Carolina Clinic is considering investing in new heart monitoring equipment. It h

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

Instructions
(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.)

Explanation / Answer

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

(1) net present value,

(40000 x5.1462---60000x.65873 ) 166321

(50000 x5.1462+ 12000x.43393 ) 280,518

LESS INITIAL INVESTMNET 160000 227,000

net present value, 6,321 53,518

(2) profitability index,

1.04, 1.24

(3)internal rate of return for each option

4, 4.54

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