Problem 24-3A (part level submission) (a) Problem 24-3A (part level submission)

Question

Problem 24-3A (part level submission)

(a)

Problem 24-3A (part level submission)

Goltra 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 7%.
Option A Option B Initial cost $184,000 $257,000 Annual cash inflows $71,500 $80,700 Annual cash outflows $28,900 $25,300 Cost to rebuild (end of year 4) $50,900 $0 Salvage value $0 $8,900 Estimated useful life 7 years 7 years

Click here to view the factor table.

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

Explanation / Answer

Calculation of NPV:- P.V. of cash inflow - P.V. of cash outflow

Option A:-

   Calculation of P.V. of cash inflow:-

Net cash flow each year = (71500 - 28900) = $ 42600

Cumulative P.V. Factor @ 7 % for seven years = 5.38929

Cumulative P.V. of cash inflow = 5.38929 * 42600 = $ 229583.754 (A)

P.V. Factor @ 7 % for fourth year = 0.76290

P.V. of cash outflow in fourth year (Cost to rebuild) = 50900 * 0.76290 = $ 38831.61 (B)

     Total P.V. of Cash inflow = 229583.754 - 38831.61

= $ 190752.144

NPV = 190752.144 - 184000

= $ 6752.144 i.e., $ 6752 (approx)

   Profitabiliti index = Total P.V. of cash inflow / Total P.V. of cash outflow

= 190752.144 / 184000

= 1.04 (approx)

Option B:-

   Calculation of P.V. of cash inflow:-

Net cash flow each year = (80700 - 25300) = $ 55400

Cumulative P.V. Factor @ 7 % for seven years = 5.38929

Cumulative P.V. of cash inflow = 5.38929 * 55400 = $ 298566.666 (C)

P.V. Factor @ 7 % for Seventh year = 0.62275

P.V. of cash inflow in seventh year (Salvage value) = 8900 * 0.62275 = $ 5542.475 (D)

     Total P.V. of Cash inflow = 298566.666 + 5542.47 [(C) + (D) ]

= $ 304109.141

NPV = 304109.141 - 257000

= $ 47109.141 i.e., $ 47109 (approx)

   Profitabiliti index = Total P.V. of cash inflow / Total P.V. of cash outflow

= 304109.141 / 257000

= 1.18 (approx)

Conclusion:-

  

Options Net present value (NPV) Profitability Index Option A $ 6752 1.04 Option B $ 47109 1.18

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