Question

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 $196,000 $291,000 Annual cash inflows $72,500 $82,500 Annual cash outflows $28,000 $25,600 Cost to rebuild (end of year 4) $49,100 $0 Salvage value $0 $8,500 Estimated useful life 7 years 7 years Click here to view PV table. Collapse question part (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 Option A $ % Option B $ %

Answer 1

Project A						A
Year	Annual cash inflows	Annual cash outflows	Cost of rebiuld	Net Cash flow	PV factor @ 5%	Present Value
1	$                  72,500	$                (28,000)		$        44,500	0.95238	$            42,381
2	$                  72,500	$                (28,000)		$        44,500	0.90703	$            40,363
3	$                  72,500	$                (28,000)		$        44,500	0.86384	$            38,441
4	$                  72,500	$                (28,000)	$ (49,100)	$        (4,600)	0.82270	$            (3,784)
5	$                  72,500	$                (28,000)		$        44,500	0.78353	$            34,867
6	$                  72,500	$                (28,000)		$        44,500	0.74622	$            33,207
7	$                  72,500	$                (28,000)		$        44,500	0.71068	$            31,625
Present Value of Net Cash inflow						$          217,100
Present Value of Net Cash inflow						$          217,100
Less: Initial cost						$          196,000
Net present value						$            21,100
Present Value of Net Cash inflow						$          217,100
Divided by: Initial cost						$          196,000
Profitability index						1.11

Project B						B
Year	Annual cash inflows	Annual cash outflows	Salvage value	Net Cash flow	PV factor @ 5%	Present Value
1	$                  82,500	$                (25,600)		$        56,900	0.95238	$            54,190
2	$                  82,500	$                (25,600)		$        56,900	0.90703	$            51,610
3	$                  82,500	$                (25,600)		$        56,900	0.86384	$            49,152
4	$                  82,500	$                (25,600)		$        56,900	0.82270	$            46,812
5	$                  82,500	$                (25,600)		$        56,900	0.78353	$            44,583
6	$                  82,500	$                (25,600)		$        56,900	0.74622	$            42,460
7	$                  82,500	$                (25,600)	$      8,500	$        65,400	0.71068	$            46,478
Present Value of Net Cash inflow						$          335,285
Present Value of Net Cash inflow						$          335,285
Less: Initial cost						$          291,000
Net present value						$            44,285
Present Value of Net Cash inflow						$          335,285
Divided by: Initial cost						$          291,000
Profitability index						1.15