Brooks Clinic is considering investing in new heart-monitoring equipment. It has
ID: 2475154 • Letter: B
Question
Brooks Clinic is considering investing in new heart-monitoring equipment. It has two options. Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 4 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 made of the cash flows. The company’s cost of capital is 5%.
OPTION A & OPTION B Initial cost $193,000 $288,000 Annual cash inflows $72,700 $81,800 Annual cash outflows $28,400 $25,400 Cost to rebuild (end of year 4) $51,500 $0
Compute the (1) net present value, (2) profitability index, and (3) 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.) Salvage value $0 $7,000 Estimated useful life 7 years 7 years
Explanation / Answer
SOLUTION :
A
B
INTIAL COST
193000
288000
Annual cash inflows
72700
81800
Annual cash outflows
28400
25400
Cost to rebuild (end of year 4)
51500
0
Salvage value
0
7000
Estimated useful life
7
7
A
B
Year
DF @5%
CASH FLOW
PV
CASH FLOW
PV
0
1
- 193,000
- 193,000
- 288,000
- 288,000
1
0.952380952
44,300
42,190
56,400
53,714
2
0.907029478
44,300
40,181
56,400
51,156
3
0.863837599
44,300
38,268
56,400
48,720
4
0.822702475
- 7,200
- 5,923
56,400
46,400
5
0.783526166
44,300
34,710
56,400
44,191
6
0.746215397
44,300
33,057
56,400
42,087
7
0.71068133
44,300
31,483
63,400
45,057
NPV
20,967
43,326
A
B
PI (NPV+INITIAL COST)/INITIAL COST
1.11
1.15
(20967+193000)/193000
(43326+288000)/288000
A
B
Year
DF @5%
CASH FLOW
PV
CASH FLOW
PV
0
1
-193000
- 193,000
-288000
- 288,000
1
0.925925926
44300
41,019
56400
52,222
2
0.85733882
44300
37,980
56400
48,354
3
0.793832241
44300
35,167
56400
44,772
4
0.735029853
-7200
- 5,292
56400
41,456
5
0.680583197
44300
30,150
56400
38,385
6
0.630169627
44300
27,917
56400
35,542
7
0.583490395
44300
25,849
63400
36,993
NPV
- 212
9,724
IRR
7.97
8.87
8+((212*3)/(-212-20967))
8+((9724*3)/(43326-9724))
A
B
INTIAL COST
193000
288000
Annual cash inflows
72700
81800
Annual cash outflows
28400
25400
Cost to rebuild (end of year 4)
51500
0
Salvage value
0
7000
Estimated useful life
7
7
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