Question

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

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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. 12.50. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

		Net Present Value		Profitability Index		Internal Rate of Return
Option A		$				%
Option B		$				%

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Which option should be accepted? Option BOption A should be accepted.

Answer 1

Option B should be selected as it has higher NPV, PI, IRR