Problem 12-3A (Part Level Submission) (a) Problem 12-3A (Part Level Submission)
ID: 2414146 • Letter: P
Question
Problem 12-3A (Part Level Submission)
(a)
Problem 12-3A (Part Level Submission)
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 $170,000 $293,000 Annual cash inflows $70,200 $83,000 Annual cash outflows $30,700 $25,600 Cost to rebuild (end of year 4) $49,000 $0 Salvage value $0 $7,800 Estimated useful life 7 years 7 years
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Explanation / Answer
Net Present Value Profitability Index Internal Rate of Return Option A $ 18,249 1.11 8% Option B $ 44,681 1.15 9% Working: Option A: a. Year 0 1 2 3 4 5 6 7 Total Initial Cost -1,70,000 Annual Cash inflows 70,200 70,200 70,200 70,200 70,200 70,200 70,200 Annual casgh outflows 30,700 30,700 30,700 30,700 30,700 30,700 30,700 Net Annual cash inflows 39,500 39,500 39,500 39,500 39,500 39,500 39,500 Cost to rebuild -49,000 Annual Cash flow -1,70,000 39,500 39,500 39,500 -9,500 39,500 39,500 39,500 Discount factor @ 5% 1.00000 0.95238 0.90703 0.86384 0.82270 0.78353 0.74622 0.71068 Present Value -1,70,000 37,619 35,828 34,122 -7,816 30,949 29,476 28,072 $ 18,249 b. Intial Cost 1,70,000 Net Present Value $ 18,249 Present Value of cash inflows 1,88,249 c. Present Value of cash inflows 1,88,249 / Initial cost 1,70,000 Profitabiity Index 1.11 d. Net Present Value at 5% $ 18,249 Net Present Value at 10% $ -11,165 Internal Rate of return = 5%+(10%-5%)*(18249/(18249+11165)) = 8% Year 0 1 2 3 4 5 6 7 Total Initial Cost -1,70,000 Annual Cash inflows 70,200 70,200 70,200 70,200 70,200 70,200 70,200 Annual casgh outflows 30,700 30,700 30,700 30,700 30,700 30,700 30,700 Net Annual cash inflows 39,500 39,500 39,500 39,500 39,500 39,500 39,500 Cost to rebuild -49,000 Annual Cash flow -1,70,000 39,500 39,500 39,500 -9,500 39,500 39,500 39,500 Discount factor @ 10% 1.00000 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447 0.51316 Present Value -1,70,000 35,909 32,645 29,677 -6,489 24,526 22,297 20,270 $ -11,165 Option B: a. Year 0 1 2 3 4 5 6 7 Total Initial Cost -2,93,000 Annual Cash inflows 83,000 83,000 83,000 83,000 83,000 83,000 83,000 Annual casgh outflows 25,600 25,600 25,600 25,600 25,600 25,600 25,600 Net Annual cash inflows 57,400 57,400 57,400 57,400 57,400 57,400 57,400 Salvage Value 7,800 Annual Cash flow -2,93,000 57,400 57,400 57,400 57,400 57,400 57,400 65,200 Discount factor @ 5% 1.00000 0.95238 0.90703 0.86384 0.82270 0.78353 0.74622 0.71068 Present Value -2,93,000 54,667 52,063 49,584 47,223 44,974 42,833 46,336 $ 44,681 b. Intial Cost 2,93,000 Net Present Value $ 44,681 Present Value of cash inflows 3,37,681 c. Present Value of cash inflows 3,37,681 / Initial cost 2,93,000 Profitabiity Index 1.15 d. Net Present Value at 5% $ 44,681 Net Present Value at 10% $ -9,550 Internal Rate of return = 5%+(10%-5%)*(44681/(44681+9550) = 9% Year 0 1 2 3 4 5 6 7 Total Initial Cost -2,93,000 Annual Cash inflows 83,000 83,000 83,000 83,000 83,000 83,000 83,000 Annual casgh outflows 25,600 25,600 25,600 25,600 25,600 25,600 25,600 Net Annual cash inflows 57,400 57,400 57,400 57,400 57,400 57,400 57,400 Salvage Value 7,800 Annual Cash flow -2,93,000 57,400 57,400 57,400 57,400 57,400 57,400 65,200 Discount factor @ 10% 1.00000 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447 0.51316 Present Value -2,93,000 52,182 47,438 43,125 39,205 35,641 32,401 33,458 $ -9,550