Case Study-Making Norwich Tool's 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 (CFo) $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.
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 solid-state 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.
TO DO:
Question 1: Use the payback period to assess the acceptability and relative ranking of each lathe.
Question 2: Assuming equal risk, use the following sophisticated capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
(A) Net present value (NPV).
(B) Internal rate of return (IRR).
Question 3: 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 unlim-ited funds and (2) if the firm has capital rationing.
Question 4: 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.
Question 5: What effect, if any, does recognition of lathe A's greater risk in part d have on your recommendation in part c?