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.)
(a) (1)NPV A $6,321
(3)IRR B 15%
(b)Which option should be accepted?