Question

P12.3A (LO 2, 3, 4), AN Service 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 main- tenance 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%. 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 $8,000 Estimated useful life 7 years 7 years $0

Answer 1

Answer with working is given below

Calculation of Net present value Annual Cash inflows Annual cash outflows Net Annual cash inflows Option A $71,000 $30,000 $41,000 Option B $80,000 $31,000 $49,000 PV factor of 8% for 7 years 5.2064 5.2064 $213,461| Α $255,112 A $50,000 0.7350 -$36,751 B Present of cash inflows Present value of cash outflow Cost to rebuild in 4th year PV factor of 8% for 4th year Present value of cash outflow Salvage value PV factor of 8% for 7th year Present value of Salvage value Total present value of cash inflow Less: Initial investment Net present value $8,000 0.5835 $4,668 $259,780 $227,000 $32,780 A+B A+B $176,710 $160,000 $16,710 Option B is better due to higher NPV