Problem:
Dr. David Dunn, head of the radiology department at Grant Clinic Inc., is adding a new piece of diagnostic equipment to the department. Two similar models are offered by two different vendors, and both models would serve the needs of the clinic. Both also have an estimated useful life of five years, with no salvage value at the end of five years. The only difference between the two models is the cost and estimated annual labor savings, as shown below:
Model A Model B
Cost, including installation $120,000 $110,000
Estimated annual labor savings $40,000 $32,000
The straight-line method of depreciation is used on the books. Senior management of the clinic has established a target rate of return of 15% for all equipment with a useful life of over two years and a desired payback period of three years.
Prepare an evaluation showing your recommendation, based on the scenario, for Dr. Dunn's purchase. Include calculations for each model using the following techniques and ignoring income taxes:
Payback method
Net present value (NPV)
Internal rate of return (cost of capital)