Problem 12-3A Brooks Clinic is considering investing in new heart-monitoring equ
ID: 2478222 • Letter: P
Question
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
$196,000
$291,000
Annual cash inflows
$72,500
$82,500
Annual cash outflows
$28,000
$25,600
Cost to rebuild (end of year 4)
$49,100
$0
Salvage value
$0
$8,500
Estimated useful life
7 years
7 years
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. 10.50. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)
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%.
Explanation / Answer
Project 1 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Cash Inflows 72500 72500 72500 72500 72500 72500 72500 Cash Outflow 196000 28000 28000 28000 28000 77100 28000 28000 Net Cash Inflow -196000 44500 44500 44500 44500 -4600 44500 44500 Present Value Factor 1 0.952 0.907 0.864 0.823 0.784 0.746 0.711 Present Value -196000 42381 40363 38441 36610 -3604 33207 31625 Net Present Value -196000 -153619 -113256 -74815 -38205 -41809 -8603 23022 Net Present Value of Project 1 = 23022 Project 2 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Cash Inflows 82500 82500 82500 82500 82500 82500 82500 Cash Outflow 291000 25600 25600 25600 25600 25600 25600 25600 Net Cash Inflow -291000 56900 56900 56900 56900 56900 56900 56900 Present Value Factor 1 0.952 0.907 0.864 0.823 0.784 0.746 0.711 Present Value -291000 54190 51610 49152 46812 44583 42460 40438 Net Present Value -291000 -236810 -185200 -136047 -89235 -44653 -2193 38245 Net Present Value of Project 2 = 38245