Brooks 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 8%. Option A Option B
Initial cost $160,000 $227,000
Annual cash inflows $71,000 $80,000
Annual cash outflows $30,000 $31,000
Cost to rebuild (end of year 4) $50,000 $0
Salvage value $0 $8,000
Estimated useful life 7 years 7 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?