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 Click here to view PV table.

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.) Net Present Value Profitability Index Internal Rate of Return Option A $ % Option B $ % Which option should be accepted? Option A or Option B should be accepted

Answer 1