In: Accounting
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 7%. Option A Option B Initial cost $155,000 $262,000 Annual cash inflows $70,700 $80,400 Annual cash outflows $32,000 $25,700 Cost to rebuild (end of year 4) $48,300 $0 Salvage value $0 $8,100 Estimated useful life 7 years 7 years Click here to view the factor 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 Option A $ % Option B $ %
Calculation of NPV, IRR & Profitability INDEX | |||||||||
Option A | |||||||||
IRR is the discount rate on which NPV is zero. To calculate this, we have to took two Random Discount Rate: | |||||||||
Period | Initial Cost | Cash Inflow | Cash Outflows | Net Cash flows | P.V.F @ 7% | N.P.V @ 7% | P.V.F @ 11% | N.P.V @ 11% | |
0 | -155000 | -155000 | 1.00000 | -1,55,000 | 1.00000 | -1,55,000 | |||
1 | 70,700 | -32,000 | 38700 | 0.93458 | 36,168 | 0.90090 | 34,865 | ||
2 | 70,700 | -32,000 | 38700 | 0.87344 | 33,802 | 0.81162 | 31,410 | ||
3 | 70,700 | -32,000 | 38700 | 0.81630 | 31,591 | 0.73119 | 28,297 | ||
4 | 70,700 | -80,300 | -9600 | 0.76290 | -7,324 | 0.65873 | -6,324 | ||
5 | 70,700 | -32,000 | 38700 | 0.71299 | 27,593 | 0.59345 | 22,967 | ||
6 | 70,700 | -32,000 | 38700 | 0.66634 | 25,787 | 0.53464 | 20,691 | ||
7 | 70,700 | -32,000 | 38700 | 0.62275 | 24,100 | 0.48166 | 18,640 | ||
NPV | 16,718 | -4,455 | |||||||
Salvage Value | NIL | ||||||||
IRR= Lower Discount Rate + [ Lower Rate NPV / ( Lower Rate NPV - Higher Rate NPV )]*(Higher Discount Rate-Lower Discount Rate) | |||||||||
So By putting figure into this formula IRR is | 10% | ||||||||
Profitability Index | PV of future Cash flows | (16718+155000) | 1.11 | ||||||
Initial cost | 155000 | ||||||||
Option B | |||||||||
Period | Initial Cost | Cash Inflow | Cash Outflows | Salvage Value | Net Cash flows | P.V.F @ 7% | N.P.V @ 7% | P.V.F @ 11% | N.P.V @ 11% |
0 | -262000 | -262000 | 1.00000 | -2,62,000 | 1.00000 | -2,62,000 | |||
1 | 80,400 | -25,700 | 54700 | 0.93458 | 51,122 | 0.90090 | 49,279 | ||
2 | 80,400 | -25,700 | 54700 | 0.87344 | 47,777 | 0.81162 | 44,396 | ||
3 | 80,400 | -25,700 | 54700 | 0.81630 | 44,652 | 0.73119 | 39,996 | ||
4 | 80,400 | -25,700 | 54700 | 0.76290 | 41,731 | 0.65873 | 36,033 | ||
5 | 80,400 | -25,700 | 54700 | 0.71299 | 39,001 | 0.59345 | 32,462 | ||
6 | 80,400 | -25,700 | 54700 | 0.66634 | 36,449 | 0.53464 | 29,245 | ||
7 | 80,400 | -25,700 | 54700 | 0.62275 | 34,064 | 0.48166 | 26,347 | ||
7 | 8,100 | 8100 | 0.62275 | 5,044 | 0.48166 | 3,901 | |||
NPV | 37,839 | Total | -342 | ||||||
IRR= Lower Discount Rate + [ Lower Rate NPV / ( Lower Rate NPV - Higher Rate NPV )]*(Higher Discount Rate-Lower Discount Rate) | |||||||||
So By putting figure into this formula IRR is | 11% | ||||||||
Profitability Index | PV of future Cash flows | (37839+262000) | 1.14 | ||||||
Initial cost | 262000 |