Question

Problem 25-03A 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 $182,000 $72,800 $30,600 $51,300 $0 7 years Option B $283,000 $81,700 $26,500 $0 $8,600 7 years Click here to view the factor 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.) (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. 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 LINK TO TEXT Which option should be accepted? should be accepted.

Answer 1

Brooks Clinic Option A Years 1 Investment Annual Cashinflow Annual Cashoutflow Net cash flow -182000 72800 30600 42200 72800 30600 42200 72800 30600 42200 72800 30600 42200 72800 30600 42200 72800 30600 42200 72800 30600 42200 Cost to Rebuild Total Cashflow D/F @ 5% Present Value -182000 -182000 42200 0.952 40174 42200 0.907 38275 42200 0.863 36419 -51300 -9100 0.823 -7489 42200 0.784 33085 42200 0.746 31481 42200 0.711 30004 NPV 19949 IRR 8.00% IRR(G6:13) 2) Profitability index = Present value of net cash flows/initial investment = 201949 / 182000 = 1.11 0.952 Option B Cost to Years Investment Annual Cashinflow Annual Cashoutflow Net cash flow Rebuild Total Cashflow D/F @ 5% Present Value -283000 -283000 1 -283000 81700 26500 55200 55200 52550 81700 26500 55200 55200 0.907 50066 81700 26500 55200 55200 0.863 47638 81700 26500 55200 55200 0.823 45430 81700 26500 55200 55200 0.784 43277 81700 26500 55200 55200 0.746 41179 81700 26500 55200 8600 63800 0.711 45362 NPV 42502 IRR 8.95% 2) Profitability index = Present value of net cash flows/initial investment IRR(G23:630) = 325502 / 283000 = 1.15 Accept Option B with higher NPV and Profitability Index