The Construction Company is considering the purchase of a new tunnel-boring machine. It has two options:

Option A: The cost is $1,000,000, with a useful life of 4 years and an estimated residual value of $0.

Option B: The cost is $1,500,000, with a useful life of 4 years and an estimated residual value of $0.

Currently, the company rents a tunnel-boring machine. If the machine is purchased, annual rental payments of $400,000 would be saved. Option B would save this same amount, and would have an additional savings in labor costs of $100,000 each year, because of the greater capabilities of that machine.

REQUIRED

a. Compute the payback period of each option. (4 points)

b. Calculate the net present value of each option assuming a cost of capital of 8%. The present value factor of an annuity for 4 years at 8% is 3.3121. (4 points)

c. Determine the profitability index assuming a cost of capital of 8%. (4 points)

d. Based on the above analysis, which option should the company pursue, and why? (2 points)