Capital budgeting techniques provide recommendations regarding company’s long-term investments. It evaluates the value of an investment and helps to determine whether the project is worth pursuing. There are several methods for evaluating projects, however for the purpose of this task we will use Net Presents Value (NPV), which takes into account the time value of money by assessing investment’s cash flows with consideration of their timing and size (Peterson & Fabozzi, 2002). All projects with positive NPV are accepted, while for mutually exclusive projects, such as buying or leasing hospital equipment, the investment with the highest NPV should be chosen.
In order to decide whether to lease or to buy the equipment it is necessary to make several assumptions. Firstly, 10% discount rate will be considered. Secondly, let’s assume that no money should be borrowed for leasing the equipment. For the purchase, on the other hand, let’s assume that the full sum should be borrowed externally. The interest rate on the borrowed amount is paid annually. Moreover, in order to take advantage of the tax-shield, that is provided by depreciation, we assume 34% tax rate, based on the current Federal corporate income tax (Federal tax brackets).
Since yearly outflows for leasing the server are $11,000 and there is no initial investment, we can use NPV formula in further analysis:
NPV = C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4 + C5/(1+r)5 = - 11000/(1+0.1) – 11,000/(1+0.1)2 – 11,000/(1.01)3 – 11,000/(1+0.1)4 –11,000/(1.01)5 = $-45,869
If the equipment is purchased, the initial investment C0 = -$50,000, therefore the interest rate of $5,000 should be paid annually. Considering depreciation and taxes, the cash flows for the project can be presented in the following table.
Therefore, NPV for buying equipment can be calculated as follows:
NPV = -5000/(1+0.1) -1,600/(1+0.1)2 -1,600/(1+01)3 -1,600/(1+01)4 – 80,000/(1+01)5 =
= $ -63620.03
Since NPV is more negative for the buying project then for leasing, under these conditions the hospital should lease the equipment. However, since no positive cash flows are provided, it is impossible to determine the viability of the selected project. Since NPV for leasing is negative, theoretically, it also should not be pursued, unless more information on the cash inflows is provided.
References
Federal tax brackets. In Investopedia Investopedia ULC. Retrieved from
http://www.investopedia.com/terms/f/federal_tax_brackets.asp
Peterson, P. P., & Fabozzi, F. J. (2002). Capital budgeting, theory and practice. New York: John
Wiley & Sons Inc.
