Chapter 12, Problem 12.3AP

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?