analsis

1. XYZ Co. is considering investing in new Machine. 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
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

2. 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.