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 |
|
|
Salvage value |
12,000 |
|
|
Estimated useful |
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.)
(b) Which option should be accepted?