Question

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Net Present Value and Competing Projects For discount factors use Exhibit 123.1 and Exhibit 120.2. Spiro Hospital is investigating the possibility of investing in new dialysis equipment. Two local manufacturers of this equipment are being considered as sources of the equipment. After-tax cash inflows for the two competing projects are as follows: Puro Equipment $320,000 Briggs Equipment $120,000 120,000 320,000 280,000 240,000 160.000 400,000 120,000 440,000 Both projects require an initial investment of $560,000. In both cases, assume that the equipment has a life of 5 years with no salvage value Required: Round present value calculations and your final answers to the nearest dollar. 1. Assuming a discount rate of 9%, compute the net present value of each piece of equipment, Puro equipment: Briggs equipment: 2. A third option has surfaced for equipment purchased from an out-of-state supplier. The cost is also $560,000, but this equipment will produce even cash flows over its 5-year life. What must the annual cash now be for this equipment to be selected over the other two? Assume a 9% discount rate.

Answer 1

Solution

Spiro Hospital

1. Assuming a discount rate of 9%, computation of the net present value of each piece of equipment:

Puro Equipment	$345,904
Briggs Equipment	$467,512

Computations:

Puro Equipment
Year	Cash Flow	Discount Factor at 9% (P/F)	Present Value
0	($560,000)	1	($560,000)
1	$320,000	0.9174	$293,568
2	$280,000	0.8417	$235,676
3	$240,000	0.7722	$185,328
4	$160,000	0.7084	$113,344
5	$120,000	0.6499	$77,988
NPV			$345,904
Briggs Equipment
Year	Cash Flows	Discount Factor at 9% (P/F)	Present Value
0	($560,000)	1	($560,000)
1	$120,000	0.9174	$110,088
2	$120,000	0.8417	$101,004
3	$320,000	0.7722	$247,104
4	$400,000	0.7084	$283,360
5	$440,000	0.6499	$285,956
NPV			$467,512

2. Computation of desired annual cash flow for the equipment to be selected over the other two, assuming a 9% discount rate:

Net present value = present value of cash inflows – present value of cash outflows

NPV = [total annual cash inflows for 5 years x (3.89)] – ($560,000 x 1.000)

Since, Briggs equipment has higher NPV, the annual cash inflows for new equipment must exceed the NPV of Briggs equipment to get selected.

Considering the NPV of Briggs equipment,

$467,512 = Cash flows x 3.89 - $560,000

Cash flows x 3.89 = $1,027,512

Cash flows = $1,027,512/3.89= $264,142

Desired annual cash flows must be higher than $264,142.

Hence, the annual cash flow for the third equipment must be higher than $264,142 to get selected over the other two.