Mar Vista Company is considering investing in new equip. Option A would have an
ID: 2496800 • Letter: M
Question
Mar Vista Company is considering investing in new equip. Option A would have an initial lower cost but would require a significant expenditure for rebuilding after three years. Option B would require no rebuilding expenditure, but maintenance costs would be higher. Since 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:
Option A Option B
Initial cost: $53,000 $58,000
Annual cash inflow: $30,000 $30,000
Annual cash outflows: $15,000 $18,000
Cost to Rebuild: $12,000 -0-
Salvage Value: $ -0- $10,000
Estimated useful life: 6 years 6 years
The company's cost of capital is 8%
a.1) Compute the net present value
a.2) Compute profitablilty index
a.3) Compute internal rate of return
b.) Which option should be accepted?
Explanation / Answer
Working Notes:
(1) Annual net cash inflow = Annual cash inflow - Annual cash outflow
Option A: $(30,000 - 15,000) = $15,000
Option B: $(30,000 - 18,000) = $12,000
(2) For option B, terminal year (year 6) will have additional cash inflow of $10,000 (Salvage).
Year 6 net cash inflow = $(12,000 + 10,000) = $22,000
(3) For option A, Year 3 has an additional cash outflow of $12,000 (re-buid cost).
Year 3 net cash inflow = $(15,000 - 12,000) = $3,000
(4) NPV = Sum of present values of all Net cash inflows, discounted at 8%
(5) Profitability Index, PI = PV of net cash inflows / Initial investment
(6) IRR is found out using Excel formula [=IRR()]
(a)
(i) NPV
Option A: $6,817
Option B: $3,776
(ii) PI
Option A: $(59,817 / 53,000) = 1.13
Option B: $(61,776 / 58,000) = 1.07
(iii) IRR
Option A: 12.09%
Option B: 9.95%
(b)
Both options have NPV > 0, IRR > Cost of capital & PI > 1. But option A has higher NPV, higher IRR & higher IRR. So A should be chosen.
Option A Year Net Cash Inflow ($) Discount Factor @8% Discounted Net Cash Inflow ($) 0 -53,000 1.0000 -53,000 1 15,000 0.9259 13,889 2 15,000 0.8573 12,860 3 3,000 0.7938 2,381 4 15,000 0.7350 11,025 5 15,000 0.6806 10,209 6 15,000 0.6302 9,453 IRR = 12.09% PV of Net Cash Inflows ($) = 59,817 NPV ($) = 6,817 Option B Year Net Cash Inflow ($) Discount Factor @8% Discounted Net Cash Inflow ($) 0 -58,000 1.0000 -58,000 1 12,000 0.9259 11,111 2 12,000 0.8573 10,288 3 12,000 0.7938 9,526 4 12,000 0.7350 8,820 5 12,000 0.6806 8,167 6 22,000 0.6302 13,864 IRR = 9.95% PV of Net Cash Inflows ($) = 61,776 NPV ($) = 3,776