Norwich Tool

Year Lathe A Lathe B

0 $660,000 $360,000
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

a)
Payback Schedule - Lathe A
Beginning Unrecovered Ending Unrecovered
Year Cash Inflow
Investment Investment
0 $660,000 $0 $660,000
1 $660,000 $128,000 $532,000
2 $532,000 $182,000 $350,000
3 $350,000 $166,000 $184,000
4 $184,000 $168,000 $16,000
5 $16,000 $450,000 ($434,000)

Payback Period 4.04

Lathe A will be rejected since the payback is longer than the 4-year maximum accepted, and lathe B is accept
payback period is less than the 4-year payback cutoff.

b)
NPV Analysis - Lathe A
Year Cash Flow PV Factor @13% PV
0 ($660,000) 1 ($660,000)
1 $128,000 0.8850 $113,274
2 $182,000 0.7831 $142,533
3 $166,000 0.6931 $115,046
4 $168,000 0.6133 $103,038
5 $450,000 0.5428 $244,242

NPV $58,132.88
IRR 15.95%

Under the NPV rule both lathes are acceptable since the NPVs for A and B are greater than zero. Lathe A ra
has a larger NPV. The same accept decision applies to both projects with the IRR, since both IRRs are greate
capital. However, the ranking reverses with the 17% IRR for B being greater than the 16% IRR for lathe A.
Under the NPV rule both lathes are acceptable since the NPVs for A and B are greater than zero. Lathe A ra
has a larger NPV. The same accept decision applies to both projects with the IRR, since both IRRs are greate
capital. However, the ranking reverses with the 17% IRR for B being greater than the 16% IRR for lathe A.

c)

Both projects have positive NPVs and IRRs above the firm's cost of capital. Lathe A, however, exceeds the m
period requirement.Because it is so close to the 4-year maximum and this is an unsophisticated capital budget
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 maxim
value. If the firm is subject to capital rationing, Lathe B, with its shorter payback period and higher IRR, sho
IRR considers the relative size of the investment, which is important in a capital rationing situation

d)
Discount Rate NPV A NPV B
0% $434,000 $237,000
NP
5% $261,182 $148,524 $500,000
10% $125,656 $78,570
15% $17,854 $22,467 $400,000
20% ($69,016) ($23,115)
$300,000
25% ($139,859) ($60,593)
30% ($198,269) ($91,744)
$200,000

Lathe B is preferred over lathe A based on the IRR. $100,000

NPV

However, as can be seen in the NPV profile, to the left of

the cross-over point of the two lines lathe A is preferred. $0
The underlying cause of this conflict in rankings arises
from the reinvestment assumption of NPV versus IRR.
NPV assumes the intermediate cash flows are reinvested at ($100,000)
the cost of capital, while the IRR has cash flows being
reinvested at the IRR. The difference in these two rates ($200,000)
and the timing of the cash flows will determine the cross-
over point. ($300,000)
0% 5% 10
D

e)
On a theoretical basis lathe A should be preferred because of its higher NPV
and thus its known impact on shareholder wealth. From a practical
perspective lathe B may be selected due to its higher IRR and its faster
payback. 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.
On a theoretical basis lathe A should be preferred because of its higher NPV
and thus its known impact on shareholder wealth. From a practical
perspective lathe B may be selected due to its higher IRR and its faster
payback. 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.
 Payback Schedule - Lathe B
Beginning Unrecovered Ending Unrecovered
Year Cash Inflow
Investment Investment
0 $360,000 $0 $360,000
1 $360,000 $88,000 $272,000
2 $272,000 $120,000 $152,000
3 $152,000 $96,000 $56,000
4 $56,000 $86,000 ($30,000)

Payback Period 3.65

ccepted, and lathe B is accepted because the project

NPV Analysis - Lathe B

Year Cash Flow PV Factor @13% PV
0 ($360,000) 1 ($360,000)
1 $88,000 0.8850 $77,876
2 $120,000 0.7831 $93,978
3 $96,000 0.6931 $66,533
4 $86,000 0.6133 $52,745
5 $207,000 0.5428 $112,351

NPV $43,483.24
IRR 17.34%

reater than zero. Lathe A ranks ahead of B since it

R, since both IRRs are greater than the 13% cost of
han the 16% IRR for lathe A.
 reater than zero. Lathe A ranks ahead of B since it
R, since both IRRs are greater than the 13% cost of
han the 16% IRR for lathe A.

he A, however, exceeds the maximum payback

nsophisticated capital budgeting technique, Lathe
ince it has a much higher NPV.

V, Lathe A, in order to maximize shareholder

ck period and higher IRR, should be chosen. The
rationing situation

NPV Profile
0,000

0,000

0,000

0,000

0,000 Column B
Column C
$0

,000)

,000)

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0% 5% 10% 15% 20% 25% 30%
Discount Rate