Brooks Clinic is considering investing in new heart-monitoring equipment. It has

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%.

7 years

Option A Option B Initial cost $196,000 $291,000 Annual cash inflows $72,500 $82,500 Annual cash outflows $28,000 $25,600 Cost to rebuild (end of year 4) $49,100 $0 Salvage value $0 $8,500 Estimated useful life 7 years

7 years

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.) (If the 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.)

Explanation / Answer

SOLUTION :

Option A

Option B

Initial cost

196000

291000

Annual cash inflows

72500

82500

Annual cash outflows

28000

25600

Cost to rebuild (end of year 4)

49100

0

Salvage value

0

8500

Estimated useful life

7

7

NPV CALCULATION

A

B

ANNUAL CASH INFLOW

         419,512

         477,376

ANNUAL CASH OUTFLOW

-       162,018

-       148,131

SALVAGE

                    -  

             6,041

INTIAL COST

-       196,000

-       291,000

Cost to rebuild (end of year 4)

-         40,395

                    -  

NPV

           21,099

           44,285

PI = (NPV + INITIAL INVESTMENT)/INITIAL INVESTMENT

                1.11

                1.15

IRR

8%

9%

Option A

Option B

Year

Discount Factor @ 8%

cash flow

Present Value

Year

Discount Factor @ 9%

cash flow

Present Value

0

1

-196000

-196000

0

1

-291000

-291000

1

0.92655

44500

41231.48

1

0.91741

56900

52200.64

2

0.858495

44500

38203.03

2

0.841641

56900

47889.39

3

0.795439

44500

35397.02

3

0.77213

56900

43934.21

4

0.737014

-4700

-3463.97

4

0.70836

56900

40305.69

5

0.68288

44500

30388.17

5

0.649857

56900

36976.85

6

0.632723

44500

28156.16

6

0.596185

56900

33922.93

7

0.586249

44500

26088.1

7

0.546946

65400

35770.29

5.21935

0

5.03253

          0.00

Option A

Option B

Initial cost

196000

291000

Annual cash inflows

72500

82500

Annual cash outflows

28000

25600

Cost to rebuild (end of year 4)

49100

0

Salvage value

0

8500

Estimated useful life

7

7

NPV CALCULATION

A

B

ANNUAL CASH INFLOW

         419,512

         477,376

ANNUAL CASH OUTFLOW

-       162,018

-       148,131

SALVAGE

                    -  

             6,041

INTIAL COST

-       196,000

-       291,000

Cost to rebuild (end of year 4)

-         40,395

                    -  

NPV

           21,099

           44,285

PI = (NPV + INITIAL INVESTMENT)/INITIAL INVESTMENT

                1.11

                1.15

IRR

8%

9%

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