Stratton Testing is considering investing in a new testing device. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 5 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 provided. The company’s cost of capital is 9%.
|
Option A |
Option B |
|
|
Initial cost |
$90,000 |
$170,000 |
|
Net annual cash flows |
$20,000 |
$32,000 |
|
Cost to rebuild (end of year 5) |
$26,500 |
$0 |
|
Salvage value |
$0 |
$27,500 |
|
Estimated useful life |
8 years |
8 years |
Instructions
(a) Compute the (1) net present value, and (2) 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.)
(b) Which option should be accepted?