a. Use the payback period to assess the acceptability and relative ranking of each lathe. b. Assuming


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 (IRTQ.

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 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.

a. Use the payback period to assess the acceptability and

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

Net Present Value
What is NPV? The net present value is an important tool for capital budgeting decision to assess that an investment in a project is worthwhile or not? The net present value of a project is calculated before taking up the investment decision at...
Internal Rate of Return
Internal Rate of Return of IRR is a capital budgeting tool that is used to assess the viability of an investment opportunity. IRR is the true rate of return that a project is capable of generating. It is a metric that tells you about the investment...
Capital Budgeting
Capital budgeting is a practice or method of analyzing investment decisions in capital expenditure, which is incurred at a point of time but benefits are yielded in future usually after one year or more, and incurred to obtain or improve the...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Payback Period
Payback period method is a traditional method/ approach of capital budgeting. It is the simple and widely used quantitative method of Investment evaluation. Payback period is typically used to evaluate projects or investments before undergoing them,...
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Principles of managerial finance

ISBN: 978-0132479547

12th edition

Authors: Lawrence J Gitman, Chad J Zutter

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