This test combines several concepts from class.

Introduction

This test combines several concepts from class. First, you must develop a set of simple models describing the profitability of an investment. Second, you must consider the choice of leasing vs. buying and model the lessee’s and lessor’s profitability. To simplify problem one you can make the following assumptions:

  • You can assume that the cost of capital is the same for the overall project and the scrap value (the scrap value discount rate is often higher in reality).
  • The hospital is a non-profit institution but the lessor is not.
  • You may ignore leveraged lease issues – this makes the lessor analysis easier.
  • You may ignore per-procedure leases.
  • Remember that (when relevant) you must pay taxes on the difference between the depreciated value and the scrap value of the asset.

 

Problem one background

Hell’s Pass Hospital (HPH) has the highest surgical mortality rate of any hospital in the Colorado area. As a result the hospital’s reputation and surgical volume has fallen in recent years. Hospital administrators attribute this excess mortality to the community’s frequency of unusually severe trauma requiring risky surgery. Consequently, the surgical department head, Dr. Gall, has requested that the hospital invest in a robotic surgery system.

As of 2009, approximately 1,400 US hospitals had acquired robotic surgery technology. These systems facilitate complicated surgeries and hold the potential to improve quality and reduce length of stay (note that in reality, the clinical evidence on robotic surgery units is far from conclusive). Dr. Gall has selected the RUR-1000, manufactured by Rossum’s Universal Robots.

The RUR-1000 has a purchase price of $2,500,000 including installation and delivery charges. This machine falls into the MACRS 5-year class with current allowances of 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06 in years 1-6 respectively. Rossum’s manufacturer warranty and maintenance policy costs $100,000 per year payable at the beginning of each year.

While the equipment has a six-year expected useful life, the hospital would only use the asset for four years. The anticipated scrap value at the end of four years is $315,000 assuming HPH owned the equipment.

This purchase could be financed by a four-year simple interest conventional bank note that would carry a 10% interest charge (i.e., a normal looking loan with a 10% cost of capital).

Alternatively, the equipment could be leased for $815,000 per year from Hejny Rentals, with each payment payable at the beginning of the year and the first payment due on delivery (i.e., time=0). Hejny has a good reputation (they were recommended by Dr. McCullough who rented a pig roaster from them) and they would purchase the RUR-1000 under the same terms as HPH (e.g., $2,500,000 price and $100,000 maintenance contract). However, Hejny can borrow at 9%, has a 40% tax rate, and they would have a $375,000 scrap value at the end of four years.

If the RUR-1000 is acquired, HPH expected to receive an additional 100 patients per year (the total quantity remains 100 during all four years of operation). On average, per procedure prices and costs will be $15,000 and $7,000 during the first year. The hospital expects that per procedure prices and costs (but not quantities) will grow by 5% per year. To make things easier, assume that per procedure revenues and costs occur at the end of each year (i.e., not at time 0 but at times 1, 2, 3, and 4).

Questions

Specific questions should be answered in a single excel document and explained with one or two sentences each. Please format the exam and your answers professionally – this doesn’t have to be fancy, but your analysis has to be organized and readable.

  1. Is the robotic surgery investment financially acceptable (i.e., profitable) if the equipment is purchased?
  2. Is the investment financially acceptable if the equipment is leased at the stated lease price?
  3. Could you negotiate a lower lease price with the lessor and would this change your decision to lease vs. buy?
  4. Based on 1, 2, and 3, should the project go forward and should HPH lease or buy?

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