Carolina Clinic is considering investing in new heart monitoring equipment. It h
ID: 2434886 • Letter: C
Question
Carolina 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 11%.Option A -----------------------------------------------Option B
Initial cost $160,000 ---------------------------------$227,000
Annual cash inflows $75,000----------------------$80,000
Annual cash outflows $35,000--------------------$30,000
Cost to rebuild (end of year 4) $60,000---------$ 0
Salvage value $ 0--------------------------------------$12,000
Estimated useful life 8 years ----------------------8 years
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.)
B) Which option should be accepted?
Explanation / Answer
Net Present value Initial investment 160,000 227,000 Net annual cash inflow 40,000 50,000 Salvage value Nil 12,000 Cost to rebuild 60,000 nil Cost of capital 11% 11% Present value (40000 x5.14612 – 60000 x .65873) 166321 (50000 x 5.14612 + 12000 x .43393) 280,518 Less Initial Investment 160000 227,000 Net Present Value 6,321 53,518 Profitability Index Profitability Index = Present value of net cash flows ÷ initial investment = 166,321 ÷ 160,000 =280,518 ÷ 227000 = 1.04 = 1.24 Internal rate of return Internal rate of return = Capital investment ÷ Net annual cash flows = 160000 ÷ 40000 = 227000 ÷ 50000 = 4.00 = 4.54 = 15% B) Which option should be accepted? In view of net present value and profitability index, Option B should be accepted.