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 $169,000 $291,000

Annual cash inflows $70,400 $82,500

Annual cash outflows $31,000 $25,400

Cost to rebuild (end of year 4) $48,600 $0

Salvage value $0 $7,200

Estimated useful life 7 years 7 years

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.)

Answer 1

Find the self explanatory table-

Year	Particular /Remarks (In $)	Project A					Project B
		Cash Inflows	Outflows	Net	PVF	PV	Cash Inflows	Outflows	Net	PVF	PV
0	Initial Cost		169000	-169000	1.00000	-1,69,000		291000	-291000	1.00000	-2,91,000
1	Annual cash inflow/Outflow	70400	31000	39400	0.95238	37,524	82500	25400	57100	0.95238	54,381
2	Annual cash inflow/Outflow	70400	31000	39400	0.90703	35,737	82500	25400	57100	0.90703	51,791
3	Annual cash inflow/Outflow	70400	31000	39400	0.86384	34,035	82500	25400	57100	0.86384	49,325
4	Annual cash inflow/Outflow/ Cost of rebuild in option A	70400	79600	-9200	0.82270	-7,569	82500	25400	57100	0.82270	46,976
5	Annual cash inflow/Outflow	70400	31000	39400	0.78353	30,871	82500	25400	57100	0.78353	44,739
6	Annual cash inflow/Outflow	70400	31000	39400	0.74622	29,401	82500	25400	57100	0.74622	42,609
7	Annual cash inflow/Outflow/Salvage value	70400	31000	39400	0.71068	28,001	89700	25400	64300	0.71068	45,697
	Net present value					19,000					44,519
	PI= (NPV+Initial investment)/Initial Investment					1.11					1.15
	IRR					8.07%					9.03%

Note- IRR is calculated with below formula

IRR?=??R1??+??	NPV1 x (R2 - R1)
	(NPV1 - NPV2)

Where:

R1 ???? =?? Lower discount rate

R2 ???? =?? Higher discount rate

NPV1 ??=?? Higher Net Present Value (derived from R1)

NPV2 ??=?? Lower Net Present Value (derived from R2)