Question 1. You own $100,000 worth of Smart Money Stock. One year from now, you will receive a dividend of $2 per share. You will receive a $4 dividend two years from now. You will sell the stock for $50 per share three years from now. Dividends are taxes at the rate of 28%. Assume there is no capital gains tax. The required rate of return is 15%. How many shares of stock do you own?
Question 2: Norwich Tool, a large machine shop is considering replacing one of its lathes with either of two new lathes – Lathe A and 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 the following table:
Lathe A Lathe B
Initial investment $660,000 $360,000
Year(t) Cash inflows (CF)
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-year cash inflows.
One of Mario’s major dilemmas centered on the risk of the two lathes. He feels that although the two lathes have similar risk, lathe A has a much higher chance of breakdown and repair due to its sophisticated and not fully proven sol-d state electronic technology. Because he is unable to effectively quantify this possibility, Mario decided to apply the firm’s 13 percent cost of capital when analyzing the lathes. Norwich Tools requires are projects to have a maximum pay-back period of 4.0 years.
Required 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 a and b, and indicate which lathe you recommend, if either, if the firm has (1) unlimited funds or (2) capital rationing.
d. Repeat part b assuming that Mario decides that, due to its greater risk, lathe A’s cash inflows should be evaluated by using 15 percent cost of capital.
e. What effect, if any, does recognition of lathe A’s greater risk in d have on your recommendation in c?