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 $183,000 $70,000 $28,000 $48,000 $0 7 years Option B $281,000 $80,000 $25,000 $0 $7,000 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 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.) Not Dorontaluo Drofitability Indoy Tntorn Dato of Datuan

Answer 1

Answer with working and explanation is given below

Profitability Index Net Present value $20,538 $42,225 Internal Rate of Return 8% 9% Option A Option B 1.11 1.15 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 $70,000 $28,000 Option B $80,000 $25,000 $55,000 PV factor of 5% for 7 years 5.78637 5.78637 $243,028 A $318,251) A -$48,000 0.822701 -$39,490 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 $323,225 $281,000 $42,225 B A+B A+B $203,538 $183,000 $20,538 Profitability index Present value of cash inflows Present value of cash outflows Option A $203,538 Option B $323,225 $281,000 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 -$183,000 $42,000 $42,000 $42,000 $6,000 $42,000 $42,000 $42,000 8% Option B $281,000 $55,000 $55,000 $55,000 $55,000 $55,000 $55,000 $62,000 For year 4 Option A net cash outflow will be Cash inflow $42,000 cost of rebuild (end of year 4) -$48,000 Net cash outflow $6,000 For year 7 Option B net cash inflow will be Annual cash inflow $55,000 Salvage value $7,000 Net cash inflow $62,000 IRR checking PV factor at 9% 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 -$183,000 $42,000 $42,000 $42,000 -$6,000 $42,000 $42,000 $42,000 8% PV factor at 8% 1 0.92593 0.85734 0.79383 0.73503 0.68058 0.63017 NPV Cash inflow/ (Outflow) $183,000 $38,889 $36,008 $33,341 $4,410 $28,584 $26,467 $24,507 $386 Option B -$281,000 $55,000 $55,000 $55,000 $55,000 $55,000 $55,000 $62,000 0.91743 0.84168 0.77218 0.70843 0.64993 0.59627 0.54703 NPV Cash inflow/ (Outflow) $281,000 $50,459 $46,292 $42,470 $38,963 $35,746 $32,795 $33,916 -$358 9% Note: IRR is kept at 0 decimal places