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PROBLEM 7-2 Given 30.00% 15.00% Tax rate Cost of Capital 2010 EBITDA Depreciation EBIT Tax Net Income Investment Year 2011 $2,400,000 2012 $2,400,000...

ANALYZING A PROJECT WITH BACK-LOADED EARNINGS (EVA ANALYSIS)

Hospital Services Inc.provides health care services primarily in the western part of the United States.The firm operates
psychiatric hospitals that provide mental health care services using inpatient, partial hos-
pitalization, and outpatient settings. In the spring of 2010, the firm was considering an
investment in a new patient-monitoring system that costs $6 million per hospital to
install.The new system is expected to contribute to firm EBITDA via annual savings of
$2.4 million in Years 1 and 2,plus $4.25 million in Year 3.
The firm’s chief financial officer is interested in investing in the new system but is
concerned that the savings from the system are such that the immediate impact of the
project may be to dilute the firm’s earnings. Moreover, the firm has just moved to an
economic profit–based bonus system,and the CFO fears that the project may also make
the individual economic profits of the hospitals look bad—a development that would
generate resistance from the various hospital managers if they saw their bonuses being
decreased.

a. Assuming that the cost of capital for the project is 15%, that the firm faces a 30%
marginal tax rate, and that it uses straight-line depreciation over a three-year life
for the new investment and that it has a zero salvage value, calculate the project’s
expected NPV and IRR.

b. Calculate the annual economic profits for the investment for Years 1 through 3.
What is the present value of the annual economic profit measures discounted
using the project’s cost of capital? What potential problems do you see for the
project?

c. Calculate the economic depreciation for the project,and use it to calculate a revised
economic profit measure following the procedure laid out in Table 7-8.What is the
present value of all the revised economic profit measures when discounted using
the project’s cost of capital? (Hint: First, revise the initial NOPAT estimate from
your answer to Question a by subtracting the economic depreciation estimate from
project free cash flow calculated in Question a.Next,calculate the capital charge for
each year based on invested capital less economic depreciation.)

d. Using your analysis in answering Questions b and c,calculate the return on invested
capital (ROIC) for Years 1 through 3 as the ratio of NOPAT for Year t to invested
capital for Year t - 1. Compare the two sets of calculations and discuss how the use
of economic depreciation affects the ROIC estimate for the project.

PROBLEM 7-2 Given Tax rate 30.00% Cost of Capital 15.00% Year 2010 2011 2012 2013 EBITDA $2,400,000 $2,400,000 $4,250,000 Depreciation EBIT Tax Net Income Investment $(6,000,000) Free Cash Flow Analysis Year 2010 2011 2012 2013 PFCF NPV IRR EVA Analysis NOPAT Invested capital $6,000,000.00 ROIC Economic Profit MVA Bierman (1988) revised EVA analysis Future Values Economic depreciation Revised NOPAT equals Project FCF + Ec. Deprn Revised Invested Capital Revised ROIC Revised capital charge Revised Economic Profit MVA Part D: Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output Assume machine life of three years Backloaded earnings We can see that ROIC has an intermediate value under the revised economic profit approach whereas it tends to seem too low or too high under the standard economic profit approach.
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