Norwich Tool case solution

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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.

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