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# 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.

(Note: Click on the icon here to copy the contents of the data table below into a spreadsheet.)

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 believes 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 13.0% cost of capital when analyzing the lathes. Norwich Tool requires all projects to have a maximum payback period of 4.0 years.

**Tasks:**

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?

d. Draw the net present value profiles for both projects on the same set of axes, and discuss any conflict in rankings that may exist between NPV and IRR. Explain any observed conflict in terms of the relative differences in the magnitude and timing of each project's cash flows.

e. Use your findings in parts (a) through (d) to indicate, on both:
1. A theoretical basis.
2. A practical basis.

Which lathe would be preferred? Explain any difference in recommendations.

Answer :

The payback period is a financial metric used to assess the time it takes to recover the initial investment in a project. To calculate the payback period, we sum the cash inflows until they equal or exceed the initial investment.



The payback period for lathe A is 3 years.
The payback period for lathe B is 4 years.

Based on the maximum payback period requirement of 4 years set by Norwich Tool, both lathes meet the criteria. Lathe A has a shorter payback period, indicating a quicker recovery of the initial investment compared to lathe B.

b. To assess the acceptability and relative ranking of each lathe using net present value (NPV) and internal rate of return (IRR), we need to discount the cash flows to their present value.

For lathe A, using a 13.0% cost of capital:
[tex]NPV = -150,000 + 40,000/(1+0.13) + 35,000/(1+0.13)^2 + 30,000/(1+0.13)^3 + 25,000/(1+0.13)^4 + 120,000/(1+0.13)^5[/tex]

For lathe B, using a 13.0% cost of capital:
[tex]NPV = -100,000 + 35,000/(1+0.13) + 35,000/(1+0.13)^2 + 30,000/(1+0.13)^3 + 25,000/(1+0.13)^4 + 120,000/(1+0.13)^5[/tex]

c. Summarize the preferences indicated by the techniques used in parts (a) and (b).

Based on the payback period analysis in part (a), lathe A has a shorter payback period and is preferred over lathe B.

In part (b), by calculating the NPV and IRR, we can compare the profitability and return on investment for both lathes. If the NPV is positive and the IRR is higher than the cost of capital (13.0%), the project is acceptable.

d. To draw the net present value (NPV) profiles for both projects on the same set of axes, we plot the NPV against the discount rate (cost of capital) for a range of discount rates. We can then identify the discount rate at which the NPV becomes zero, which is the internal rate of return (IRR).

The NPV profile for lathe A may intersect the x-axis (zero NPV) at a higher discount rate compared to lathe B. This means that the IRR for lathe A may be higher than lathe B. However, the NPV at the cost of capital (13.0%) should still be positive for both lathes.

e. Based on the findings in parts a through d, on both a theoretical basis and a practical basis, we can indicate which lathe would be preferred.

The theoretical basis would favor lathe A due to its shorter payback period and potentially higher IRR. Lathe A offers a quicker recovery of the initial investment and potentially higher returns.

To know more about cash inflows visit:

https://brainly.com/question/10714011

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