Problem 26-7A LINK TO TEXT LINK TO TEXT Problem 26-7A Brooks Clinic is consideri

Question

Problem 26-7A

LINK TO TEXT

LINK TO TEXT

Problem 26-7A

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 6%.
Option A Option B Initial cost $173,000 $267,000 Annual cash inflows $70,800 $80,100 Annual cash outflows $29,100 $25,900 Cost to rebuild (end of year 4) $51,500 $0 Salvage value $0 $7,000 Estimated useful life 7 years 7 years
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Click here to view PV of Annuity table.

Explanation / Answer

Solution 1:

Solution 2:

For IRR calculation let calculate NPV of option A at 9% and 10%, NPV for option B at 10% and 11%

IRR option A = 9% + $390.23 / ($390.23 + $5,162.13) = 9.07%

IRR option B = 10% + $460.41 ( $460.41 + $8,227.35) = 10.05%

Therefore Option B should be accepted as its IRR and NPV both are higher.

Compuation of NPV Particulars Period PV Factor Option A Option B Amount Present value Amount Present value Cash Outflows: Initial Cost 0 1 $173,000.00 $173,000.00 $267,000.00 $267,000.00 Annual cash outflows 1-7 5.582381 $29,100.00 $162,447.30 $25,900.00 $144,583.68 Cost to rebuild 4 0.792094 $51,500.00 $40,792.82 $0.00 $0.00 Present value of cash outflows (A) $376,240.12 $411,583.68 Cash Inflows: Annual Cash Inflows 1-7 5.582381 $70,800.00 $395,232.61 $80,100.00 $447,148.75 Salvage Value 7 0.665057 $0.00 $0.00 $7,000.00 $4,655.40 Present Value of cash inflows (B) $395,232.61 $451,804.15 NPV (B-A) $18,992.48 $40,220.47

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