Brooks Clinic is considering investing in new heart-monitoring equipment. It has
ID: 2481067 • 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 8%. Option A Option B Initial cost $160,000 $227,000 Annual cash inflows $71,000 $80,000 Annual cash outflows $30,000 $31,000 Cost to rebuild (end of year 4) $50,000 $0 Salvage value $0 $8,000 Estimated useful life 7 years 7 years Instructions (a) 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.) (b) Which option should be accepted?
Explanation / Answer
1. NPV & 2. PI
3. IRR
4. Option B should be accepted as it has higher NPV & PI is > 1.
Option A Option B Year Net Cash Flows Discounted Rate Discounted cash flows Year Net Cash Flows Discounted Rate Discounted cash flows 0 (160,000) 0 (227,000) 1 41,000 0.93 37,963 1 49,000 0.93 45,370 2 41,000 0.86 35,151 2 49,000 0.86 42,010 3 41,000 0.79 32,547 3 49,000 0.79 38,898 4 (9,000) 0.74 (6,615) 4 49,000 0.74 36,016 5 41,000 0.68 27,904 5 49,000 0.68 33,349 6 41,000 0.63 25,837 6 49,000 0.63 30,878 7 41,000 0.58 23,923 7 57,000 0.58 33,259 NPV 16,710 NPV 32,780 Profitability Index = 1+NPV/Initial Investment 1.10 Profitability Index = 1+NPV/Initial Investment 1.14Related Questions
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