Goltra Clinic is considering investing in new heart-monitoring equipment. It has
ID: 2499991 • Letter: G
Question
Goltra 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 7%. Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each option.Explanation / Answer
Option A
Initial Cost = 158000
Annual Cash Inflow = 70300
Annual Cash Outflow = 31600
Annual Net cash Inflow = Annual Cash Inflow - Annual Cash Outflow
Annual Net cash Inflow = 70300-31600
Annual Net cash Inflow = 38700
Cost to rebuild at the end of year 4 = 51500
Salvage Value = 0
Estimated Useful life = 7
Net Present value = -Initial Cost + Annual Net cash Inflow *PVIFA(7%,7) - Cost to rebuild at the end of year 4 *PVIF(7%,4)
Net Present value = -158000 + 38700*5.38929 - 51500*0.76290
Net Present value = 11,276
Profitability Index = (1+Net Present value /Initial Cost)
Profitability Index = (1+ 11276/158000)
Profitability Index = 1.07 times
Internal Rate of Return :
At this Rate NPV is equal to zero
Net Present value = -Initial Cost + Annual Net cash Inflow *PVIFA(r,7) - Cost to rebuild at the end of year 4 *PVIF(r,4)
0 = -158000 + 38700*PVIFA(r,7) - 51500*PVIF(r,4)
By using Present Value table , using alternative discount rate to arrive at a IRR
IRR = 9%
Option B
Initial Cost = 250000
Annual Cash Inflow = 81900
Annual Cash Outflow = 26000
Annual Net cash Inflow = Annual Cash Inflow - Annual Cash Outflow
Annual Net cash Inflow = 81900-26000
Annual Net cash Inflow = 55900
Cost to rebuild at the end of year 4 = 0
Salvage Value = 7100
Estimated Useful life = 7
Net Present value = -Initial Cost + Annual Net cash Inflow *PVIFA(7%,7) + Salvage Value *PVIF(7%,7)
Net Present value = -250000 + 55900*5.38929 + 7100*0.62275
Net Present value = 55,682
Profitability Index = (1+Net Present value /Initial Cost)
Profitability Index = (1+ 55682/250000)
Profitability Index = 1.22 times
Internal Rate of Return :
At this Rate NPV is equal to zero
Net Present value = -Initial Cost + Annual Net cash Inflow *PVIFA(r,7) + Salvage Value*PVIF(r,7)
0 = -250000 + 55900*PVIFA(r,7)+ 7100*PVIF(r,7)
By using Present Value table , using alternative discount rate to arrive at a IRR
IRR = 13%
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