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Planning for capital investments

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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

Compute net present value, profitability index, and internal rate of return.


(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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Solution Summary

The solution explains how to decide which capital investment should be accepted