Problem 24-3A (Part Level Submission) Brooks Clinic is considering investing in

Question

Problem 24-3A (Part Level Submission) 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 $196,000 $291,000 $72,500 $82,500 $28,000 $25,600 Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 4) Salvage value Estimated useful life $49,100 $0 $8,500 7 years 7 years Click here to view PV table ? (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.) (Ifthe net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round answers for present value and IRR to 0 decimal places, e.g. 125 and round profitability index to 2 decimal places, e.g. 10.50. For calculation purposes, use 5 decimal places as displayed in the factor table provided.) Net Present Value Profitability Index Internal Rate of Return Option A Option B

Explanation / Answer

(1) Computation of the net present value of option A & B. We have,

Step1: Computation of the present value of net cash inflow for option A & B.We have,

Option A:

Option B:

Step2: Computation of net present value(NPV) of option A & B.We have,

NPV = Present value of cash inflow - Present value of cash outflow

Option A:

NPV = 217,066 - 196,000 = $ 21,066

Option B:

NPV = 335,267 - 291,000 = $ 44,267

(2) Computation of the profitability index for option A & B.We have,

Profitabiltiy index = Present value of future cash inflow / Initital investment

Option A:

Profitability index = 217,066 / 196,000 = 1.11

Option B:

Profitability index = 335,267 / 291,000 = 1.15

(3) Computation of the internal rate of return for option A & B.We have,

Step1: Computation of the present value of cash inflow at 10% rate of return.We have,

Option A:

Option B:

Step2: Computation of the internal rate of return(IRR) of option A & B.We have,

IRR = Interest rate - [ ( present value of cash outflow - present value of cash inflows)/ differences in calculated PV of inflows] Differences in interest rates

Option A:

IRR = 10 - [ ( 196,000 - 183,044) / ( 217,066 - 183,044) ] ( 10 - 5)

IRR = 10 - [ 12,956 / 34,022] 5

IRR = 10 - 1.90 = 8.10 %

Option B:

IRR = 10 - [ ( 291,000 - 281,293) / ( 335,267 - 281,293) ] ( 10 - 5)

IRR = 10 - [ 9,707 / 53,974 ] 5

IRR = 10 - 0.90 = 9.10 %

year 1 2 3 4 5 6 7 Total Cash Inflow $ 72,500 $ 72,500 $ 72,500 $ 72,500 $ 72,500 $ 72,500 $ 72,500 Less: Cash outflow 28,000 28,000 28,000 28,000 28,000 28,000 28,000 Less: Cost to rebuild 0 0 0 49,100 0 0 0 Net Cash inflow 44,500 44,500 44,500 (4,600) 44,500 44,500 44,500 PVIF@5% 0.952 0.907 0.864 0.823 0.783 0.746 0.711 Present value of cash inflow 42,364 40,361 38,448 (3,786) 34,843 33,197 31,639 $ 217,066

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