Question

Compute net present value, profitability C index, and internal rate of return. 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%. Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 4) Salvage value Estimated useful life Option A $160,000 $71,000 $30,000 $50,000 $0 7 years Option B $227,000 $80,000 $31,000 $0 $8,000 7 years Instructions a. (1) NPV A $16,709 (3) IRR B 12% a. Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each op- tion. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.) b. Which option should be accepted?

Answer 1

solution: - Computation Option A of Net Present Value La yoor Coh Inflow - Neffost flow (169000) 41000 71000 71,000 71000 71,000 79000 | 71000 71,000 outflow (160,000) (30,000) (30000) (30,000) (80,000) (30000) 30,000) (30,000) 41,000 41,000 (9,000) 41,000 (160,000) 37,962.29 35,150.89 32,549.12 (6,615.27) 27,903.91 25,836.95 23,923.11 $ 16,709 con'in 7 41,000 NPV = 2) | Profitability Index = PU of fullore cash flow - initial Investment - 1.104 196,709 160,000

3 Calculation of IRRI oven Year 11. 11.05. O vFCosh flow (160,000 41,000 41,000 41,000 (9000) 41,000 49,000 41000 NPV (160,000) 36,607:14 32,686.95 29,182.99 (5,719.66) 23,264.50 20,771.88 18,546.32 64,661186) 36,920.31 33,24 6.56 . 29,938. 37 (5719.91) 24,276.78 21,861.12 19,685.84 209.07 Spread between 8% & 12% SL 16,709 - (4661.88)] *100 160,00OXA = Rate = 0.951, 12 -0.95% 11.05% • IRR - 11.05 ° C approx)

Option B (a O S Computation [ Year cash inflow - 80,000 80,000 89000 80000 80000 80,000 88000 wolnewlnl-10 of Net Present Value cash outflow cash flow (229,000). (227,000) (31000) 49,000 (34,000) 49000 (31,000 49000 (31,000) 49000 (31,000) 49,000 (34000) 49,000 (31,060) 57000 NPV = pu8, (222,000) 45,320.37 42,009.60 33,899.77 36,016:46 33,347.50 30,878.31 33258.95 $32,780.05 - (2) Profitability Index = PV of future Cash flow Initial Investment = 1,144 259780.05 222,000 (3) Calculation of Year estan flow 6 (227,000) 49,000 49,000 49,000 49000 IRR : PU@ 14²1 (227,000) 42,982.46 37,703.91 33,093.60 29.011.93 25,449.06 22,323.24 22,779.33 (13,675.96) Pu@ 12% (227,000) 43,750.50 39,062.50 24.622.23 31,140.39 23,703.92 24,824,42 25,783.91 242.82 49000 57,000

Spread (32,780.0S - (13623.46)) a 46,456,64 >446456.01 x 100 x1_=1.45 T 7x229060I Rate : 14- 146 - 12.5", :. IRR = 12°! (approx)