The staff of Jefferson Medical Services has estimated the following net cash flo

Question

The staff of Jefferson Medical Services has estimated the following net cash flows for a food services operation that it may open in its outpatient clinic:

Year                                                    Expected Net Cash Flow

0                                                          ($100,000)

1                                                          $30,000

2                                                          $30,000

3                                                          $30,000

4                                                          $30,000

5                                                          $30,000

5 (salvage value)                                 $20,000

      The Year 0 cash flow is the net investment outlay, while the final amount is th terminal cash flow. (The clinic is expected to move to a new building in five years.) All other flows represent net operating cash flows. Jefferson’s corporate cost of capital is 10 percent.

C. Now, assume that the operating cash flows in Years 1 through 5 could be as low as $20,000 or as high as $40,000. Furthermore, the salvage value cash flow at the end of Year 5 could be as low as $0 or as high as $30,000. What are the worst case and best case IRRs? The worst case and best NPVs?

Explanation / Answer

A) Worst case scenerio

:NPV at the 10% cost of capital

Net Present Value (NPV)=$ 20,000 * Cumulative doscounting factor @ 10%- $ 100,000

                                        = $ 20,000*3.791-$ 100,000

                                        = - $ 24,180

Net present Value (NPV) at 5% Cost of capital= $ 20,000 * Cumulative doscounting factor @ 5%- $ 100,000
                                                                           = $ 20,000 * 4.329-$ 100,000

                                                                             = -$13,410

IRR= L+(A/A-B)* (H-L)

        =5+(-13410/-13410+24180)* (10-5)                                  

         = -1.23%

Best Case Scenerio

NPV @ 10% Cost of capital

=40000* cumulative discounting factor for 5 years+ Terminal Value at the end of year 5* discounting factor for 5th year-Initial Outlay

=40000*3.791+30000* .621-100000

=$ 70270

NPV @ 30% Cost of capital

=40000* cumulative discounting factor for 5 years+ Terminal Value at the end of year 5* discounting factor for 5th year-Initial Outlay

=40000*2.436+30000* .269-100000

=$ 5,510

IRR= L+(A/A-B)* (H-L)

        =10+(70270/70270-5510)* (30-10)                                  

         = 31.70%

Where,

L=Cost of capital at lower rate

H= Cost of capital at higher rate

A= NPV at lower rate

B=NPV at higher rate

NPV

Worst Case: -$ 24,180

Best Case: $ 70,270

IRR

Worst Case: -1.23%

Best Case: 31.7%

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