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 6%. Option A Option B Initial cost $176,000 $271,000 Annual cash inflows $71,700 $80,200 Annual cash outflows $29,900 $25,300 Cost to rebuild (end of year 4) $48,000 $0 Salvage value $0 $7,800 Estimated useful life 7 years 7 years Click here to view PV 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 $ % LINK TO TEXT LINK TO TEXT LINK TO TEXT LINK TO VIDEO Attempts: 0 of 1 used SAVE FOR LATER SUBMIT ANSWER

(b) The parts of this question must be completed in order. This part will be available when you complete the part above.

Answer 1

					Present value
		Year	Option A		Option B		Present value factor @6%	Option A	Option B
		0	-$176,000		-$271,000		1	-$176,000	-$271,000
		1	$41,800	(71,700-29,900)	$54,900	(80,200-25,300)	0.9434	$39,434	$51,793
		2	$41,800	(71,700-29,900)	$54,900	(80,200-25,300)	0.89	$37,202	$48,861
		3	$41,800	(71,700-29,900)	$54,900	(80,200-25,300)	0.83962	$35,096	$46,095
		4	-$6,200	(71,700-29,900-48,000)	$54,900	(80,200-25,300)	0.79209	-$4,911	$43,486
		5	$41,800	(71,700-29,900)	$54,900	(80,200-25,300)	0.74726	$31,235	$41,025
		6	$41,800	(71,700-29,900)	$54,900	(80,200-25,300)	0.70496	$29,467	$38,702
		7	$41,800	(71,700-29,900)	$62,700	(80,200-25,300+7800)	0.66506	$27,800	$41,699
						Present value		$195,323	$311,661
						Net Present value		$19,323	$40,661

Profitability Index:-

Profitability index is a ratio of present value of cash flows and initial investment

option A
=195,323 / 176,000

=1.11

option b

=311,661 / 271,000

=1.15

3. IRR we would select two rates and find NPV at those discounted rates

Option A

Rate 1 = 6% NPV 1 =$19,323

R2=10% NPV2 = $419

years	Cash flow	PV factor at 10%	present value of cash flow
0	($176,000)	1	($176,000)
1-7	$41,800	4.86842	$203,500
	(71,700-29,900)	[1/1.10]7
4	(48,000)	0.68301	($32,784)
		Net present Value	-$5,284

IRR = R1 + ((NPV1 * (R2 - R1)) / (NPV1 - NPV2)

=0.06 + (19,323 * (0.10-0.06) /(19,323 + 5,284)

= 9%

At 9% NPV would be zero IRR is the rate where present value of cash inflow= cash outflow

option B

years	Cash flow	PV factor at 10%	present value of cash flow
0	($271,000)	1	($271,000)
1-7	$54,900	4.86842	$267,276
	(80,200-25,300)	[1/1.10]7
7	$7,800	0.51316	$4,003
		NPV	$279

IRR = R1 + ((NPV1 * (R2 - R1)) / (NPV1 - NPV2)

=0.06 + (40,661 * (0.10-0.06) / (40,661-279)

=0.06+(1135/40382)

=10%

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