), net advantage to leasing (NAL), and sensitivity analysis.

Present Value Cost of Owning the Equipment

The ownership evaluation begins with calculating the initial purchase cost, financing costs, tax considerations, and residual value at the end of four years. The system costs $1,000,000, and Lewis can finance this amount at 10%, with interest deductible owing to the tax shield effect. The equipment's classification as a three-year MACRS asset influences depreciation calculations, impacting the tax savings over the asset’s life.

Annual depreciation under MACRS for a three-year class is accelerated, with approximate percentages: Year 1 (33.33%), Year 2 (44.45%), Year 3 (14.81%), Year 4 (7.41%). The depreciation schedule affects taxable income and, consequently, tax savings, which must be incorporated into the PV calculations.

The purchase's net present value (NPV) considers the initial investment, the tax shield from depreciation, maintenance costs, residual value, and finance costs discounted at the company's cost of capital (assumed to be the loan rate). Considering the tax rate of 40%, the tax savings from depreciation and interest expense are significant. The formula to compute the PV of owning includes the initial outlay minus the present value of tax shields plus the discounted residual value, accounting for the costs associated with carrying the asset over four years.

Mathematically, PV of owning (PV_own) approximates as:

PV_own = Cost of equipment - PV of tax shields + PV of residual value - PV of maintenance costs

where PV calculations are performed at the 10% discount rate.

Present Value Cost of Leasing the Equipment

Leasing involves annual payments of $260,000 at the beginning of each year, including expected maintenance. These payments are tax-deductible, providing an effective cost reduction. Since payments are made at the beginning of each year, this constitutes an annuity due, which has a different PV calculation compared to ordinary annuities.

The lease's PV is the sum of discounted lease payments:

PV_lease = Σ (Lease payment / (1 + r)^t), t = 0 to 3

where r is the interest rate (10%).

Tax considerations benefit the lessee because lease payments reduce taxable income, leading to tax savings. The after-tax lease cost is computed as:

Adjusted lease cost = Lease payment × (1 - tax rate)

The PV of the lease cost incorporates these tax savings, giving an effective cost comparison with ownership.

Net Advantage to Leasing (NAL)

The NAL is calculated as:

NAL = PV of owning - PV of leasing

A positive NAL indicates ownership is more cost-effective, while a negative value suggests leasing is advantageous.

Initial calculations at a 10% interest rate show that leasing might be more attractive primarily due to flexibility and residual value uncertainty. Conversely, ownership may be favored by tax benefits and residual value recovery.

Sensitivity Analysis

By altering the key assumptions, the impact on NAL can be gauged:

- Increasing interest rate to 12% increases the PV of both lease and ownership costs; typically, higher discount rates diminish the present value of future costs, possibly favoring leasing if lease payments are fixed.

- Falling tax rate from 40% to 34% reduces the tax shield benefit, increasing the effective cost of purchase and lease.

- Raising maintenance costs to $25,000 per year increases the cost burden, making leasing more attractive if lease payments do not escalate.

- Dropping residual value to $150,000 decreases the salvage benefit of ownership, favoring leasing.

- Raising the price of the system to $1,050,000 increases initial investment, likely making leasing more favorable due to reduced upfront cash outlay.

Conclusion

Changes in economic and tax assumptions significantly affect the lease versus buy decision. Higher costs and lower residual values tend to favor leasing, especially when the residual value is uncertain or depreciates rapidly. Sensitivity analysis indicates that organizations should consider scenario planning as part of their decision-making process to optimize financial outcomes under fluctuating conditions.

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