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 |
(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?
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