Cash Flow Estimation for Pinehill Medical Associates - Essay Example

PMA analyzes the worth of medical facilities of option 1 and option 2 with the discount rate defined as 10% and the cost of capital as 15%. Cash flow estimation for option 1 is included in the following table: Formula for the payback period is as follows: Payback Period = Year before Cumulative Cash Flow becomes positive + (-Cumulative cash flow in the year before it becomes positive i.e. Total amount to be paid)/ (Incremental Cash flow in the year when it becomes positive i.e. Total amount to be paid) (Fabozzi, 2003).

Payback period of Option 1: Payback Period = 3 + 47,800/137,400 = 3.35 years Net Present Value (NPV) for Option 1 Excel calculation for NPV provides the value of $13,263.03 for Option 1. Internal Rate of Return (IRR) for Option 1 Excel calculation for IRR provides the value of 12.25% for Option 1. Cash flow estimation for option 2 is included in the following table: Payback period of Option 2: Payback Period = 3 + 99,600/136,800 = 3.73 years Net Present Value (NPV) for Option 2 Excel calculation for NPV provides the value of -$38,638. 89 for option 2. Internal Rate of Return (IRR) for Option 1 Excel calculation for IRR provides the value of 4.38% for Option 2. The attached Excel sheet contains the step of calculation: Rationale behind Selection of Preferable Medical Facilities Emery, Finnerty, Stowe (2007) define the internal rate of return (IRR) as the discount rate estimated for the project that provides the point at which cash inflow and cash outflow of the organization becomes equal. If IRR is taken as the discount rate of the project, then the net present value becomes equal to zero.

Most of companies choose IRR for the rate of re-investment. The comparison between IRR and the cost of capital provides the criteria for selecting or rejecting the project. If IRR is greater than the cost of capital, then investors benefit from surplus returns from the project (Emery, Finnerty, Stowe, 2007). If IRR is lesser than the cost of capital, then investors need to invest further capital for operating the project (Emery, Finnerty, Stowe, 2007). Valuation techniques applying the decision-making criteria of IRR and the cost of capital for assessment of option 1 and option 2 do not satisfy acceptance criteria in both cases as IRR of 4.

38% is significantly lower than the cost of capital in option 2 whereas IRR of 12.25% for option 1 is also lower than the cost of capital\, but it is comparable. The risk classification of both options should also be taken into account before accepting or rejecting the decision. Net Present Value (NPV) and Payback are other criteria for selecting profitable options. NPV sensitivity analysis provides the net cash flows across the year accommodating the amount of initial investment (Fabozzi, 2003).

The payback period includes the time to retrieve initial investment from future cash flows (. As NPV and payback criteria are the preferable options for maximizing the wealth of its shareholders, option 1 provides better facilities for achieving the objective of maximizing the wealth of shareholders because of NPV of option 1 is greater than the NPV of option 2, but payback period of option 1 is lesser than option 2.