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XYZ Co. is considering two options for a new machine:
Option A has a lower initial cost but requires rebuilding after 4 years, while Option B has higher initial and maintenance costs but no rebuilding and a salvage value.
Calculating the net present value and profitability index shows Option B has a higher NPV of $35,513 and profitability index of 1.0931, so Option B should be accepted.
XYZ Co. is considering two options for a new machine:
Option A has a lower initial cost but requires rebuilding after 4 years, while Option B has higher initial and maintenance costs but no rebuilding and a salvage value.
Calculating the net present value and profitability index shows Option B has a higher NPV of $35,513 and profitability index of 1.0931, so Option B should be accepted.
XYZ Co. is considering two options for a new machine:
Option A has a lower initial cost but requires rebuilding after 4 years, while Option B has higher initial and maintenance costs but no rebuilding and a salvage value.
Calculating the net present value and profitability index shows Option B has a higher NPV of $35,513 and profitability index of 1.0931, so Option B should be accepted.
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 companys 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 Instructions (a) Compute the (1) net present value, (2) profitability index, (b) which option should be accepted?
Solution: Option Initial Cost Annual Cash Inflow Annual Cash Outflow Cost of Rebuild Salvage Value Useful Life Option A 160000 75000 35000 60000 0 8 yrs Option B 227000 80000 30000 0 12000 8 yrs
Calculation of Net Present Value: Option A Particulars Amount Discount Factor Discounted Cash flow Initial Cash Outflow 160000 1 160000 Annual Cash Outflow (year 1-8) 35000 5.146123 180114 Cost of Rebuild (Year 4) 60000 0.658731 39524 Total PV of Cash Outflow 379638 Annual cash Inflow 75000 5.146123 385959 Total PV of Cash Inflow 385959 Net Present Value 6321
Calculation of Net Present Value: Option B Particulars Amount Discount Factor Discounted Cash flow Initial Cash Outflow 227000 1 227000 Annual Cash Outflow (year 1-8) 30000 5.146123 154384 Total PV of Cash Outflow 381384 Annual cash Inflow 80000 5.146123 411690 Salvage Value (Year 8) 12000 0.433926 5207 Total PV of Cash Inflow 416897 Net Present Value 35513
2.Profitability Index: Profitability Index = PV of Cash Inflow/PV of Cash Outflow So, Profitability Index of A = 385959/379638 = 1.0167 So, Profitability Index of B = 416897/381384 = 1.0931
b) Option B must be selected, as it has higher Profitability and higher Net Present Value.