Problem 12-3A Problem 12-3A Brooks Clinic is considering investing in new heart-
ID: 2392556 • Letter: P
Question
Problem 12-3A
Problem 12-3A
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 $183,000 $281,000 Annual cash inflows $70,000 $80,000 Annual cash outflows $28,000 $25,000 Cost to rebuild (end of year 4) $48,000 $0 Salvage value $0 $7,000 Estimated useful life 7 years 7 years
Click here to view PV table.
Explanation / Answer
Solution 1 & 2:
Solution 3:
Lets compute NPV at discount rate of 8% and 9% for option A and option B.
As NPV is zero near IRR at 8%, therefore rounding off IRR for option A = 8%
As NPV is zero near IRR at 9%, therefore rounding off IRR for option B = 9%
As NPV, PI and IRR are high for option B therefore option B should be accepted.
Compuation of NPV and Profitability index Particulars Period PV Factor Option A Option B Amount Present value Amount Present value Cash Outflows: Initial Cost 0 1 $183,000 $183,000 $281,000 $281,000 Annual cash outflows 1-7 5.78637 $28,000 $162,018 $25,000 $144,659 Cost to rebuild 4 0.8227 $48,000 $39,490 $0 $0 Present value of cash outflows (A) $384,508 $425,659 Cash Inflows: Annual Cash Inflows 1-7 5.78637 $70,000 $405,046 $80,000 $462,910 Salvage Value 7 0.71068 $0 $0 $7,000 $4,975 Present Value of cash inflows (B) $405,046 $467,884 NPV (B-A) $20,538 $42,225 Profitability Index (PV of cash inflows / PV of cash outflows) 1.05 1.10