Problem 3 Capitol Health Plans, Inc., is evaluating two different methods for pr
ID: 2780951 • Letter: P
Question
Problem 3
Capitol Health Plans, Inc., is evaluating two different methods for providing home health services to its members. Both methods involve contracting out for services, and the health outcomes and revenues are not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows.
Here are the projected flows:
Year Method A Method B
0 -$300,000 -$120,000
1 -$66,000 -$96,000
2 -$66,000 -$96,000
3 -$66,000 -$96,000
4 -$66,000 -$96,000
5 -$66,000 -$96,000
a. What is each alternative's IRR?
b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why?
Explanation / Answer
I think there is typo error in the cash flows starting from year 1 onwards for both the projects
All the cash flows given are negative. If that is the case, IRR is not possible and why would anyone logically invest in the project if only outflow is there. Assuming al the cash flows are correct in magnitude but incorrect in sign starting from year 1, hence taking all the negative cash flows starting from year 1 as positive cash flows.
Method A:
NPV=-300000+66000/(1+r)+66000/(1+r)^2+66000/(1+r)^3+66000/(1+r)^4+66000/(1+r)^5
IRR is the rate or r at which NPV is zero..hence, IRR=3.2635%
Method B:
NPV=-120000+96000/(1+r)+96000/(1+r)^2+96000/(1+r)^3+96000/(1+r)^4+96000/(1+r)^5
IRR is the rate or r at which NPV is zero..hence, IRR=75.14%
So, we should invest in Method B as its IRR is higher than the cost of capital of 9%
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