Problem:
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.
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