Question

Kimmel, Accounting, 6e Help I System Announcements CALCULATOR??pRINTER VERSIONI : 4EACK Brooks Clinic is considering investing in new heart-m oring equipment. It has two options. Option A would have an initial cost but would require a significant expenditure for rlding 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 6% Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 4) Salvage value Estimated useful life Option A Option B $181,000 $283,000 $73,000 $82,400 $30,200 $25,100 $0 $0 $8,300 7 years7 years $48,000 Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each option. (Hint: To internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.) (If the value is negative, use either a negative sign preceding the number eg-45 or parentheses eg (45). Round anwers for present value and IRR to 0 decimal places, e.g. 125 and round profitability index to 2 decimal places, eg·10.50 For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

Answer 1

Solution a:

Compuation of NPV and Profitability index
Particulars	Period	PV Factor	Option A		Option B
			Amount	Present value	Amount	Present value
Cash Outflows:
Initial Cost	0	1	$181,000	$181,000	$283,000	$283,000
Annual cash outflows	1-7	5.582381	$30,200	$168,588	$25,100	$140,118
Cost to rebuild	4	0.792094	$48,000	$38,020	$0	$0
Present value of cash outflows (A)				$387,608		$423,118
Cash Inflows:
Annual Cash Inflows	1-7	5.582381	$73,000	$407,514	$82,400	$459,988
Salvage Value	7	0.665057	$0	$0	$8,300	$5,520
Present Value of cash inflows (B)				$407,514		$465,508
NPV (B-A)				$19,905		$42,390
Profitability Index (PV of cash inflows / PV of cash outflows)				1.05		1.10

To compute IRR let calculate NPV of option A at 9% and 10% discount rate. Further lets calculate NPV of option B at 10% and 11% discount rate. IRR is the rate at which NPV of project will be zero.

Compuation of NPV - Option A at 9% and 10%
Particulars	Period	Amount	PV Factor at 9%	Present Value at 9%	PV Factor at 10%	Present Value at 10%
							Cash Outflows:
Initial Cost	0	$181,000.00	1	$181,000.00	1	$181,000.00
Annual cash outflows	1-7	$30,200.00	5.032952835	$151,995.18	4.868418818	$147,026.25
Cost to rebuild	4	$48,000.00	0.708425211	$34,004.41	0.683013455	$32,784.65
Present value of cash outflows (A)				$366,999.59		$360,810.89
Cash Inflows:
Annual Cash Inflows	1-7	$73,000.00	5.032952835	$367,405.56	4.868418818	$355,394.57
Salvage Value	7	$0.00	0.547034245	$0.00	0.513158118	$0.00
Present Value of cash inflows (B)				$367,405.56		$355,394.57
NPV (B-A)				$405.97		-$5,416.32

As we have to round IRR at zero decimal place, therefore IRR for option A is 9%, becuase at 10% NPV is negative.

Compuation of NPV - Option B at 10% and 11%
Particulars	Period	Amount	PV Factor at 10%	Present Value at 10%	PV Factor at 11%	Present Value at 11%
							Cash Outflows:
Initial Cost	0	$283,000.00	1	$283,000.00	1	$283,000.00
Annual cash outflows	1-7	$25,100.00	4.868418818	$122,197.31	4.712196265	$118,276.13
Cost to rebuild	4	$0.00	0.683013455	$0.00	0.658730974	$0.00
Present value of cash outflows (A)				$405,197.31		$401,276.13
Cash Inflows:
Annual Cash Inflows	1-7	$82,400.00	4.868418818	$401,157.71	4.712196265	$388,284.97
Salvage Value	7	$8,300.00	0.513158118	$4,259.21	0.481658411	$3,997.76
Present Value of cash inflows (B)				$405,416.92		$392,282.74
NPV (B-A)				$219.61		-$8,993.39

As we have to round IRR at zero decimal place, therefore IRR for option B is 10%, becuase at 11% NPV is negative.