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Toronto General Hospital is reviewing ways of cutting the cost of stocking medical supplies
Toronto General Hospital is reviewing ways of cutting the cost of stocking medical supplies. Two new stockless systems are being considered, to lower the hospital's holding and handling costs. The hospital's industrial engineer has compiled the relevant financial data for each system as follows (dollar values are in millions): Current Practice Just-In-Time System Stockless Supply System Start-up cost $0 $2.5 $5 $1.5 $0.5 Annual stock $3.2 holding cost Annual operating $2 cost $1.5 $1.2 System life 7years 7years 7years The system life of 7 years represents the period that the contract with the medical suppliers is in force. The hospital's MARR is 9%, a) What is the incremental rate of return going from the current practice to the just in time system? IRR for (Just in time - Current practice) = % b) What is the incremental rate of return going from the just in time system to the stockless supply system? IRR for (Stockless supply - Just in time) = % (keep 2 decimal places in numerical results) c) What is the incremental rate of return going from the current practice to the stockless supply system? IRR for (Stockless supply - Current practice) = % d) Based on the above calculated numbers, which option is the best by utilizing the incremental rate of return criterion?
Expert Solution
a) Annual Savings = $3.2 +$2 - $1.5 - $1.5 = $2.2
Investment = $2.5 - 0 = $2.5
| Year | Cash Inflows/(Outflows) |
| 0 | (2.50) |
| 1 | 2.20 |
| 2 | 2.20 |
| 3 | 2.20 |
| 4 | 2.20 |
| 5 | 2.20 |
| 6 | 2.20 |
| 7 | 2.20 |
| IRR = | 87% |
b) Annual Savings = $1.5 +$1.5 - $0.5 - $1.2 = $1.3
Investment = $5 - $2.5 = $2.5
| Year | Cash Inflows/(Outflows) |
| 0 | (2.50) |
| 1 | 1.30 |
| 2 | 1.30 |
| 3 | 1.30 |
| 4 | 1.30 |
| 5 | 1.30 |
| 6 | 1.30 |
| 7 | 1.30 |
| IRR = | 49% |
c) Annual Savings = $3.2 +$2 - $0.5 - $1.2 = $3.5
Investment = $5 - $0 = $5
| Year | Cash Inflows/(Outflows) |
| 0 | (5.00) |
| 1 | 3.50 |
| 2 | 3.50 |
| 3 | 3.50 |
| 4 | 3.50 |
| 5 | 3.50 |
| 6 | 3.50 |
| 7 | 3.50 |
| IRR = | 68% |
d) Based on the above numbers, using incemental rate of return criterion, best option is Just in Time System.
Note:- For IRR, use the excel formula IRR with reference to the cash flows of 0 to 7 Years.
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