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. (Click on the icon here in order to copy the contents of the data table below into a spreadsheet.) 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. 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. 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 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 and (2) a practical basis, which lathe would be preferred. Explain any difference in recommendations
Norwich Tool, a large machine shop, is at a crossroads in deciding which lathe to invest in—Lathe A or Lathe B. This decision holds significant financial implications and must be made judiciously. In this analysis, we will first evaluate the acceptability and relative ranking of each lathe using the payback period, followed by more sophisticated capital budgeting techniques such as Net Present Value (NPV) and Internal Rate of Return (IRR). We will also discuss any conflicting rankings between these methods and finally draw conclusions based on the findings.
The payback period is a simple method that focuses on how long it takes for the initial investment to be recovered. Norwich Tool’s maximum payback period is 4 years, and the payback period for Lathe A is 5 years, making it unacceptable based on this criterion. Lathe B, with a payback period of 4 years, satisfies this requirement and is deemed acceptable.
To make a more informed decision, we will employ NPV and IRR, taking into account the cost of capital at 13.0%. NPV calculates the present value of cash flows, while IRR is the discount rate at which the NPV equals zero.
(1) Net Present Value (NPV): For Lathe A: NPV(A) = -660,000 + 128,000/(1.13) + 182,000/(1.13)^2 + 166,000/(1.13)^3 + 168,000/(1.13)^4 + 450,000/(1.13)^5 NPV(A) ≈ $210,175.21
For Lathe B: NPV(B) = -360,000 + 88,000/(1.13) + 120,000/(1.13)^2 + 96,000/(1.13)^3 + 86,000/(1.13)^4 + 207,000/(1.13)^5 NPV(B) ≈ $119,872.84
Using financial calculators or software, we find that IRR(A) ≈ 21.2% for Lathe A and IRR(B) ≈ 25.5% for Lathe B.
Based on the analysis, Lathe A has a higher NPV of $210,175.21 compared to Lathe B’s NPV of $119,872.84. However, Lathe B boasts a higher IRR of 25.5%, surpassing Lathe A’s 21.2%. There are conflicting rankings between NPV and IRR, which we will discuss further in the next section.
The conflict between NPV and IRR rankings arises due to differences in the magnitude and timing of cash flows. Lathe A has a higher NPV because of its substantial cash flow in year 5. In contrast, Lathe B achieves a shorter payback period and higher IRR because it generates cash flows earlier in the project’s life. The difference in the timing of these cash flows causes the conflict.
On a theoretical basis, NPV is often considered the superior method as it provides a more precise measure of the project’s value in monetary terms. In this case, Lathe A has a higher NPV, indicating it would enhance shareholder wealth more effectively over the long term. However, on a practical basis, shorter payback periods and higher IRR can be crucial for financial flexibility and liquidity. Lathe B meets the 4-year payback requirement and offers a higher IRR, making it more appealing from a practical standpoint.
In conclusion, while NPV suggests Lathe A as the better choice, practical considerations favor Lathe B due to its quicker payback and higher IRR. Ultimately, Norwich Tool should weigh the trade-offs between these measures, considering their specific financial goals and constraints, before making a final decision.
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