Case study:

Capital Budgeting

Al-Teqaniyah Tool, a large machine shop, plans to replace one of its lathes with either two new lathesthe A or the B lath. Lathe A is a highly digital, computer-controlled lathe; lathe B less costly using standard technology. To evaluate these alternatives, financial analyst Abdullah Hamdan prepared estimates of initial investment and cumulative (relevant) cash inflows associated with each lathe. The following table shows these.

	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 Abdullah 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.

Abdullah 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.

Required:

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. Do the projects have conflicting rankings?

e. Use your findings in parts a through d to indicate, on both (1) a theoretical and (2) a practical basis, which lathe would be preferred. Explain any difference in recommendations.