Aqua Tech is considering investing in a new testing device. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 5 year. 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 salvage value at the end of its useful life. The following estimates were provided. The company's cost of capital is 9%. Option A: Initial cost $90,000, Annual cash inflows $180,000, Annual cash outflows $160,000, cost to rebuild(end of year 5) $26,500, Salvage value $0, estimated useful life = 8 years. Option B: Initial cost $170,000, annual cash flows $140,000, Annual cash outflows $108,000, Cost to rebuild (end of year 5) $0, Salvage Value $27,500, Estimated useful life 8 years. Instructions: a) Compute (1) the net present value, (2) profitability index, and (3) internal rate of return for each option. b) Which option should be accepted?

PROBLEM 3 (a) (1) Option A Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows a $20,000 ( (26,500) ( 0) X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($x,xxx) (2) Profitability index = $xx,xxx/$xx,xxx = x.xx (3) The internal rate of return can be approximated by finding the discount rate that results in a net present value of approximately zero. This is accomplished with a xx% discount rate. Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows a $xx,xxx ( (xx,xxx) ( x) X X X X 10% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($ x,xx qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc PROBLEM 3 (Continued) (1) Option B Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows b $xx,xxx x xx,xxx X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value = = = = Present Value $xxx,xxx x xx,xxx xxx,xxx xxx,xxx $xx,xxx (2) Profitability index = $xxx,xxx/$xxx,xxx = x.xx (3) Internal rate of return on Option B is xx%, as calculated below: Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows $xx,xxx x xx,xxx X X X X 12% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = $xxx,xxx = x = xx,xx xxx,xxx xxx,xxx $ xxx (b) qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc PROBLEM 3 (a) (1) Option A Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows a $20,000 ( (26,500) ( 0) X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($x,xxx) (2) Profitability index = $xx,xxx/$xx,xxx = x.xx (3) The internal rate of return can be approximated by finding the discount rate that results in a net present value of approximately zero. This is accomplished with a xx% discount rate. Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows a $xx,xxx ( (xx,xxx) ( x) X X X X 10% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($ x,xx qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc PROBLEM 3 (Continued) (1) Option B Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows b $xx,xxx x xx,xxx X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value = = = = Present Value $xxx,xxx x xx,xxx xxx,xxx xxx,xxx $xx,xxx (2) Profitability index = $xxx,xxx/$xxx,xxx = x.xx (3) Internal rate of return on Option B is xx%, as calculated below: Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows $xx,xxx x xx,xxx X X X X 12% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = $xxx,xxx = x = xx,xx xxx,xxx xxx,xxx $ xxx (b) qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc PROBLEM 3 (a) (1) Option A Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows a $20,000 ( (26,500) ( 0) X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($x,xxx) (2) Profitability index = $xx,xxx/$xx,xxx = x.xx (3) The internal rate of return can be approximated by finding the discount rate that results in a net present value of approximately zero. This is accomplished with a xx% discount rate. Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows a $xx,xxx ( (xx,xxx) ( x) X X X X 10% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = ($xxx,xxx) = ( (xx,xxx) = ( x) (xx,xxx) (xx,xxx) ($ x,xx qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc PROBLEM 3 (Continued) (1) Option B Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Cash Flows b $xx,xxx x xx,xxx X X X X 9% Discount Factor x.xxxxx x.xxxxx x.xxxxx Capital investment Net present value = = = = Present Value $xxx,xxx x xx,xxx xxx,xxx xxx,xxx $xx,xxx (2) Profitability index = $xxx,xxx/$xxx,xxx = x.xx (3) Internal rate of return on Option B is xx%, as calculated below: Present value of net annual cash flows Present value of cost to rebuild Present value of salvage value Capital investment Net present value Cash Flows $xx,xxx x xx,xxx X X X X 12% Discount Factor x.xxxxx x.xxxxx x.xxxxx Present = Value = $xxx,xxx = x = xx,xx xxx,xxx xxx,xxx $ xxx (b) qattachments_7be18f0ff2b83fc1e78d841dff20506246b497f6.doc