Aqua Tech Testing is considering investing in a new testing device. It has two o

Question

Aqua Tech Testing is considering investing in a new testing device. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 5 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were provided. The company’s cost of capital is 9%.
Option A Option B
Initial cost $90,000 $170,000
Net annual cash flows $20,000 $32,000
Cost to rebuild (end of year 5) $26,500 $ 0
Salvage value $ 0 $27,500
Estimated useful life 8 years 8 years


Instructions

Compute the following for each option:

Net present value
Option A $
Option B $

Internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.)
Option A %
Option B %

Which option should be accepted? Option AOption B

Explanation / Answer

Option A

Option B

Discount Rate

Present value

Present value

Years

Cash Flows

Cash Flow

10%

Cash Flow of A

Cash Flow of B

Option A

Option B

Discount Rate

Present value

Present value

Years

Cash Flows

Cash Flow

10%

Cash Flow of A

Cash Flow of B

Year 1 20000 32000 0.909090909 18181.81818 29090.90909 Year 2 20000 32000 0.826446281 16528.92562 26446.28099 Year 3 20000 32000 0.751314801 15026.29602 24042.07363 Year 4 20000 32000 0.683013455 13660.26911 21856.43057 Year 5 20000 32000 0.620921323 12418.42646 19869.48234 Year 6 20000 32000 0.56447393 11289.4786 18063.16576 Year 7 20000 32000 0.513158118 10263.16236 16421.05978 Year 8 20000 32000 0.46650738 9330.147604 14928.23617 Present value of Cash Flows - (A) 106698.524 170717.6383 Innitial Investment 90000 170000 0 90000 170000 Rebuilt Cost 26500 0 0.620921323 16454.41506 Total Investment - (B) 106454 170000 Net Present Value = (A - B) 245 718

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