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 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. Initial investment (at Year 0) Year (t) Lathe A Lathe B $660,000 $360,000 Cash inflows 128,000 88,000 182,000 120,000 166,000 96,000 168,000 86,000 450,000 207,000 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 believe that the two lathes are equally risky and that the acceptance of either of them will not change the firm's overall risk. He therefore 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. What is the payback period of each lathe? Which lathe should Norwich Tool choose? Why? What is the profitability index of each lathe? Which lathe should Norwich Tool choose? Why? 3. What is the internal rate of return (IRR) of each lathe? Which lathe should Norwich Tool choose? Why? What is the net present value (NPV) of each lathe? Which lathe should Norwich Tool choose? Why? Which lathe should Mario recommend the company to buy? Why? 1 Year 2 Cash flows: Lathe A 3 Cash flows: Lathe B 660,000 $ 360,000 $ 128,000 $ 88,000 $ 182,000 $ 120,000 $ 166,000 $ 96,000 $ 168,000 $ 86,000 $ 450,000 207,000 5 Cost of capital 13% 7 Accumulated cash inflows: Lathe A 8 Payback period: Lathe A 9 Accumulated cash inflows: Lathe B 10 Payback period: Lathe B 11 Which Lathe should Norwich Tool choose? 12 Why? 14 Present value of cash inflows: Lathe A 15 Present value of cash outflows: Lathe A 16 Profitability index: Lathe A 17 Present value of cash inflows: Lathe B 18 Present value of cash outflows: Lathe B 19 Profitability index: Lathe B 20 Which Lathe should Norwich Tool choose? 21 Why? 22 23 Internal rate of return (IRR): Lathe A 24 Internal rate of return (IRR): Lathe B 25 Which Lathe should Norwich Tool choose? 26 Why? 28 Net present value (NPV): Lathe A 29 Net present value (NPV): Lathe B 30 Which Lathe should Norwich Tool choose? 31 Why? 32 33 Which lathe should Mario recommend the company to buy? 34 Why? 2
