Problem: 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
Hint:
Compute net present value, profitability index, and internal rate of return.
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?