# Computing the Expected Net Present Value

Athens Development Corporation is considering a new product that will be sensitive to both economic conditions and competitor response. The product manager has decided to focus on three economic conditions: weak economy, normal economy, and strong economy. Competitors either will or will not respond with a competitive product, and competitor response is unlikely unless economic conditions turn out to be strong. Annual cash flows for each of these conditions appear below. The product has a six-year life and will require an initial cash outlay of $332,000. The cost of capital is 7 percent. Should Athens invest in this product? Explain.

Competitor Weak Normal Strong

Response Economy Economy Economy

Yes $36,500 $52,000 $73,000

No $48,500 71,000 94,000

Please complete the table of net present values below:

Competitor Weak Normal Strong

Response Economy Economy Economy

Yes $ ______ $______ $______

No $ ______ $______ $______

As a follow on to the prior problem, assume that the investment committee determined the probabilities below:

Probability the competitor will response 40%, will not respond 60%

Probability of each economic state over the six year horizon Weak - 10%., Normal - 60% and Strong 30%

Please complete the table of joint probabilities (by multiplying the economy probability by the competitor response probability) below and then calculate the expected net present value.

Competitor Weak Normal Strong

Response Economy Economy Economy

Yes ______% ______% ______%

No ______% ______% ______%

The expected net present value is ________________.

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#### Solution Summary

This solution illustrates how to compute a project's net present value under different economic and competitive conditions, how to create a table of joint probabilities, and how to compute the expected net present value.

Net Present Value in Health Care Organizations

Capitol Healthplans, Inc., is evaluating two different methods for providing home health services to its members. Both methoeds 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?

Great Lakes Clinic has been asked to provide exclusive healthcare services for next year's World Exposition. Although flattered by the request, the clinic's managers want to conduct a financial analysis of the project. There will be an up-front cost of $160,000 to get the clinic inoperation. Then, a net cash inflow of $1 million is expected from operations in each of the two years of the exposition. However, the clinic has to pay the organizers of the exposition a fee for the marketing value of the opportunity. This fee, which must be paid at the end of the second year, is $2 million.

a. What are the cash flows associated with the project?

b. What is the projects's IRR?

c. Assuming a project cost of capital of 10 percent, what is the project's NPV?

d. What is the project's MIRR?

Assume that you are the chief financial officer at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments-Project X and Project Y. Each project requires a net investment outlay of $10,000, and the cost of capital for each project is 12 percent. The projects' expected net cash flows are as follows:

Year Project X Project Y

0 ($10,000) ($10,000)

1 6,500 3,000

2 3,000 3,000

3 3,000 3,000

4 1,000 3,000

a. Calculate each project's payback period, net present value (NPV), and internal rate of return (IRR).

b. Which project (or projects) is financially acceptable? Explain your answer.

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)

0.20 (250,000)

0.50 120,000

0.20 200,000

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 the expected NPV? Explain your answer.

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?

b. What are the projects'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?

On a typical day, Park Place Clinic writes $1,000 in checks. It generally takes four days for those checks to clear. Each day the clinic typically receives $1,000 in checks that take three days to clearn. What is the clinic's average net float?

Drugs R Us operates a mail-order pharmaceutical business on the West Coast. The firm reveives an average of $325,000 in payments per day. On average, it takes four days for the firm to receive payment, from the time customers mail their checks to the time the first receives and processes them. A lockbox system that consists of 10 local depository banks and a concentration bank in San Francisco would cost $6,500 per month. Under this system, customers' checks would be received at the lockbox locations one day after they are mailed, and the daily total would be wired to the concentration bank at a cost of $9.75 each. Assume that the firm could earn 10 perent on marketable securities and that there are 260 working days and hence transfers from each lockbox location per year.

a. What is the total annual cost of operativing the lockbox system?

b. What is the dollar benefit of the system to Drugs R Us?

c. Should the firm initiate the lockbox system?

a. Modern Medical Devices has a current ratio of 0.5. Which of the following actions would improve this ratio?

Use cash to pay off current liabilities.

Collect some of the current accounts receivable.

Use cash to pay off some long-term debt.

Purchase addtional inventory on credit.

Sell some of the existing inventory at cost.

b. Assume that the company has a current ratio of 1.2. Now which of the above actions would improve this ratio?

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