Problem:
Making Norwich Tools Lathe Investment Decision. 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, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.
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
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. Mario believes that the two lathes are equally risky and that the acceptance of either of them will not change the firms overall risk. He therefore decides to apply the firms 13% cost of capital when analyzing the lathes. Norwich Tool requires all projects to have a maximum payback period of 4.0 years.
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
(2) if the firm has capital rationing.