CASE: MAKING NORWICH TOOLS LATHE

INVESTMENT DECISIONS

PAR T A:

PAYBACK PERIOD

years

cash

flows

0

1

2

3

4

5

(660,000)

128,000

182,000

166,000

168,000

450,000

PBPA

LATHE A

cumulative cash

flows

cash

flows

LATHE B

cumulative cash

flows

128,000

310,000

476,000

644,000

1,094,000

(360,000)

88,000

120,000

96,000

86,000

207,000

88,000

208,000

304,000

390,000

597,000

4.04

PBPB

3.65

ACCEPTABILTY OF EACH PROJECT:

Lathe A will be rejected because it¶s payback period is longer than 4 years maximum expected payback period

4.04years > 4years

Lathe B project is accepted because it payback period is less than the 4 year maximum payback period

3.65years < 4 years

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PART B:

NPV &IRR

LATHE A NPV & IRR

years

0

1

2

3

4

5

cash flow

(660,000)

128,000

182,000

166,000

168,000

450,000

cash flows

(360,000)

88,000

120,000

96,000

86,000

207,000

LATHE B NPV & IRR

PV Factor

@13%

1

0.885

0.783

0.693

0.613

0.543

PV Factor @13%

1

0.885

0.783

0.693

0.613

0.543

PV

(660,000)

113,274

142,533

115,046

103,038

244,242

PV

(360,000)

77,876

93,978

66,533

52,745

112,351

NPVA

58,133

NPVB

43,483

IRRA

16%

IRRB

17%

ACCEPTABILTY OF EACH PROJECT:

Under the NPV calculations both projects are acceptable because NPV of both project is positive or we can say greater than zero.

y

y

NPV LATHE A:

NPV LATHE B:

58,133 >

43,483 >

0

0

Lathe A has a larger NPV than B so it is preferable.

IRRs of both projects are greater than the 13% cost of capital so both project are acceptable. However, 17% IRR for B is greater than the 16% IRR for lathe A so it is B is preferable.

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PART 3:

SUMMARY:

LATHE A

LATHE B

PBP

4.04 years

3.65 years

NPV

58,133

43,483

IRR

16%

17%

Both projects have positive NPVs and IRRs above the firm's cost of capital. Lathe A, however, exceeds the maximum payback period requirement. Because it is so close to the 4-year maximum and this is an unsophisticated capital budgeting technique, Lathe A should not be eliminated from consideration on this basis alone, particularly since it has a much higher NPV. If the firm has unlimited funds, it should choose the project with the highest NPV, Lathe A, in order to maximize shareholder value. If the firm is subject to capital rationing, Lathe B, with its shorter payback period and higher IRR, should be chosen. The IRR considers the relative size of the investment, which is important in a capital rationing situation. PART: 4:

NPV PROFILE

discount rate

0%

5%

10%

15%

20%

NPV A

$434,000

$261,182

$125,656

$17,854

($69,016)

NPV B

237,000

148,524

78,570

22,467

(23,115)

25%

($139,859)

(60,593)

30%

($198,269)

(91,744)

$500,000

$400,000

$300,000

CROSS OVER

POINT

NPV

$200,000

NPV A

$100,000

NPV B

$0

0%

5%

10%

15%

20%

25%

30%

-$100,000

-$200,000

-$300,000

DISCOUNT RATE

PART 5:

y

Theoretical Basis:

On a theoretical basis lathe A should be preferred because it has a higher NPV and thus it has a good impact on shareholder wealth.

y

Practical Basis:

On a practical basis lathe B may be selected because it has a higher IRR and r payback period less than the maximum 4 year period.

This difference results from managers preference for evaluating decisions based on percent returns rather than dollar returns, and on the desire to get a return of cash flows as quickly as possible.