Question

Problem 25-03A a-b (Video) (Part Level Submission) Bonita 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 7%. Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 4) Salvage value Estimated useful life Option A $155,000 $70,700 $32,000 $48,300 $0 7 years Option B $262,000 $80,400 $25,700 $0 $8,100 7 years Click here to view PV table. (a) 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 1. Option A A Option B to

Answer 1

(1) Net present value is the difference between initial cost and present value of Net cash inflows.

option A

years	Cash flow	PV factor at 7%	present value of cash flow
0	($155,000)	1	($155,000)
1-7	$38,700	5.38929	$208,566[38700*5.38929]
	[70700-32000]	[1/1.07]7
4	(48,300)	0.76290	($36,848)
		Net present Value	$16,718	[208566-36848-155000]

option B

years	Cash flow	PV factor at 7%	present value of cash flow
0	($262,000)	1	($262,000)
1-7	$54,700	5.38929	$294,794[54700*5.38929]
	[80400-25700]	[1/1.07]7
7	$8,100	0.62275	$5,044
		Net present Value	$37,838	[294794-262000+5044]

2. profitability index is a ratio of present value of cash flows and initial investment

option A
=[208566-36848]/155000

=1.11

option b

=[294794+5044]/262000

=1.14

3. IRR we would select two rates and find NPV at those discounted rates

Option A

Rate 1 = 7% Npv1 =$16,718

R2=10% NPV2 = $419

years	Cash flow	PV factor at 10%	present value of cash flow
0	($155,000)	1	($155,000)
1-7	$38,700	4.86842	$188,408
	[70700-32000]	[1/1.10]7
4	(48,300)	0.68301	($32989)
		Net present Value	$419	[188408-32989-155000]

IRR = R1 + ((NPV1 * (R2 - R1)) / (NPV1 - NPV2)

=0.07 + (16718 * (0.10-0.07) /(16718-419)

=10%

At 10% NPV would be zero IRR is the rate where present value of cash inflow= cash outflow

option B

years	Cash flow	PV factor at 10%	present value of cash flow
0	($262,000)	1	($262,000)
1-7	$54,700	4.86842	$266,303
	[80400-25700]	[1/1.10]7
7	$8,100	0.51316	$4157
		NPV	$8,460	[266303+4157-262000]

IRR = R1 + ((NPV1 * (R2 - R1)) / (NPV1 - NPV2)

=0.07 + (37838 * (0.10-0.07) / (37838-8460)

=0.07+(1135/29378)

=11%