Problem 123A Problem 123A Brooks Clinic is considering inves

Problem 12-3A

Problem 12-3A 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%. Option A Option B Initial cost $183,000 $281,000 Annual cash inflows $70,000 $80,000 Annual cash outflows $28,000 $25,000 Cost to rebuild (end of year 4) $48,000 $0 Salvage value $0 $7,000 Estimated useful life 7 years 7 years Click here to view PV table.

Solution

1. NPV

Option A

NPV = $20538

Option B

NPV = $42225

2. Profitability index

PI = (NPV + Initial Investment) / Initial Investment

Option A:

= (20538 + 183000)/ 183000

= 1.11

Option B:

= (42225 + 281000)/ 281000

= 1.15

3. IRR

Option A:

NPV @ 7% (in the same way as calculated in point 1)

= -183000 + (42000 x 5.38929) + (-48000 x 0.76290)

= $6731

NPV @ 9%

= -183000 + (42000 x 5.03295) + (-48000 x 0.70843)

= -$5621

IRR = Lower rate + [NPV at lower rate/ (NPV at lower rate - NPV at higher rate)] x Difference in rates

= 7% + [6731/ (6731 + 5621)] x 2

= 8.09%

Option B:

NPV @ 7% (in the same way as calculated in point 1)

= -281000 + (55000 x 5.38929) + (7000 x 0.62275)

= $19770

NPV @ 9%

= -281000 + (55000 x 5.03295) + (7000 x 0.54703)

= -$359

IRR = Lower rate + [NPV at lower rate/ (NPV at lower rate - NPV at higher rate)] x Difference in rates

= 7% + [19770/ (19770 + 359)] x 2

= 8.96%

Option B should be accepted.