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Brooks Clinic is considering investing in new heart-monitoring equipment. It has two options. Option A would...

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 $ %

Solutions

Expert Solution

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

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