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 8%.

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Please calculate the IRR of Option A and B

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

Explanation / Answer

Calculation of IRR NPV@5% NPV@10% Year Capital cost Annual revenue Annual cost Project A PV factor PV Project A PV factor PV Project A 0         (160,000)      (160,000) 1.000 (160,000) 1.000 (160,000) 1          71,000         (30,000)           41,000 0.952        39,048 0.909        37,273 2          71,000         (30,000)           41,000 0.907        37,188 0.826        33,884 3          71,000         (30,000)           41,000 0.864        35,417 0.751        30,804 4           (50,000)          71,000         (30,000)           (9,000) 0.823        (7,404) 0.683        (6,147) 5          71,000         (30,000)           41,000 0.784        32,125 0.621        25,458 6          71,000         (30,000)           41,000 0.746        30,595 0.564        23,143 7          71,000         (30,000)           41,000 0.711        29,138 0.513        21,039 NPV        36,106          5,454 IRR =Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV) IRR =5%+5%*(36106/(36106-5454)) 10.89% NPV@5% NPV@10% Year Capital cost Annual revenue Annual cost Project A PV factor PV Project A PV factor PV Project A 0         (227,000)      (227,000) 1.000 (227,000) 1.000 (227,000) 1          80,000         (31,000)           49,000 0.952        46,667 0.909        44,545 2          80,000         (31,000)           49,000 0.907        44,444 0.826        40,496 3          80,000         (31,000)           49,000 0.864        42,328 0.751        36,814 4          80,000         (31,000)           49,000 0.823        40,312 0.683        33,468 5          80,000         (31,000)           49,000 0.784        38,393 0.621        30,425 6          80,000         (31,000)           49,000 0.746        36,565 0.564        27,659 7                8,000          80,000         (31,000)           57,000 0.711        40,509 0.513        29,250 NPV        62,218        15,658 IRR =Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV) =5%+5%*(62218/(62218-15658) 11.68%

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