Finance Question

profileAmazingExpert
chapter-12-problems.xls-workshop-4.xls
Home>Business & Finance homework help>Finance Question

Problem 1

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
PROBLEM 1
The managers of Merton Medical Clinic are analyzing a proposed project. The project's most likely
NPV is $120,000, but, as evidenced by the following NPV distribution, there is considerable risk
involved:
Probability NPV
0.05 -$700,000
0.2 -$250,000
0.5 $120,000
0.2 $200,000
0.05 $300,000
a. What are the project's expected NPV and standard deviation of NPV?
b. Should the base case analysis use the most likely NPV or expected NPV? Explain your answer.
ANSWER

Problem 2

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
PROBLEM 2
Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and
probabilities:
Year Prob=0.2 Prob=0.6 Prob=0.2
0 -$100,000 -$100,000 -$100,000
1 $20,000 $30,000 $40,000
2 $20,000 $30,000 $40,000
3 $20,000 $30,000 $40,000
4 $20,000 $30,000 $40,000
5 $30,000 $40,000 $50,000
The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent.
a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net
cash flows are the expected cash flows in each year.)
b. What are the project's most likely, worst, and best case NPVs?
c. What is the project's expected NPV on the basis of the scenario analysis?
d. What is the project's standard deviation of NPV?
e. Assume that Heywood's managers judge the project to have higher-than-average risk. Furthermore, the
company's policy is to adjust the corporate cost of capital up or down by 3 percentage points to account
for differential risk. Is the project financially attractive?
ANSWER

Problem 3

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
PROBLEM 3
Consider the project contained in Problem 7 in Chapter 11 (California Health Center).
a. 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.
b. 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
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
c. 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?
d. 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 4

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
PROBLEM 4
The managers of United Medtronics are evaluating the following four projects for the coming budget
period. The firm's corporate cost of capital is 14 percent.
Project Cost IRR
A $15,000 17%
B $15,000 16%
C $12,000 15%
D $20,000 13%
a. What is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process.
Project A has average risk, B has below-average risk, C has above-average risk, and D has average
risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's
managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk
projects by the same amount.)
ANSWER

Problem 5

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
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 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?
ANSWER

Problem 6

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 12 -- Project Risk Analysis
PROBLEM 6
University Health System has three divisions: Real Estate, with an 8 percent cost of capital; Health
Services, with a 10 percent cost of capital; and Managed Care, with a 12 percent cost of capital. The
System's risk adjustment procedures call for adding 3 percentage points to adjust for high risk and
subtracting 2 percentage points for low risk. Construct a diagram such as the one in Figure 12.4 that
illustrates the range of project costs of capital for the system.
ANSWER