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%. Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 4) Salvage value Estimated useful life Option A Option B $193,000 $288,000 $72,700 $81,800 $28,400 $25,400 $51,500 $0 $0 $7,000 7 years 7 years Click here to view PV table. 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.) of the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses es (45). Round answers for present value and IRR to O decimal places, e-g. 125 and round profitability index to 2 decimal places, e.g. 12.50. 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 $ e Textbook and Media Which option should be accepted? uld be accepted. Option A Option B

Answer 1

Answer with working notes is given below

Internal Rate Net Present value $20,967 $43,326 Profitability Index 1.11 1.15 Option A Option B of Return 8% 9% Option B should be accepted Working note and explanation: Calculation of Net present value Annual Cash inflows Annual cash outflows Net Annual cash inflows Option A $72,700 $28,400 $44,300 Option B $81,800 $25,400 $56,400 PV factor of 5% for 7 years 5.78637 5.78637 $256,336 Α $326,351 -$51,500 0.82270 -$42,369 Present of cash inflows Present value of cash outflow Cost to rebuild in 4th year PV factor of 5% for 4th year Present value of cash outflow Salvage value PV factor of 5% for 7th year Present value of Salvage value Total present value of cash inflow Less: Initial investment Net present value $7,000 0.71068 $4,975 $331,326 $288,000 $43,326 B A+B A+B $213,967 $193,000 $20,967 Profitability index Present value of cash inflows Present value of cash outflows Option A $213,967 $193,000 Option B $331,326 $288,000 1.11 1.15 Internal Rate of Return Year o Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Internal Rate of Return Option A $193,000 $44,300 $44,300 $44,300 -$7,200 $44,300 $44,300 $44,300 8% Option B -$288,000 $56,400 $56,400 $56,400 $56,400 $56,400 $56,400 $63,400 9% For year 4 Option A net cash outflow will be Cash inflow $44,300 cost of rebuild (end of year 4) -$51,500 Net cash outflow -$7,200 For year 7 Option B net cash inflow will be Annual cash inflow $56,400 Salvage value $7,000 Net cash inflow $63,400 IRR checking PV factor at 8% PV factor at 9% Internal Rate of Return Year o Year 1 Year 2 Option A -$193,000 $44,300 $44,300 $44,300 -$7,200 $44,300 $44,300 $44,300 8% au WN NPV Cash inflow/ (Outflow) $193,000 $41,019 $37,980 $35,167 -$5,292 $30,150 $27,917 $25,849 $212 0.92593 0.85734 0.79383 0.73503 0.68058 0.63017 0.58349 Option B -$288,000 $56,400 $56,400 $56,400 $56,400 $56,400 $56,400 $63,400 9% Year 4 Year 5 Year 6 Year 7 Internal Rate of Return NPV Cash inflow/ (Outflow) -$288,000 $51,743 $47,471 $43,551 $39,955 $36,656 $33,629 $34,682 -$312 0.91743 0.84168 0.77218 0.70843 0.64993 0.59627 0.54703 Note: IRR is kept at 0 decimal places