25. Add-or-drop with net present value analysis (builds on material in Chapters
ID: 2455194 • Letter: 2
Question
25. Add-or-drop with net present value analysis (builds on material in Chapters Six and Seven). Franklin County Hospital, a nonprofit hospital, bought and installed a new com- puter system last year for $90,000. The system is designed to relay information between labs and medical units. Charlene Walker, the hospital’s new computer specialist, had a meeting with Lou Campbell, vice president of finance. She said: “Lou, today I read in a journal that a new computer system has just been introduced. It costs $50,000, but I believe that by replacing our old system, we could reduce operating and maintenance costs that are now being incurred.” The following are Walker’s estimates:
Present System
New System
Purchase and installment price
$90,000
$50,000
Useful life when purchased
6years
5 years
Computer operating costs per year
$35,000
$25,000
Computer operating and maintenance costs per year
$15,000
$8,000
Depreciation expenses per year
$15,000
$10,000
Cost of capital
10%
10%
a. Based on an analysis, what advice should Walker give Campbell?
b. At what price for the new computer system would Campbell be indifferent on this decision?
c. Is this a typical make-or-buy decision? Why or why not?
Present System
New System
Purchase and installment price
$90,000
$50,000
Useful life when purchased
6years
5 years
Computer operating costs per year
$35,000
$25,000
Computer operating and maintenance costs per year
$15,000
$8,000
Depreciation expenses per year
$15,000
$10,000
Cost of capital
10%
10%
Explanation / Answer
a)
Annual Cash saving from reduction in operating & mainenace cost = (35000-25000) + (15000-8000)
Annual Cash saving from reduction in operating & mainenace cost = $ 17000
Initial Investment = $ 50000
NPV = -Initial Investment + Annual Cash Flow*PVA(rate,nper)
NPV = -50000 + 17000*PVA(10%,5)
NPV = -50000 + 17000*3.790787
NPV= 14,443.38
Decision : Walker should advice campell that they should introduce new system as it NPV is positive
b)
Price for the new computer system Campbell be indifferent on this decision = Annual Cash Flow*PVA(rate,nper)
Price for the new computer system Campbell be indifferent on this decision = 17000*PVA(10%,5)
Price for the new computer system Campbell be indifferent on this decision = 17000*3.790787
Price for the new computer system Campbell be indifferent on this decision = $ 64,443.38
c) It is not a typical make-or-buy decision because in make or buy decision involves either making something or buying through outside , it is a capital budget analysis, In make-or-buy decision , we should go either for manufacturing or outsourcing for buying.
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