Case Scenario:
Norwich Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes—lathe A or lathe B. Lathe A is a highly automated, computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mario Jackson, a financial analyst inflows associated with each lathe. These are shown in the following table.
Note that Mario plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows.
One of Mario’s dilemmas centered on the risk of the two lathes. He believes that although the two lathes are equally risky, lathe A has a much higher chance of breakdown and repair because of its sophisticated and not fully proven solidstate electronic technology. Mario is unable to quantify this possibility effectively, so he decides to apply the firm’s 13% cost of capital when analyzing the lathes.
Norwich Tool requires all projects to have a maximum payback period of 4.0 years.
Lathe A Lathe B
Initial investment (CF0) $660,000 $360,000
Year (t) Cash inflows (CFt)
1 $128,000 $ 88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000
TO DO:
a. Use the payback period to assess the acceptability and relative ranking of each lathe.
b. Assuming equal risk, use the following sophisticated capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
(1) Net present value (NPV).
(2) Internal rate of return (IRR).
c. Summarize the preferences indicated by the techniques used in parts a and b, and indicate which lathe you recommend, if either, (1) if the firm has unlimited funds and (2) if the firm has capital rationing.
d. Repeat part b assuming that Mario decides that because of its greater risk, lathe A’s cash inflows should be evaluated by using a 15% cost of capital.
e. What effect, if any, does recognition of lathe A’s greater risk in part d have on your recommendation in part c?